AAIPHARMA INC - 10-K Annual Report

Back to GetFilings.com

- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 0-21185

AAIPHARMA INC.
(Exact name of Registrant as specified in its charter)

DELAWARE 04-2687849
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)

2320 SCIENTIFIC PARK DRIVE, WILMINGTON, NC 28405
(Address of principal executive office) (Zip code)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:
(910) 254-7000

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

COMMON STOCK, $0.001 PAR VALUE PER SHARE
(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K of any
amendment to this Form 10-K. [ ]

The number of shares outstanding of the Registrant's common stock, as of
January 31, 2002 was 18,034,068 shares. The aggregate market value for the
voting stock held by non-affiliates of the Registrant on January 31, 2002 was
approximately $176,218,175.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the 2002 annual meeting of
stockholders are incorporated by reference in Part III hereof.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

PART I

ITEM 1. BUSINESS

The terms "we", "us" or "our" in this Form 10-K include aaiPharma Inc., its
corporate predecessors and its subsidiaries, except where the context may
indicate otherwise. Our corporation was incorporated in 1986, although its
corporate predecessor was founded in 1979. In 1999, we merged with Medical &
Technical Research Associates, Inc.

TRADEMARKS AND TRADE NAMES

We own the following registered and unregistered trademarks: M.V.I.(R),
M.V.I.-12(R), M.V.I.-Pediatric(TM), Aquasol A(R), Aquasol E(R), Aquasol D(TM),
Brethine(R), ProSorb(R), ProSLO(TM), ProSLO II(TM), ProCore(TM), ProSpher(TM),
ProLonic(TM), ProMelt(TM), NeoSan(TM), AzaSan(TM), aaiPharma(TM), and AAI(R). We
also reference trademarks owned by other companies. Darvon(R), Darvon-N(R) and
Darvocet-N(R) are registered trademarks of Eli Lilly and Company, and we
reference these trademarks in this report with its permission. References in
this document to Darvon are to Darvon(R) and Darvon-N(R) collectively and
references to Darvocet are to Darvocet-N(R). Following our pending acquisition
of these branded product lines from Eli Lilly, as described below, we will own
the Darvon(R), Darvon-N(R) and Darvocet-N(R) trademarks in the U.S. Cataflam(R)
is a registered trademark of Novartis Corporation, Infuvite(R) is a registered
trademark of Sabex Inc., Oxycontin(R) is a registered trademark of Purdue Pharma
L.P., Prilosec(R) is a registered trademark of AstraZeneca AB, Proventil(R) is a
registered trademark of Schering Corporation, Prozac(R) is a registered
trademark of Eli Lilly and Company, and Volmax(R) is a registered trademark of
GlaxoSmithKline. All references in this document to any of these terms lacking
the "(R)" or "(TM)" symbols are defined terms that reference the products,
technologies or businesses bearing the trademarks with these symbols.

OVERVIEW

We are a specialty pharmaceutical company focused on the acquisition,
development, enhancement and commercialization of branded pharmaceutical
products. We have over 20 years of pharmaceutical research and development
experience, with operations primarily in the United States and Europe.
Historically, we have generated our revenues by providing a comprehensive
spectrum of pharmaceutical research and development services on a
fee-for-service basis to a broad base of customers, including large
pharmaceutical companies such as AstraZeneca PLC, Bayer AG, Eli Lilly and
Company, and Novartis Corporation. In addition, we have dedicated a portion of
our resources to developing our own proprietary drug products and drug-delivery
technologies, with the goal of licensing or selling rights to these products and
technologies to our customers.

In recent years, the pharmaceutical industry has been characterized by
consolidation, which has increased the level of sales necessary for large
pharmaceutical companies to justify active marketing, promotion, and research
and development of an individual product. We believe that large pharmaceutical
companies have begun to focus their resources on existing drugs with annual
sales in excess of $500 million, new drugs with high-revenue potential, and
products that fit within core therapeutic classes or marketing priorities. These
large pharmaceutical companies are divesting smaller volume or non-strategic
branded pharmaceutical products. With our established relationships with many of
these large pharmaceutical companies, our product development expertise and
capabilities, and our existing proprietary drugs and drug-delivery technologies,
we believe that we are well positioned to acquire, revitalize and improve
established, branded pharmaceutical products.

In 2001, we began acquiring branded pharmaceutical products whose sales we
believe could be increased through enhanced promotion and marketing. We seek to
acquire established, branded products that we believe we can improve by applying
our significant research and development capabilities and that fall within
targeted therapeutic classes -- critical care, central nervous system, pain
management, oncology, immunosuppression and cardiology.

2

We operate through the following businesses:

- NeoSan Pharmaceuticals. NeoSan acquires, markets and promotes
established branded pharmaceutical products in targeted therapeutic
classes that we believe will benefit from our sales promotion and product
improvement strategies.

- aaiResearch. aaiResearch uses its significant research and development
capabilities and a portfolio of proprietary drug-delivery technologies
and intellectual property rights to improve our acquired products and
internally develop new products. Additionally, we offer these
capabilities and technologies to our customers for royalties, milestone
payments and fees.

- AAI International. AAI International offers on a fee-for-service basis a
comprehensive range of pharmaceutical product development services to our
customers on an international basis.

NEOSAN PHARMACEUTICALS -- OUR PRODUCT SALES BUSINESS

NeoSan acquires established branded pharmaceutical products in targeted
therapeutic classes that we believe will benefit from our sales promotion and
product improvement strategies. Once acquired, we market and promote these
brands directly through our contract sales force to high-prescribing physicians.
We use data generated by third-parties to identify physicians who prescribe our
products and products in our targeted therapeutic classes. We seek to develop
improved products or line extensions to be sold under the acquired brands by
applying the significant expertise and scientific capabilities of AAI
International and aaiResearch. We also are employing these capabilities to
develop new products to be sold under our own brand names. NeoSan intends to
focus on the following therapeutic classes -- critical care, central nervous
system, pain management, oncology, immunosuppression and cardiology.

In August 2001, we acquired from AstraZeneca AB the U.S. rights to the
M.V.I. and Aquasol branded product lines of critical care injectable and oral
nutritional products, which provide nutrients to cancer, AIDS, post-operative
and nutritionally compromised patients. In December 2001, we acquired from
Novartis Pharmaceuticals Corporation and Novartis Corporation the U.S. rights to
the Brethine branded product line, which treats asthma. In February 2002, we
entered into a purchase agreement with Eli Lilly and Company to acquire the U.S.
rights to Darvon and Darvocet branded product lines, which treat mild to
moderate pain.

Through NeoSan, we seek commercially stable products within our targeted
therapeutic classes with strong brand recognition and high gross margins. We
also seek established pharmaceutical products that we believe have not been
actively marketed and promoted for at least several years prior to our acquiring
them. Our goal is to increase the value of the brands that we acquire by
promoting them to high-prescribing physicians, using one-on-one meetings, free
product samples, educational programs, advertising, direct mail, and website
promotion. We intend to acquire products that we can promote to our existing
customer base, thereby leveraging our sales force.

We also plan to apply the significant expertise and scientific capabilities
of AAI International and aaiResearch's portfolio of patents and proprietary and
in-licensed technologies to develop new formulations, delivery systems,
indications, dosage forms and line extensions for NeoSan's branded products that
will improve their safety, efficacy, convenience or cost effectiveness or reduce
their side effects. Once approved by the FDA, we intend to market these products
under the acquired brand names, thereby leveraging the value of the existing
brand for our product improvements and line extensions. Additionally, we will
seek renewed regulatory or patent exclusivity for these improved products. A new
indication for an existing product or changes in product composition, method of
use, formulation and process may provide three-year non-patent exclusivity or
longer-term patent protection.

Additionally, through the development expertise of aaiResearch, our NeoSan
business is continuing internal development efforts on our own branded
pharmaceutical products. Product candidates in the later stages of development
include three new dosage strengths of azathioprine tablets for treatment of
rheumatoid arthritis and post-transplant rejection, and an imidapril tablet,
which is an angiotensin converting enzyme (ACE)-inhibitor, for treatment of
cardiovascular disease. Earlier stage products include a quick-dissolving
omeprazole tablet for treatment of stomach and ulcer ailments, a microsphere
anticancer agent delivered by
3

injection, and a controlled release mesalamine tablet for treatment of Crohn's
disease, a particular type of gastrointestinal disease. The details of NeoSan's
pipeline of product candidates from the development work of aaiResearch is
discussed in "-- aaiResearch -- Our Product Development Business." We do not
know, however, whether we will ever be able to successfully commercialize any of
these product candidates.

M.V.I. AND AQUASOL ACQUISITION

On August 17, 2001, we acquired the U.S. rights to a line of critical care
injectable and oral nutritional products from AstraZeneca for up to $100 million
in cash, of which we paid $52.5 million at closing of the acquisition. Future
guaranteed payments of $1.0 million each are due in August 2002 and 2003. Future
contingent payments of $2.0 million and $43.5 million are potentially due in
August 2003 and 2004, respectively. The acquired products are M.V.I.-12,
M.V.I.-Pediatric, Aquasol A and Aquasol E. The M.V.I.-12, M.V.I.-Pediatric and
Aquasol A products are administered by intravenous or injected solution to
provide nutrients to severely ill patients for whom oral nutrition is not
feasible. Aquasol E is administered by oral solution.

The M.V.I. and Aquasol brands had net sales of $24.6 million for the period
from January 1, 2001 to August 17, 2001, the audited period prior to their
acquisition. These brands had net revenues of $16.8 million for us during the
remaining portion of 2001. The initial M.V.I. product and Aquasol A were
approved for marketing over 45 years ago, and M.V.I.-Pediatric was approved in
1983. No FDA approval is necessary to market Aquasol E.

The M.V.I. products and Aquasol A are approved by the FDA for the following
uses:

- M.V.I.-12 is a multivitamin solution for intravenous use as a daily
multivitamin for adults and children over 11 years receiving parenteral
nutrition. It also is used in other situations where intravenous dosing
is required due to nutrient depletion, including in surgery, for
extensive burns, fractures and other trauma, for severe infectious
diseases, and for comatose states.

- M.V.I.-Pediatric is a sterile powder intended for reconstitution as a
solution for intravenous use as a daily multivitamin for infants and
children up to 11 years of age receiving parenteral nutrition. It also is
used in other situations where intravenous dosing is required due to
nutrient depletion, including in surgery, for extensive burns, fractures
and other trauma, for severe infectious diseases, and for comatose
states.

- Aquasol A (vitamin A) Parenteral is an injectable vitamin solution used
to provide vitamin A. Aquasol E (vitamin E) Drops, which do not require
FDA approval to be marketed, are nutritional supplements taken orally to
provide vitamin E.

On February 13, 2002, we acquired from Aesgen, Inc. the rights to a generic
injectable vitamin D nutritional product that we intend to market under our
Aquasol brand name as Aquasol D. We paid $1.0 million for this product at the
time of acquisition and agreed to make additional contingent milestone payments
of up to $1.5 million and certain royalty payments for the eight-year period
following the first commercial sale of this product. We are awaiting FDA
approval and are seeking as the approved indication of this drug the management
of hypocalcemia, or bone loss, in patients undergoing chronic kidney dialysis.

Product Market. According to IMS data, the U.S. market for injectable
nutritional products was approximately $310 million in annual sales in 2001, up
from $60 million of annual sales in 1996. Of this $310 million, the market for
injectable vitamin D products, where Aquasol D will compete, was approximately
$267 million in annual sales in 2001 and the market for injectable general
nutritional products, where M.V.I.-12 and M.V.I.-Pediatric compete, was $39
million in annual sales in 2001. Injectable nutrition products are used
primarily as part of total parenteral nutrition therapy for patients, both in
the hospital and for in-home health care. Many patients receiving this therapy
are recovering from malnutrition, burns, trauma and surgery.

M.V.I.-12 and M.V.I.-Pediatric are market leaders in the U.S. for
injectable multi-vitamin drugs. According to IMS data, in 2001, M.V.I.-12 had
over a 90% share of the market for adult injectable multi-

4

vitamins and M.V.I.-Pediatric had over a 90% share of the market for pediatric
injectable multi-vitamins. The main competition for M.V.I.-12 is Infuvite Adult,
which is marketed by Baxter Healthcare Corporation. The main competition of
M.V.I.-Pediatric is Infuvite Pediatric, which also is marketed by Baxter
Healthcare Corporation. Aquasol A is the only injectable Vitamin A product on
the market. Aquasol E competes with various other vitamin E products. If
approved by the FDA, the main competition of Aquasol D is expected to be
Calcijex and Zemplar, marketed by Abbott Laboratories, and Hectorol, marketed by
Bone Care International, Inc. Aquasol D has been submitted for approval by the
FDA as a generic substitute for Calcijex, although Aquasol D will be packaged in
a vial, rather than an ampoule, form.

The FDA has examined the product formulation and the current state of
medical thought on the vitamin levels needed in M.V.I.-12. After examining data
from a public workshop between the FDA and the American Medical Association as
to the appropriate dosage level of vitamins in parenteral multivitamin
preparations, the FDA increased the targeted dosage levels of vitamins B1, B6, C
and folic acid to be included in multivitamin injectable products to a level
greater than that included in any existing product and required the inclusion of
Vitamin K. Prior to our acquisition of the M.V.I. product line from AstraZeneca,
we had been working with AstraZeneca on a fee-for-service basis to reformulate
M.V.I.-12 to meet these guidelines. We anticipate that an application will be
submitted to the FDA for this reformulated product in the second half of this
year.

Product Line Strategy. We acquired the M.V.I. and Aquasol brands because
of their strong brand names and high market share. We believe that the M.V.I.
and Aquasol brands have significant growth opportunities that we can capture
through heightened promotional support and product line extensions.

We intend to enhance the sales of the M.V.I. and Aquasol products by
actively promoting them with our sales force. Our sales efforts have focused on
the supply of over 20 group purchasing organizations, or GPOs, for hospital and
outpatient settings, whose purchase contracts for M.V.I. were assigned to us by
AstraZeneca, and other wholesale customers, including managed care
organizations. We have actively marketed to GPOs, both to expand sales of M.V.I.
and to add Aquasol products to the contracts. Additionally, we are marketing to
pharmacy directors, nutritional staff and key physicians in the hospital and
institutional health care markets. The targeted physician groups are intensive
care specialists in hospitals, and oncologists and geriatricians active in-home
health care programs. We believe that significant marketing opportunities also
exist with providers in extended care, oncology, HIV, substance abuse and
outpatient surgery -- providers that deliver parenteral nutrition in markets
that have traditionally been underserved by M.V.I. Augmenting our sales force
activities are indirect marketing initiatives that revolve around our websites,
including www.neosan.com, www.mvi-us.com and www.TPNpro.com. The data on these
websites is not part of this report.

We are directing some of our marketing efforts at educating hospitals about
a change in the recommended dosage of injectable nutritional products. Due to
industry-wide shortages in the mid-1990s, we believe the dosage used at many
hospitals for total parenteral nutritional therapy was changed from once a day
to every other day. The American Society of Parenteral and Enteral Nutrition, or
ASPEN, has recently reaffirmed its recommended daily dosage of parenteral
nutritional products, which we intend to emphasize in our promotional efforts.
Also, we intend to work with ASPEN and leading physicians to have their
recommendations for nutritional products specifically address the benefits of
the M.V.I. and Aquasol product lines.

Our product line strategy for M.V.I. and Aquasol will also focus on
developing and marketing new replacement products, product improvements and
product line extensions, such as Aquasol D, as well as developing more efficient
packaging for our product line offerings. The reformulation of M.V.I.-12
described above to add vitamin K will create additional product line
opportunities within and outside the U.S. We also plan to reformulate M.V.I.-12
without vitamin K to be used for patients who cannot receive Vitamin K and are
developing a liquid injectable form of M.V.I.-Pediatric.

Since our acquisition of the M.V.I. and Aquasol product lines, we have
demonstrated success in increasing their sales and unit growth. We have
recruited a highly competent sales force and focused their promotional emphasis
on hospitals with the largest sales potential for these products. Additionally,
we have expanded the use of Aquasol A and Aquasol E in the marketplace by
including them within the scope of our
5

contracts with group purchasing organizations. We have increased the average
monthly sales of the M.V.I. and Aquasol products sold in a month to $3.8 million
in the period September 2001 to December 2001, from an average of approximately
$3.3 million in the period January 1, 2001 to August 17, 2001 and $3.1 million
in 2000. We believe this increase reflects the focused promotional efforts of
our sales force on hospitals with the highest sales potential. Additionally, we
have expanded the use of Aquasol A and Aquasol E in the marketplace by including
these products in the scope of our contracts with group purchasing
organizations.

Acquisition Terms. We acquired the rights to M.V.I. and Aquasol in the
U.S. and its territories for payments of up to $100 million over three years,
with an initial payment of $52.5 million paid on August 17, 2001. Additional
payments of $1.0 million each are due in August 2002 and August 2003 (subject to
reduction in the event that product returns in each preceding period exceed
certain dollar minimums set forth in the purchase agreement). A contingent
payment of $2.0 million is due in August 2003 if the FDA approves by December
31, 2002 the reformulated M.V.I.-12 product with a minimum shelf life of 12
months. In addition, a contingent payment of up to $43.5 million is due in
August 2004 if the FDA approval of the reformulated M.V.I.-12 product is
received on or before December 31, 2003, with the $43.5 million payment being
reduced by $1.0 million for each month after December 31, 2002 during which FDA
approval is not obtained and with the contingent $43.5 million payment becoming
$0 in the event FDA approval is not obtained on or prior to December 31, 2003.
As indicated above, we believe that approval of this reformulation could be
obtained by the end of 2002 or early 2003.

Supply of Product. In connection with the M.V.I. and Aquasol acquisition,
we entered into an interim supply arrangement with AstraZeneca to supply us with
M.V.I.-12 in single-dose vials, multi-dose vials and bulk, Aquasol A and Aquasol
E. The initial term of this interim supply agreement is for two years through
August 17, 2003, but we have the option to extend the term for an additional
year. Under the interim supply agreement, we may purchase the products for a
fixed unit cost for the first two years equal to AstraZeneca's cost of goods
sold during 2000 for the relevant product, subject to full adjustment in August
2002 for changes in the cost of raw materials and an adjustment (limited to
changes in the Consumer Price Index) for changes in other manufacturing costs.
If the contract is extended to the third year, the price will increase to
AstraZeneca's full variable and fixed costs plus 20%. If we obtain FDA approval
for the reformulated M.V.I.-12 product, AstraZeneca will supply the reformulated
product to us at a price equal to AstraZeneca's costs, including materials,
labor and variable overhead. In addition, AstraZeneca assigned to us its
manufacturing agreement with a third-party supplier for the production of
M.V.I.-Pediatric for an indefinite period of time, provided that either party
can terminate this agreement upon at least four year's prior notice.

M.V.I. product line shortages existed in the mid-1990s due to third-party
manufacturing problems, which were resolved in 2000 when AstraZeneca brought
manufacturing of M.V.I.-12 in-house. Additionally, in September 2001 after an
FDA inspection of its facilities, our third party supplier of M.V.I.-Pediatric
halted production of M.V.I.-Pediatric at its manufacturing facility upon
discovery of microbial growth in other products manufactured in the section of
its facility used for the production of M.V.I.-Pediatric. This shutdown created
temporary shortages in marketplace. The manufacturer resumed production of
M.V.I.-Pediatric in February 2002 and experienced initial production problems.
We anticipate that these problems will be promptly resolved and that new
products will be shipped to our customers beginning early in the second quarter
of 2002. M.V.I.-Pediatric accounted for 31% of the M.V.I. product line sales in
2000 and 34% in 1999.

We expect to transfer the manufacture of the Aquasol products to our
Charleston and Wilmington manufacturing facilities, and to either bring the
manufacture of the M.V.I. product lines in-house or contract with third-party
manufacturers to ensure a continued, long-term supply on market terms.

BRETHINE ACQUISITION

On December 13, 2001, we acquired the U.S. rights to the Brethine branded
product line from Novartis Pharmaceuticals Corporation and Novartis Corporation
for $26.6 million in cash. Brethine is administered in oral and injectable forms
for the prevention and reversal of bronchospasm in patients age 12 and older
with asthma and reversible bronchospasm associated with bronchitis and
emphysema. Although physicians also

6

prescribe Brethine to stop premature labor, this drug has not been approved by
the FDA for this indication and thus it cannot be marketed or promoted for this
use. Brethine had net sales of $15.2 million for the eleven and one-half months
ended December 13, 2001, the audited period prior to our acquisition. Brethine
was initially marketed beginning in 1975. We believe that Novartis ceased
actively promoting Brethine in the early 1990s, although Novartis selectively
marketed and promoted Brethine since then and a third party provided marketing
support for Brethine during 1999 and 2000.

Product Market. Brethine, or terbutaline sulfate, is a beta-adrenergic
agonist bronchodilator, meaning that it aids in the flow of air through the
bronchial tubes for people suffering from asthma, emphysema, chronic bronchitis,
and other lung diseases. According to Scott-Levin data, oral and injectable
drugs to treat these ailments generated sales of approximately $200 million in
2001. IMPAX Laboratories has been marketing a generic form of the oral form of
Brethine since July 2001. There are no approved generic forms of the injectable
form of this drug. Major branded products competing against Brethine to treat
these ailments include Volmax, Proventil, and branded and generic forms of
albuterol. Additionally, Brethine is prescribed to stop premature labor in
pregnant women. According to Scott-Levin data, this use is estimated to have
generated 42% of the total sales of Brethine in 2000.

Product Line Strategy. We acquired Brethine because of its strong brand
recognition, 25 years of clinical experience and well established safety record.
Our goal is to enhance the sales of Brethine by actively promoting the brand
name and using our existing relationships with hospitals and group purchasing
organizations to expand Brethine's distribution channels. We are initially
seeking to position Brethine as a preferred treatment of asthma, when a
short-acting agent is required. Our marketing efforts emphasize this product's
efficacy and its 25-year record of safety.

Historically, Brethine has been sold through wholesalers, and we are
considering the benefit of adding it to product lines carried by group
purchasing organizations that we already have as customers. Our existing sales
force also is targeting high-prescribing physicians in hospitals and private
practices and hospital and retail pharmacists to expand the use of Brethine. We
also are working with leading physician groups to have Brethine included in
their recommendations and guidelines for the treatment of asthma and related
ailments.

Our strategy for Brethine also involves product line extensions and
improvements. We plan to develop a glass vial form of the injectable Brethine
product, rather than the current glass ampoule formulation, to improve the
safety and convenience of administering this drug. We also are exploring the
development of an extended release tablet to be taken twice a day, rather than
three times a day as is the case under its current formulation. The
extended-release line extension is expected to use our patented drug-delivery
technologies that could provide us with patent exclusivity protection.

Acquisition Terms. We acquired the rights to Brethine in the U.S. and its
territories on December 13, 2001 for $26.6 million in cash from Novartis. In
connection with this acquisition, we agreed to pay Novartis royalties on our
sales in the U.S. and its territories of products developed by us that are
derivative of Brethine. Separately, we will be entitled to receive royalty
payments on sales outside of the U.S. and its territories of any of these future
derivative Brethine products, but not Brethine itself, if Novartis timely elects
to exercise its right to obtain an exclusive license from us to market any of
these derivative products outside the U.S.

Supply of Product. We entered into an interim supply agreement with
Novartis providing for its manufacture and packaging of the oral and injectable
form of Brethine for sale by us in the U.S. through December 13, 2004. We may
terminate the manufacturing component of the supply agreement on 12-months
notice and the packaging component on six months' notice. Under the supply
agreement, we may purchase the products for a fixed unit cost during the term of
the agreement, subject to an annual price adjustment on January 1, 2003 and
January 1, 2004 tied to the Consumer Price Index and to a downward adjustment in
the event product packaging is moved to a third party. We intend to transfer the
Brethine manufacturing processes to our own facilities prior to expiration of
the supply agreement. This move, however, is subject to FDA approval, and it is
possible that this approval will not be obtained on a timely basis, if at all.

7

Novartis maintains an inventory of the active ingredient, terbutaline
sulfate, used to manufacture both the oral and injectable forms of the Brethine
products. The supplier of this existing inventory, however, has stopped
producing terbutaline sulfate. As a result, we have identified and are seeking
FDA approval of a new supplier and are responding to FDA requests regarding the
new supplier's material. We believe the current inventory of terbutaline sulfate
from the approved supplier is sufficient to continue to manufacture the oral
form of Brethine to supply anticipated orders until September 2002 for some
dosage strengths and several months later for other dosage strengths and to
manufacture the injectable form of Brethine to fill anticipated orders for
several years. Novartis has acquired an inventory of terbutaline sulfate from
the new supplier, but the Brethine products it manufactures for us with this
material may not be sold until the new supplier is approved by the FDA. We
believe that we will obtain approval of the new supplier prior to September
2002, but it is possible that we may not receive approval until much later, if
at all. If the FDA does not approve the new supplier, we will not be able to
supply one dosage strength of Brethine tablets to our customers after August
2002 and will not be able to supply the remaining oral dosage strength within
several months after that. Sales of the oral form of Brethine accounted for
approximately 65% of net sales of Brethine in 2001.

PENDING DARVON AND DARVOCET ACQUISITION

On February 18, 2002, we entered into an agreement with Eli Lilly to
acquire the U.S. rights to the Darvon and Darvocet branded product lines for
$211.4 million in cash, subject to reduction based on net sales of these
products before and after the closing of the acquisition. These products are
used to treat mild to moderate pain. The Darvon and Darvocet product lines had
net sales of $62.9 million in 2001, $56.5 million in 2000 and $49.5 million in
1999. Net sales of Darvon and Darvocet in November and December 2001 and January
2002, however, were less than their average monthly sales during each of 2001,
2000 and 1999. See "Additional Risk Factors -- Risks Relating to Our
Business -- Our acquisition strategy could have a material and adverse effect on
us; the product sales of Darvon and Darvocet have recently decreased" contained
elsewhere in this report. The Darvon and Darvocet product lines have been sold
in the U.S. for over 25 years. We believe that Eli Lilly ceased actively
marketing and promoting these products approximately nine years ago.

We are acquiring the Darvon and Darvocet brands because we believe they
have high customer recognition in the pain management therapeutic class, an area
where we currently have products under development. Our goal is to increase the
value of these brands by actively marketing and promoting them and repositioning
them through the development of line extensions. We believe that these brands
will respond positively to the marketing and promotional support that we intend
to provide. Specifically, we intend to enhance the value of the Darvon and
Darvocet brands by:

- actively promoting the Darvon and Darvocet brands with our sales force;

- increasing our sales force from 20 to 50 people;

- creating incentives for this sales force to generate new prescriptions
for Darvon and Darvocet;

- working with respected physicians at leading pain clinics to develop
pain-management guidelines that specify the use of the Darvon and
Darvocet products;

- targeting our brand promotion towards high-prescribing physicians; and

- developing, marketing and promoting improved products and line extensions
with improved product, delivery, and therapeutic characteristics and
potential regulatory and patent exclusivity.

In connection with this pending acquisition, we have entered into an
interim supply agreement with Eli Lilly for the manufacture of the Darvon and
Darvocet products through December 31, 2004. Upon the satisfaction of certain
conditions, we may extend the agreement for an additional six months, during
which Eli Lilly will use commercially reasonable efforts to supply NeoSan with a
calender year's supply of products during the extension period, subject to
certain maximum and minimum quantities. Prior to expiration of this agreement,
we intend to have FDA approval permitting the transfer of the manufacturing of
these products to our manufacturing facilities, one or more third-party
manufacturing facilities, or a combination of these

8

facilities. Darvon and Darvocet contains a controlled substance. Therefore, this
approval could take longer and will involve start up and transfer costs.

We have filed a Current Report on Form 8-K with the Securities and Exchange
Commission on March 11, 2002 with respect to our proposed acquisition of Darvon
and Darvocet. This current report includes our unaudited consolidated pro forma
financial statements giving effect to the acquisition and related financing
transactions.

SALES AND DISTRIBUTION OF BRANDED PRODUCTS

In connection with our acquisition of the M.V.I. and Aquasol product lines,
we engaged Ventiv Health U.S. Sales, Inc., a national pharmaceutical sales
organization, to provide us with a dedicated contract sales force of 20 sales
representatives and two sales managers. As we expand our branded product line
offerings, we intend to use Ventiv to assist us in expanding our field sales
organization. With the addition of the Darvon and Darvocet products, we plan to
expand the size of our dedicated sales force to 50 and the sales management team
to five. Ventiv provides over 2,500 sales representatives to pharmaceutical
clients, with each sales representative dedicated exclusively to one
pharmaceutical company pursuant to contract. Our relationship with Ventiv
enables us to ramp up our sales staff quickly and economically in connection
with the acquisition of a branded product and avoid incurring incremental sales
and marketing costs prior to an acquisition. The initial term on our contract
with Ventiv runs through December 31, 2003. However, either party may terminate
the agreement at any time upon 90 days prior written notice. If we decide to
employ any contract personnel provided by Ventiv under the agreement during the
term of the agreement or within one year of its termination, we must pay Ventiv
certain fees. Additionally, we have approximately 11 employees marketing and
promoting our branded products in support of our sales force.

Similarly, we have also contracted with Integrated Commercialization
Solutions, Inc., or ICS, to provide warehousing, distribution, inventory
tracking, customer service and financial administrative assistance related to
the distribution program (including management of applicable rebates,
chargebacks and accounts receivable collection).

SMALL VOLUME MANUFACTURING

We currently manufacture certain high-potency and high-toxicity drug
products, along with controlled substance products, for clients in our
manufacturing facility in Wilmington, North Carolina. Our manufacturing
generally covers small volume products. We also manufacture certain drugs
developed on behalf of clients for commercial sale while client production
facilities are being built and validated. We recently acquired a 48,000 square
foot sterile facility in Charleston, South Carolina where we manufacture sterile
products. Our manufacturing facilities and equipment are qualified and validated
to operate under current Good Manufacturing Practice regulations. We also
provide manufacturing, packaging and labeling of non-parenteral clinical trial
materials.

AAIRESEARCH -- OUR PRODUCT DEVELOPMENT BUSINESS

aaiResearch provides research and development expertise and a portfolio of
proprietary drug-delivery technologies and intellectual property rights, which
we use to enhance and develop products that are innovative, safer, more
effective, or more convenient or cost-efficient. This can result in renewed
regulatory or patent exclusivity, adding to the commercially valuable life of
the product. We offer these product improvement, or life cycle management,
activities to our customers for royalties, milestone payments and fees, and
apply this expertise to improve our acquired products and internally develop our
own new products. Net revenues for aaiResearch in 2001 were $20.4 million.

In addition to product development, aaiResearch seeks to develop
proprietary drug delivery technologies for licensing to our clients. We have
historically dedicated a portion of our technical resources and operating
capacity to internal drug and technology development with the objective of
licensing marketing rights to third parties. aaiResearch continues to pursue
this strategy today.

9

Our internal product and technology development program has resulted in
multiple product applications filed with the FDA and European regulatory
agencies. Many of these products have been licensed or sold. Others are still in
development. The internal development program has also resulted in patents
covering drugs and drug technology and numerous pending patent applications.
During 2001, we filed 15 new patent applications with the U.S. Patent and
Trademark Office, with international patent applications filed according to
applicable conventions.

We have significant experience in providing product life cycle management
services to our clients, which we leverage to develop our own proprietary
products. Product life cycle management offers product improvement and line
extension opportunities to clients, generally for marketed products facing
patent expiration and that could commercially benefit from improvements or line
extensions. Product improvements and line extensions offer clients an
opportunity to improve product or product delivery characteristics, thus
enhancing and extending the commercial value of a branded product line. Improved
product characteristics may include enhancement of product stability, creation
of additional absorption profiles (e.g., quick or sustained release), higher
drug absorption or bioavailability (permitting reduced drug loads per dose with
the potential for lower costs and side effects), improved taste, more attractive
appearance, or better dosage regimes (e.g., once a day versus multiple doses per
day). Product line extensions may include new dosage forms, such as solids,
liquids and chewables, to increase patient populations who can benefit from such
drugs (e.g., pediatric or geriatric patient populations), as well as new dosage
strengths that may be more convenient for doctors and patients under current
treatment regimens. Product modifications and line extensions offer clients the
opportunity to target new patient subpopulations and improve patient compliance
and convenience. Product life cycle management activities also can lead to new
inventions and discoveries in the course of the research and development work,
providing new opportunities for long-term patent protection for the modified
products and potential long-term value for licensees of our technologies.

OUR DRUG-DELIVERY TECHNOLOGIES

Our portfolio of internally developed and in-licensed drug-delivery
technologies provide us with some opportunities for the expansion of a drug
product's effective market life. Our currently available technologies include:

- ProCore -- a patented multiparticulate technology for controlled release
of a drug incorporated into a two-layered pellet. The first layer allows
for control of the lag time before an active agent begins its release
while the second layer controls the rate of release, and thus the duration
of the sustained release effect for the product.

- ProSorb -- technologies designed to accelerate absorption rates and thus
permit weakly acidic compounds to exhibit a longer duration and shorter
onset of action relative to conventional dosage forms. The concept of the
technology is that the acidic drugs incorporated into the technology form
a dispersion pattern upon release in the stomach that allows faster and
more complete absorption. ProSorb is a broad-based technology primarily
used with liquid or encapsulated drug products. Using this technology with
diclofenac, a non-steroidal anti-inflammatory drug, has resulted in our
proprietary ProSorb-D product candidate, which is discussed below.

- ProSLO I and ProSLO II -- an osmosis technology designed for combination
product therapy. Osmotic action is the natural movement of water through a
membrane and is used to make oral drug administration more accurate,
precise and convenient. Our technology has an immediate release component
in the outside layer of a laser drilled tablet. This tablet allows a
controlled release of multiple active ingredients. The advantages over
existing technologies are its easy scalability, the ability to use it with
numerous active ingredients, the ability to create both a long- and
short-acting drug combination, and its ability to handle what normally are
insoluble active ingredients.

- ProLonic -- a drug-delivery technology specifically designed to release
an active agent in the colon. This patented technology can be incorporated
into a tablet, a pellet, or a capsule dosage form and uses conventional
manufacturing equipment and processes. The advantage represented by this
technology is the ability to control the location and timing of release.
10

- ProMelt -- a fine particle, rapidly disintegrating technology that allows
for creation of a fast melt tablet dosage form while also permitting taste
masking, targeted delivery or controlled release of the active agent. The
technology is particularly applicable to pediatric and geriatric
treatments for patients who have difficulty swallowing more traditional
dosage forms such as tablets and capsules.

- ProSpher -- an injectable, depot formulation for controlled release of
active agents from days to months. It is capable of delivering
therapeutically important agents with reduced "burst effect," or immediate
release, upon administration, as compared to other depot technologies. The
technology is designed to allow the development of convenient single does
treatment for drug therapies lasting up to six months.

The ProSLO I and ProSLO II technologies are available for use by us and our
clients in the U.S. through an exclusive cooperative agreement with Osmotica
Corporation, provided that Osmotica Corporation must agree that the technology
is suitable for use with a particular drug product. Osmotica Corporation will
receive royalties from the use of these technologies. Additionally, the
ProLonic, ProMelt and ProSpher technologies are available to us pursuant to a
joint development agreement with Tanabe Seiyaku Co. Ltd. This agreement with
Tanabe provides for the joint development by us and Tanabe of certain mutually
agreeable drug technologies identified by Tanabe. Under this agreement, we have
an exclusive worldwide license to the developed technologies and we are required
to pay Tanabe a portion of all down payments and milestone payments, and all
royalties, received by us in connection with the commercialization of products
using these jointly developed technologies.

aaiResearch has continued our internal development of products to be
licensed to third parties that have additional marketing and distribution
capabilities or a therapeutic focus different than ours. We have entered into
multiple licensing agreements for products that are currently in development.
The terms of the agreements vary as to amounts of milestone payments and fees,
as well as methods and extent of revenue participation such as royalties. While
we anticipate that most of our product licensing agreements will provide that
prospective clients will ultimately sponsor the approved product, in certain
instances we have made submissions for internally developed products in our own
name.

Continuing to leverage our development capabilities, we have expanded into
product line extension development and have also begun developing new compounds
that are chemically similar to currently marketed products with proven
therapeutic and safety profiles, and that offer improved characteristics over
the marketed product. Examples of these efforts are found in the chart below and
include leuprolide and omeprazole. The anticipated improved product
characteristics that our work could create potentially include improved product
characteristics such as new therapeutic indications, reduced side effects,
improved bioavailability, and improved interaction characteristics within
patients. Because considerable toxicity data already exists for established
products, we believe that line extensions and improvements based on known active
ingredients generally can be developed with less risk of failure, less research
and development costs and in a shorter time frame than the development of new
chemical entities. We also believe that virtual and limited-resource drug
companies provide opportunities to enter into cooperative ventures to identify
and develop these types of compounds.

PROSORB-D

ProSorb-D is a softgel capsule that combines diclofenac, a proven pain
medication, with our ProSorb rapid-absorption technology. We are developing this
product for the management of pain and have recently begun Phase III clinical
trials. We have enrolled the first group of patients in our Phase III studies
and expect the Phase III clinical trials to be completed by the end of 2002,
with the filing of a New Drug Application, or NDA, with the FDA in early 2003.

Our completed Phase II clinical studies involving ProSorb-D examined the
reduction of pain in approximately 75 patients given either a single dose of
ProSorb-D, a single dose of Cataflam, which is an established diclofenac branded
product marketed by Novartis, or a placebo after the removal of three or more
impacted third molars. The results of the study indicated that 50% of the
subjects taking ProSorb-D reported the onset of meaningful analgesic activity,
or pain relief, within 18 minutes, with a median duration of
11

302 minutes. By comparison, 50% of those taking Cataflam reported an onset of
meaningful analgesic activity within 38 minutes, with a median duration of 272
minutes. After six hours from the time of molar removal, 72% of the patients
given ProSorb-D rated the medication as a very good or excellent pain reliever,
while only 45% of the subjects rated Cataflam with this mark.

In accordance with FDA requirements agreed upon at a pre-Phase III meeting
in 2001, our Phase III clinical studies will use two different pain models:
post-operative dental pain and knee pain. In each model we are conducting two
identical Phase III trials using separate groups of clinical investigators. The
dental pain studies will evaluate the safety and efficacy of a single dose of
ProSorb-D in the treatment of post-operative dental pain. We plan to study over
400 patients with full enrollment anticipated by the end of the second quarter
2002. The studies of knee pain will evaluate the safety and efficacy of
ProSorb-D in the treatment of arthroscopic knee surgery pain. We plan to study
over 300 patients. These clinical trials have only recently begun enrollment,
with full enrollment anticipated by the end of the third quarter 2002.

We also will undertake Phase III studies to evaluate the safety and
efficacy of diclofenac potassium softgel capsules to treat orthodontic
discomfort in patients eight to 16 years of age. This food-effects study will
evaluate the drug's interaction in healthy patients with and without food in
their stomachs.

12

OUR INTERNAL PRODUCT PIPELINE

Our internal product development pipeline as of the date of this report is
described in the following chart, which identifies by product, the drug delivery
mechanism or technology, the therapeutic class, stage of development and whether
marketing rights are held by NeoSan or one of our customers:

- ---------------
(1) These products are undergoing stability testing. Under FDA regulations, we
believe that approval of these products will not require any clinical
studies.

AAI INTERNATIONAL -- OUR FEE-FOR-SERVICE BUSINESS

AAI International offers a comprehensive range of pharmaceutical product
development services to our customers on a worldwide basis. These services
include formulation development, analytical, bioanalytical and stability testing
services, production scale-up, human clinical trials, regulatory consulting, and
manufacturing. These services generally are provided on a fee-for-service basis.
Net revenues for AAI International were $93.2 million in 2001 and $87.0 million
in 2000.

Until our transition to a specialty pharmaceutical company, this
fee-for-service business was the core of our operations. AAI International
provides its services, both individually and in an integrated fashion, to

- pharmaceutical customers, to help them develop, control, and improve
their drug products;

- NeoSan, to improve its acquired drug products; and

13

- aaiResearch, to assist in its development of drugs and drug-delivery
technologies and product life cycle management activities.

We have a strong base of resources, expertise and ideas that allows us to
develop and improve drug products and carry out product life cycle management
activities both for our customers and ourselves. AAI International provides
analytical, clinical and manufacturing services and expertise to our other
business units, which do not have independent operations in these areas.

We focus on our customers' individual needs when marketing our services,
often placing our technical personnel with our clients' development teams to
participate in planning meetings for the development or improvement of a
product. We assign our sales and technical personnel as contacts for our larger
clients, understanding that technical personnel may be better able to identify
the full scope of our client's needs and suggest innovative approaches.
Additionally, we host several technical seminars each year to help our customers
stay abreast of the latest developments in their industries.

Our third-party product development contracts typically provide for upfront
fees and milestone payments. The commercialization of the products on which AAI
International works is the responsibility of our client. We typically provide
signed service estimates estimating fees for specified services. During our
performance of a project, clients often adjust the scope of services to be
provided by us, at which time the amount of fees is adjusted accordingly.
Generally, AAI International's fee-for-service contracts are terminable by the
client upon notice of 30 days or less. Although the contracts typically permit
payment of certain fees for winding down a project, the loss of a large contract
or the loss of multiple contracts could adversely affect our future revenue and
profitability in our research revenues business. Contracts may be terminated for
a variety of reasons, including the client's decision to stop a particular
study, the failure of product prototypes to satisfy safety requirements, and
unexpected or undesired results of product testing.

Since our founding in 1979, we have contributed to the submission, approval
or continued marketing of many client products, encompassing a wide range of
therapeutic categories and technologies. We believe that our ability to offer an
extensive portfolio of high quality drug development and support services
enables us to effectively compete as pharmaceutical and biotechnology companies
look for a mixture of standalone and integrated drug development solutions that
offer cost-effective results on an accelerated basis. AAI International's core
services are organized internally along pharmaceutical, analytical,
biopharmaceutical, clinical and regulatory affairs lines to best address the
product life cycle issues challenging a client.

PHARMACEUTICAL SERVICES

AAI International provides a variety of pharmaceutical services to its
customers, including drug formulation development, niche manufacturing, and
storage and distribution of clinical trial supplies. The services are organized
to help clients from the pre-clinical to post-marketing stages.

Formulation Development Services. AAI International provides integrated
formulation development services for its customers' pharmaceutical products, by
which it takes a compound and works to develop a safe and stable product with
desired characteristics. We believe that AAI International's formulation
expertise and significant analytical capabilities enable it to provide an
efficient development program, with a dedicated project team tracking the
product through all stages of formulation development. AAI International
provides formulation development services during each phase of the drug
development process, from new compounds to modifications of existing products.
AAI International's formulation development projects may support a small segment
of critical development activities for a short duration or may last for several
years, ranging from early formulation development to a validated,
production-scale, commercial product.

AAI International's formulation development group's expertise spans a broad
spectrum of therapeutic classes. It works with clients, and its own product
development personnel in the course of proprietary work, to develop products
with desired characteristics, including dosage form, strength, release rate,
absorption properties, stability and appearance. AAI International has developed
significant product and process capabilities that enhance its ability to
efficiently solve the complex problems that arise in developing

14

formulations with targeted characteristics and has developed a range of
proprietary product technologies that enhance its ability to efficiently achieve
desired results in product design and development.

In providing formulation services, AAI International works closely with
clients to design and conduct feasibility studies to chart the potential of
formulating a drug using a combination of active drug ingredients and inert
materials called excipients. Using experimental designs, initial prototype
formulations are prepared to identify potential problems in stability,
bioavailability and manufacturing. Generally, formulation development is an
iterative process, with numerous formulations being modified as problems are
encountered or to provide our clients with viable options.

We believe that AAI International's experience and expertise in formulation
development, as well as certain proprietary technologies, permit it to design
efficient protocols for identifying and enhancing formulation prototypes with
the greatest potential. Upon selection of the final product prototypes, AAI
International develops protocols to scale the product batch size from
development stage (e.g., hundreds or thousands of units) to clinical scale
(e.g., thousands or millions of units). During the clinical phase, AAI
International refines the formulation in response to clinical, bioanalytical and
stability data. The manufacturing scale-up process involves identifying and
resolving manufacturing problems to facilitate an efficient transfer to the
full-scale production equipment of AAI International's clients. Throughout the
development process, AAI International develops and validates the analytical
methods necessary to test the product to establish and confirm product
specifications.

In addition to new drug development, AAI International's formulations team
provides product modification and line extension services to clients through
product life cycle management contracts it enters into by us, generally for
marketed products facing patent expiration or that can benefit from formulation
improvements. Modifications of existing products offer clients an opportunity to
improve product characteristics, increasing product market viability. Improved
product characteristics include enhancement of stability, absorption profiles
(e.g., quick, controlled or sustained release), taste, and appearance. Product
line extensions may include new dosage forms, such as solids, liquids and
chewables, as well as new dosage strengths. Product modifications and line
extensions offer clients the opportunity to target new patient sub-populations
and improve patient acceptance of the product. AAI International's product
optimization services also cover investigation of impurities, contaminants and
degradation, the updating of mature products to meet current regulatory
standards and laboratory validation services.

Manufacture of Clinical Trial Supplies. AAI International manufactures
clinical trials materials for Phase I through Phase IV drug-product clinical
trials. It has expertise in manufacturing tablets, capsules, sachets, liquids
and suspensions, creams, gels, lotions and ointments. We believe that
outsourcing of clinical supply manufacturing is particularly attractive to
pharmaceutical companies that maintain large, commercial-quantity, batch
facilities, where clinical supply manufacturing would divert resources from
revenue-producing manufacturing. AAI International has a dedicated 25,000 square
foot facility in Wilmington, North Carolina and another facility in Neu-Ulm,
Germany to distribute and track clinical trial materials used in clinical
studies, with the capacity for controlled substance storage and handling. In
addition, AAI International provides its clients with assistance in scaling up
production of clinical supply quantities to commercial quantity manufacturing.

ANALYTICAL SERVICES

AAI International provides a wide variety of analytical services, as well
as services pertaining to method development and validation, drug product and
active pharmaceutical ingredient characterization and control, microbiological
support, stability storage and studies, and technical support and problem
solving with respect to pharmaceuticals. In support of the drug development and
compliance programs of its customers, AAI International offers laboratory
services to characterize and measure drug components and impurities. We have
more than two decades' of experience in providing analytical testing services
dedicated exclusively to the drug industry and have developed the scientific
expertise, technologically advanced equipment, and broad range of scientific
methods to accurately and quickly analyze almost any compound or product.

15

Method Development and Validation. AAI International develops and
validates methods used in a broad range of laboratory testing necessary to
determine physical or chemical characteristics of compounds. Over the last 20
years, we have developed over ten thousand methods on behalf of clients to be
applied to all types of dosage forms and drug substances. Analytical methods are
developed to demonstrate potency, purity, stability, or other physical or
chemical attributes. These methods are validated to ensure the data generated by
these methods are accurate, precise, reproducible and reliable, and are used
throughout the drug development process and in product support testing.

Product Characterization. AAI International has the expertise and
instruments required to identify and characterize a broad range of chemical
entities. Characterization analysis identifies the chemical composition,
structure, and physical properties of a compound, and characterization data
forms a significant portion of an application to seek regulatory approval to
market a new or modified drug. AAI International uses numerous techniques to
characterize a compound, including spectroscopy, chromatographic analyses and
other physical chemistry techniques. Additionally, it uses such information for
control testing to be performed throughout development and marketing to confirm
consistent drug composition. Once appropriate test methods are developed and
validated, and appropriate reference standards are characterized and certified,
AAI International can assist clients by routinely testing compounds for clinical
and commercial use.

Raw Materials and Product Release Testing. AAI International offers
testing required by the FDA and other regulatory agencies to confirm that raw
materials used in production of finished drug products, and the resulting
finished products themselves, are consistent with established specifications.
Due to the incorporation of "just-in-time" inventory control systems in client
production schedules, release testing for both raw materials and the finished
products often cannot be scheduled by clients in advance, yet must be performed
immediately. AAI International believes that its internal scheduling systems,
analytical laboratory expertise and systems for prompt testing provide it with a
competitive advantage in providing both raw material and batch release testing.
AAI International believes that this service enhances its clients' confidence in
adopting cost-saving "just-in-time" inventory control systems.

Microbiological Testing. Microbiological testing is an essential indicator
to ensure that a drug product, whether raw material or finished product, does
not contain harmful microorganisms. AAI International performs sterility testing
to ensure the absence of microorganisms from injection products. AAI
International has significant experience conducting various microbial tests to
identify and quantify micro-organisms that may be present, including limulus
amebocyte lysate testing, which measures endotoxins (toxic byproducts of
micro-organisms) and particulate matter testing, which determines the presence
of foreign matter in injectable drug products. In addition, it performs tests to
determine the effectiveness of antibiotics against microorganisms and the
minimum levels of preservatives necessary in product formulations to ensure that
they remain resistant to bacteria throughout their shelf life.

AAI International also assists clients with environmental monitoring,
including water and air systems testing, using an automated biochemical system
to identify microorganisms that are present and determine whether such systems
are within applicable microbial limits. It also assists clients in validating
their environmental control systems to ensure compliance with the FDA's current
Good Manufacturing Practice regulations.

Stability Studies. AAI International provides stability testing and secure
storage facilities necessary to establish and confirm product purity, potency
and other shelf-life characteristics. Stability testing is required at all
phases of product development, from dosage form development through commercial
production, to confirm the shelf life of each manufactured batch. AAI
International maintains technologically advanced climate-controlled facilities
in the United States and Germany to determine the impact of a range of storage
conditions on product integrity. FDA regulations and the regulations of European
regulatory authorities require that samples of clinical and commercial products
placed in stability chambers be analyzed in a timely fashion after scheduled
"pull points" occur, based on the date of manufacture.

16

BIOPHARMACEUTICAL SERVICES

AAI International integrates a Phase I clinical study capability with
strong bioanalytical and biotechnology expertise to provide biopharmaceutical
services to its customers. The analysis of drugs, metabolites and endogenous
compounds in biological samples is a core service of AAI International.

Phase I Clinical Services. AAI International has a 48-bed Phase I clinical
trial facility located in Research Triangle Park, North Carolina, and a 76-bed
facility in Neu-Ulm, Germany for conducting certain Phase I clinical trials. In
Phase I clinical trials, drugs are administered to human volunteers pursuant to
protocols approved by institutional review boards and blood samples are taken at
the times prescribed in the study protocols for subsequent bioanalytical testing
of the plasma samples.

Bioanalytical Testing. AAI International offers bioanalytical testing
services to support bioequivalence studies and Phase I through Phase IV clinical
trials for its clients' pharmaceutical product development needs, analyzing
plasma samples to characterize the metabolized forms of the drug and determine
the rate of absorption. Bioanalytical studies of new drugs often present
challenging and complex issues, with products being metabolized into multiple
active and inactive forms, each of which must be measured. AAI International
works with its clients to develop and validate analytical methods to permit
detection and measurement of the various components to trace levels.

Biotechnology Analysis and Synthesis. Although the types of analytical
investigations of biotechnology products are similar to those required for more
traditional pharmaceutical products, the complex molecular structure of many
biotechnology products require different technology and expertise. AAI
International provides a broad array of biotechnology services, including both
analytical and biological testing and method development and validation. AAI
International's breadth of services allows it to rapidly deduce and characterize
the complex structure of the biotechnology product and measure the molecule or
its metabolites in human blood plasma to support clinical trial evaluation. It
has expertise in a broad spectrum of biochemical and immunochemical methods for
characterization and analysis of biotechnology drugs. These methods include
amino acid sequencing, amino acid analysis, peptide mapping, carbohydrate and
lipid analysis and electrophoresis. AAI International also has expertise in
developing chromatographic methods that precisely evaluate the purity and
stability of biotechnology products. This breadth and diversity of analytical
skills and technologies enable AAI International to assist its clients from
early product development through the investigational new drug application and
product license application stages and commercial production.

PHASE I TO IV CLINICAL SERVICES

In the late 1990's, we expanded our Phase I clinical trial capabilities and
added the ability to conduct and monitor Phase II to Phase IV clinical studies
and multi-center trials focused in niche therapeutic classes, including hepatic
disease, chemotherapeutics and hormone replacement therapy.

AAI International can provide a broad range of Phase I through Phase IV
clinical services to customers in the pharmaceutical, biotechnology and medical
device industries for assistance in the drug development and regulatory approval
process in North America. The clinical services include clinical trial
management and monitoring, site selection, medical affairs (including safety
surveillance and serious adverse event management), data management and
statistics, with the core services focused on clinical monitoring and data
management.

REGULATORY AND OTHER CONSULTING SERVICES

AAI International provides consulting services with respect to regulatory
affairs, quality compliance, and process validations. It assists in the
preparation of regulatory submissions for drugs, devices and biologics, audits a
client's vendors and client operations, conducts seminars, provides training
courses, and advises clients on applicable regulatory requirements. AAI
International also assists clients in designing development programs for new or
existing drugs intended to be marketed in the United States and Europe.

17

At a client's request, AAI International will review client-prepared
submissions, draft and assemble regulatory submission packages, and attend FDA
meetings with clients. AAI International assists clients in preparation for FDA
inspections and in correcting any deficiencies noted in FDA inspections. In
preparation for an FDA inspection, AAI International's regulatory affairs
specialists conduct mock inspections to anticipate FDA observations and advise
clients of appropriate remedial actions.

AAI International also audits manufacturers of active and excipient
ingredients used in the drug product, as well as packaging components, on behalf
of clients to ensure that the manufacturers' facilities are in compliance with
GMP regulations. Such audits generally include review of the vendor's drug
master files, analysis of written standard operating procedures, or SOPs, review
of production records, and observation of operations to ensure that written SOPs
are being followed. Audit reports include recommendations to address any
deficiencies. In addition, AAI International advises clients on validation
issues concerning their systems and processes and audits client facilities to
assist them in validating their processes and their cleaning, water and air
handling systems.

AAI International organizes and conducts seminars worldwide on a number of
topical industry issues. AAI International also leverages its in-house
laboratory training programs by providing training to clients' employees.

COMPETITIVE STRENGTHS

We believe that our competitive position is attributable to our scientific
capabilities and a number of our other key strengths, including the following:

ESTABLISHED PHARMACEUTICAL PRODUCT DEVELOPMENT INFRASTRUCTURE. We have a
long history of assisting our customers in developing and commercializing
pharmaceutical products and have an established infrastructure to do so. Our
platform of businesses offers our customers a wide range of scientific
capabilities, including analytical services, biopharmaceutical services,
pharmaceutical product development services, Phase I to IV clinical services,
product manufacturing, and regulatory and other consulting services, in addition
to product life cycle management activities. We have approximately 700 employees
working on the development of drugs and have worked with over 2,000
pharmaceutical compounds in the past 20 years. We plan to use these capabilities
to enhance our internal proprietary product candidates.

STRONG BRANDS WITH ESTABLISHED CASH FLOWS. Each of the product lines we
have acquired has been sold in the U.S. for over 18 years, and the Darvon and
Darvocet products have been sold in the U.S. for over 25 years. These branded
product lines have generated sales and gross profits for many years despite
competition from generic and other competitive products. The product lines that
we have acquired, and Darvon and Darvocet, had gross margin percentages ranging
from 46% to 92% in the last audited period prior to their acquisition. We
believe that the cash flows that these products generate are sustainable, and,
moreover, we believe we can increase sales of these products by actively
promoting them.

ESTABLISHED CUSTOMER BASE ENHANCES PRODUCT ACQUISITION OPPORTUNITIES. We
have developed strong relationships with major pharmaceutical companies through
years of client service on research, product development, and product life cycle
management projects. For example, AAI International provided development
services to AstraZeneca for both M.V.I.-12 and M.V.I.-Pediatric for several
years prior to our acquisition of these products. We have, over the past 15
years, worked on some element of over 80% of the top 200 drug products in the
U.S., as ranked by IMS data for 2000. These relationships position us to acquire
established, branded products that are no longer the focus of our customers'
development, marketing and promotional efforts. We have more than 50
representatives in our research service business who regularly call on key
decision makers of the large pharmaceutical companies. These relationships
provide important insights into product portfolios and development pipelines and
may allow for more rapid identification and acquisition of attractive branded
pharmaceutical products.

EXPERTISE IN PRODUCT LIFE CYCLE MANAGEMENT. Through AAI International and
aaiResearch, we offer our customers a strong base of resources, expertise and
ideas to better understand and improve their existing products and develop new
products. Our portfolio of patents and proprietary and in-licensed technologies
may

18

provide our customers with new formulations, delivery systems, indications and
dosage forms to improve the safety, efficacy or cost effectiveness, or reduce
the side effects, of their drugs. This can result in renewed regulatory or
patent exclusivity, adding to the commercially valuable life of the product. For
example, we are currently working with a major pharmaceutical company to
reformulate their allergy product to be taken once a day instead of four times a
day. In the past, we also have worked with a major pharmaceutical company to
develop a long acting version of a cardiovascular product to be taken once a day
instead of twice a day and with another major pharmaceutical company to develop
a chewable tablet form of an antidepressant.

EXPERIENCED AND DEDICATED MANAGEMENT TEAM. We have an experienced
management team that is led by Frederick D. Sancilio, Ph.D., Chairman and Chief
Executive Officer, Philip S. Tabbiner, D.B.A., President and Chief Operating
Officer, William L. Ginna, Jr., Executive Vice President and Chief Financial
Officer, David Johnston, Ph.D., President of AAI International, George E. Van
Lear, Ph.D., President of aaiResearch, and David M. Hurley, President of NeoSan
Pharmaceuticals. These senior executives have an average of over 20 years of
experience in the pharmaceutical industry.

GROWTH STRATEGY

We believe that our ability to identify and acquire branded pharmaceutical
products, to apply our scientific capabilities to develop new and improved
products and product line extensions, and to leverage our marketing and
promotion organization and our strong relationships with many large
pharmaceutical companies, positions our company for continued growth.
Specifically, we intend to pursue the following growth strategies:

ENHANCE SALES THROUGH FOCUSED MARKETING AND PROMOTION. We seek to increase
sales of our branded pharmaceutical products through active marketing and
promotion directed at high-prescribing physicians, using one-on-one meetings,
free product samples, educational programs, advertising, direct mail and website
promotion. We also seek to acquire products that we believe have not been
actively marketed and promoted for at least a few years prior to our acquiring
them. For example, we believe that Eli Lilly stopped actively marketing and
promoting Darvon and Darvocet approximately nine years ago. We believe that we
can successfully increase sales by combining the strength of the brand name with
active promotion of the product.

STRENGTHEN BRANDS THROUGH PRODUCT LIFE CYCLE MANAGEMENT. We plan to
strengthen our branded product lines through product life cycle management
activities. We plan to use our research and development expertise and our
portfolio of patents and proprietary and in-licensed technologies to provide new
formulations, delivery systems, indications and dosage forms that will improve
the characteristics of our products, such as their safety, efficacy,
convenience, cost effectiveness or side effects. We will seek renewed regulatory
or patent exclusivity for our improved drugs, and we plan to market them as line
extensions to our acquired branded product lines. We intend to develop product
line extensions for each of our acquired product lines. For example, on February
13, 2002, we acquired the rights to a generic injectable vitamin D nutritional
product that we intend to market under the name Aquasol D as a line extension to
our Aquasol brand name.

LAUNCH INTERNALLY DEVELOPED BRANDED PRODUCTS. We plan to continue to
develop new drugs in our targeted therapeutic classes, with the view of
marketing these products under our own brand names. Although we have
successfully developed a number of products in the past, we did so with the
intention of licensing or selling the products to our customers. We are
currently developing several new drug products using our patented drug delivery
technologies that we intend to market under our own brand names. For example, we
recently concluded Phase II clinical studies for our ProSorb-D product to treat
pain. This internally developed product combines the proven pain drug diclofenac
with our patented ProSorb drug-delivery technology. ProSorb-D potentially offers
the strong pain relief associated with diclofenac, but could act faster, taste
better and cause less stomach irritation than other forms of this drug. We
recently began Phase III clinical trials for this drug.

19

SEEK ATTRACTIVE ACQUISITION OPPORTUNITIES. We intend to continue to take
advantage of industry consolidation trends to identify and selectively acquire
branded pharmaceutical products. We generally will seek attractive branded
pharmaceutical products that:

- can benefit from focused sales and marketing efforts;

- lend themselves to product life cycle management opportunities such as
new formulations, delivery systems, indications and dosage forms;

- fall within our targeted therapeutic classes -- critical care, central
nervous system, pain management, oncology, immunosuppression and
cardiology;

- can be sold to our existing customer base, thereby leveraging our
sales-force capabilities; and

- have annual sales of less than $100 million with stable and high gross
margins.

INFORMATION TECHNOLOGY

We have made significant investments in information technology. Our
customized data management system connects analytical instruments with multiple
software architectures permitting automated data capture. We believe that
information technology will enable us to expedite the development process by
designing innovative services for individual client needs, providing project
execution, monitoring and control capabilities that exceed a client's internal
capabilities, streamlining and enhancing data presentation to the FDA and
enhancing our own internal operational productivity while maintaining quality.

We are continuing the implementation of an enterprise wide financial and
operational integrated management information system, including significant
systems licensed from SAP, which began in 1998. Initial financial components
became operational at year-end 1998, and other operational management systems
followed later in 1999 and 2000. We continue to implement these systems company
wide.

CUSTOMERS

Historically, our primary customers have been large and small
pharmaceutical and biotechnology companies serviced by aaiResearch and AAI
International. Significant research and development projects have a defined
cycle, and accordingly the composition of our customer group in these areas of
our business changes from year to year. In addition, because of the project
nature of engagements in these segments of our business, we may have a
concentration of business among some large customers in one period that we would
not expect to continue into subsequent periods. We have experienced
concentration in our business in the past, and we do not believe that this is
unusual for companies in the same markets as aaiResearch and AAI International.
During 2000 and 2001, net revenues from several product development agreements
with AstraZeneca and its affiliates accounted for approximately 15% of our
consolidated net revenues in each year. We cannot assure you that net revenues
from our agreements with AstraZeneca and its affiliates will continue at this
level in the future.

NeoSan's customers are primarily large well-established medical wholesalers
and distributors. We anticipate that as NeoSan's business expands as a result of
the addition of our acquired product lines, some of these wholesalers and
distributors may become significant customers accounting for 10% or more of our
consolidated net revenues. Correspondingly, we do not believe that revenues from
any large pharmaceutical company or other customer of aaiResearch or AAI
International is likely to exceed 10% of our consolidated net revenues in future
years.

BACKLOG

Backlog consists of anticipated net revenues from signed service estimates
and other fee-for-service contracts that have not been completed and provide for
a readily ascertainable price. Once contracted work begins, net revenues are
recognized as the service is performed. Occasionally, but infrequently, we begin
work for a client before a contract is signed. Accordingly, backlog does not
include anticipated net revenues for which we have begun work but for which we
do not have a signed service estimate, or for any variable-priced
20

contracts. In addition, during the course of a project, the client may
substantially adjust the requested scope of services and corresponding
adjustments are made to the price of services under the contract.

We believe that our backlog as of any date is not a meaningful predictor of
future results because the backlog can be affected by a number of factors,
including variable size and duration of contracts and adjustments in the scope
of a contracted project as interim results become available. Additionally,
fee-for-service contracts generally are subject to termination by clients upon
30 days notice or less. Moreover, the scope of a contract can change over the
course of a project. At December 31, 2001 and 2000, backlog was approximately
$66 million and $91.4 million, respectively. Of the 2001 amount, approximately
$17.7 million is not expected to be filled within year 2002.

COMPETITION

We compete with companies and organizations in multiple segments of the
pharmaceutical industry. The branded drug products of our NeoSan business unit
are subject to competition from the branded and generic products of other
pharmaceutical companies, ranging from other small specialty pharmaceutical
companies to the large pharmaceutical companies who are among the customers of
the fee-for-service business of AAI International.

The main competition for M.V.I.-12 is Infuvite Adult, which is marketed by
Baxter Healthcare Corporation. The main competition of M.V.I.-Pediatric is
Infuvite Pediatric, which also is marketed by Baxter Healthcare Corporation.
Aquasol A is the only injectable Vitamin A product on the market. Aquasol E
competes with various other vitamin E products. If approved by the FDA, the main
competition of Aquasol D is expected to be Calcijex and Zemplar, marketed by
Abbott Laboratories, and Hectorol, marketed by Bone Care International, Inc.
Aquasol D has been submitted for approval by the FDA as a generic substitute for
Calcijex, although Aquasol D will be packaged in a vial, rather than an ampoule,
form. Brethine competes in the market for the treatment of asthma and related
bronchial ailments, which is a market led by Volmax, Proventil, and branded and
generic forms of albuterol sulfate.

Darvon and Darvocet compete primarily in the broad pain management market,
especially with products indicated for the management of mild to moderate pain.
Competitive products indicated for the management of mild to moderate pain
include Ultram and other non-steroidal anti-inflammatory drugs such as
ibuprofen. Additionally, major promotional efforts in the U.S. pain management
market today involve a relatively new class of drugs, the cyclo-oxygenase 2, or
the COX-2 enzyme, inhibitors. They are designed to work as effectively as Darvon
and Darvocet and NSAIDs, but without side effects such as ulcers and
gastrointestinal bleeding. These new inhibitors are more selective than
traditional NSAIDS. The non-selective inhibition of both COX-1 and COX-2 enzymes
in other NSAIDs is responsible for the toxicities and side effects.

The Darvon and Darvocet product lines no longer have patent exclusivity.
While precise data on generic substitution for these products is not available,
we believe a vast majority of the prescriptions written for Darvon and Darvocet
are filled with generic products. These generic substitutes are sold at
significantly lower prices, without the research, development and approval costs
associated with the branded Darvon and Darvocet products. Two of the world's
largest manufacturers of generic products, Teva Pharmaceutical Industries Ltd.
and Mylan Laboratories Inc., sell propoxyphene generic substitutes to Darvon and
Darvocet.

Sellers of generic products typically do not bear the related research and
development costs associated with branded products and, thus, are able to offer
their products at considerably lower prices. There are, however, a number of
factors that enable branded products to remain profitable once patent protection
has ceased. These include the establishment of a strong brand image with the
prescriber or the consumer, supported by the development of improved products
and line extensions to differentiate the branded products from the generic
competition.

Our AAI International and aaiResearch businesses compete primarily with
in-house research, development, quality control, and other support service
departments of pharmaceutical and biotechnology companies, as well as university
research laboratories and other contract research organizations. In addition,

21

we believe that although there are numerous fee-for-service competitors in our
industry, there are few competitors that offer the depth or breadth of
scientific capabilities that we provide. Some of our competitors, however, may
have significantly greater resources than we do. Competitive factors generally
include reliability, turn-around time, reputation for innovative and quality
science, capacity to perform numerous required services, financial viability,
and price. We believe that we compete favorably in each of these areas.

GOVERNMENT REGULATION

The services that we perform and the pharmaceutical products that we
develop and manufacture are subject to various rigorous regulatory requirements
designed to ensure the safety, effectiveness, quality and integrity of
pharmaceutical products, primarily under the Federal Food, Drug, and Cosmetic
Act, including current Good Manufacturing Practice regulations. These
regulations are commonly referred to as the cGMP regulations and are
administered by the FDA in accordance with current industry standards. Our
services and development efforts performed outside the U.S. and products
intended to be sold outside the U.S. are also subject to additional foreign
regulatory requirements and government agencies.

U.S. laws and regulations apply to all phases of the development,
manufacturing, testing, promotion and distribution of drugs, including with
respect to our personnel, record keeping, facilities, equipment, control of
materials, processes, laboratories, packaging, labeling, storage, pricing and
advertising. If we fail to comply with these laws and regulations, our drugs,
drug improvements, and product line extensions will not be approved by the FDA,
the data we collect may not be acceptable to the FDA, and we may not be
permitted to market our products. Additionally, we could be subject to
significant monetary fines, recalls and seizures of products, closing of our
facilities, revocation of drug approvals previously granted to us, and criminal
prosecution. Any of these regulatory actions could materially and adversely
affect our business, financial condition and results of operations.

To help assure our compliance with applicable laws and regulations, we have
quality assurance controls in place at our facilities and we use FDA regulations
and guidelines, as well as applicable international standards, as a basis for
our standard operating procedures. We regularly audit test data and inspect our
facilities and procedures. In addition, our facilities are inspected from time
to time by the FDA. We also have in place a system for monitoring
product-related complaints that we receive with respect to our products. Despite
our efforts, however, the rigorous nature and extensive scope of the applicable
regulatory requirements mean that the risk of regulatory citation or action by
the FDA cannot be completely eliminated. In the event of any such citation or
action of a material nature, the resulting restrictions on our business could
materially and adversely affect our business, financial condition and operating
results.

All of our drugs must be manufactured in conformity with the FDA's cGMP
regulations, and drug products subject to an approved FDA-application must be
manufactured, processed, packaged, held and labeled in accordance with
information contained in the application. Additionally, modifications,
enhancements, or changes in manufacturing sites of approved products are in many
circumstances subject to FDA inspections and approvals that we may not be able
to obtain and that may be subject to a lengthy application process. Our
facilities, including the facilities used in our fee-for-service business, and
those of our third-party manufacturers are periodically subject to inspection by
the FDA and other governmental agencies, and operations at these facilities
could be interrupted or halted for lengthy periods of time if such inspections
prove unsatisfactory.

Failure to comply with FDA or other governmental regulations can result in
fines, unanticipated compliance expenditures, recall or seizure of products,
total or partial suspension of production or distribution, suspension of the
FDA's review of our drug approval applications, termination of ongoing research,
disqualification of data for submission to regulatory authorities, enforcement
actions, injunctions and criminal prosecution. Under certain circumstances, the
FDA also has the authority to revoke previously granted drug approvals. Although
we have instituted internal compliance programs, if these programs do not meet
regulatory agency standards or if compliance is deemed deficient in any
significant way, it could have a material adverse effect on us. Most of our
vendors are subject to similar regulations and periodic inspections.

22

Some of our development and testing activities (which will include the
manufacture, development and testing of the Darvon and Darvocet products) are
subject to the Controlled Substances Act, administered by the Drug Enforcement
Administration, or the DEA, which strictly regulates all narcotic and
habit-forming substances. We maintain separate, restricted-access facilities and
heightened control procedures for projects involving such substances due to the
level of security and other controls required by the DEA.

Additionally, our business involves the controlled storage, use and
disposal of hazardous materials and biological hazardous materials. We are
subject to numerous federal, state, local and foreign environmental regulations
governing the use, storage, handling and disposal of these materials. Although
we believe that our safety procedures for handling and disposing of these
hazardous materials comply in all material respects with the standards
prescribed by law and regulation in each of our locations, the risk of
accidental contamination or injury from hazardous materials cannot be completely
eliminated. We maintain liability insurance for some environmental risks that
our management believes to be appropriate and in accordance with industry
practice. However, we may not be able to maintain this insurance in the future
on acceptable terms. In the event of an accident, we could be held liable for
damages that are in excess or outside of the scope of our insurance coverage or
that deplete all or a significant portion of our resources.

We are also governed by federal, state and local laws of general
applicability, such as laws regulating intellectual property, including patents
and trademarks, working conditions, equal employment opportunity, and
environmental protection.

In connection with our activities outside the U.S., we also are subject to
foreign regulatory requirements governing the testing, approval, manufacture,
labeling, marketing and sale of pharmaceutical products, which requirements vary
from country to country. Whether or not FDA approval has been obtained for a
product, approval by comparable regulatory authorities of foreign countries must
be obtained prior to marketing the product in those countries. For example, some
of our foreign operations are subject to regulations by the European Medicines
Evaluations Agency and the U.K. Medicines Control Agency. The approval process
may be more or less rigorous from country to country, and the time required for
approval may be longer or shorter than that required in the U.S. No assurance
can be given that clinical studies conducted outside of any country will be
accepted by that particular country, and the approval of a pharmaceutical
product in one country does not assure that the product will be approved in
another country. In addition, regulatory agency approval of pricing is required
in many countries and may be required for the marketing in those countries of
any drug that we develop.

THE DRUG DEVELOPMENT REGULATORY PROCESS

New Drug Approval Process. FDA approval is required before any new drug
can be marketed and sold in the U.S. This approval is obtained through the new
drug application process, which involves the submission to the FDA of complete
pre-clinical data about new compounds and their characteristics and then
clinical data obtained from studies in humans showing the safety and
effectiveness of the drug for the proposed therapeutic use.

Before introducing a new drug into humans, stringent government
requirements for pre-clinical data must be satisfied. The pre-clinical data is
obtained from laboratory studies, and tests performed on animals, which are
submitted to the FDA in an investigational new drug application, or an IND. The
pre-clinical data must provide an adequate basis for evaluating both the safety
and the scientific rationale for the initiation of clinical trials of the new
drug in humans. Pursuant to the IND, the new drug is tested in humans for
safety, adverse effects, dosage, tolerance absorption, metabolism, excretion and
other elements of clinical pharmacology, and for effectiveness for the proposed
therapeutic use.

Clinical trials typically are conducted in three sequential phases,
although the phases may overlap. The process of completing clinical trials for a
new drug may take several years and require the expenditure of substantial
operational and financial resources.

- Phase I clinical trials frequently begin with the initial introduction of
the compound into healthy humans and test primarily for safety.

23

- Phase II clinical trials typically involve a small sample of the intended
patient population to assess the efficacy of the compound for a specific
indication, to determine dose tolerance and the optimal dose range and to
gather additional information relating to safety and potential adverse
effects.

- Phase III clinical trials are undertaken to further evaluate clinical
safety and efficacy in a much larger patient population at different
study sites to determine the overall risk-benefit ratio of the drug and
provide an adequate basis for product labeling.

Each clinical trial is conducted in accordance with rules, or protocols,
that are developed to detail the objectives of the study, including methods to
monitor safety and efficacy and the precise criteria to be evaluated. These
protocols must be submitted to the FDA as part of the IND. In some cases, the
FDA allows a company to rely on data developed in foreign countries, or
previously published data, which eliminates the need to independently repeat
some or all of the studies.

Once sufficient data have been developed pursuant to the IND, the new drug
application, or NDA, is submitted to the FDA to request approval to market the
new drug. Preparing an NDA involves substantial data collection, verification
and analysis, and there is no assurance that FDA approval of an NDA can be
obtained on a timely basis, if at all. The approval process is affected by a
number of factors, primarily the risks and benefits demonstrated in clinical
trials as well as the severity of the disease and the availability of
alternative treatments. The FDA will deny an NDA if the regulatory criteria are
not satisfied or, alternatively, may require additional testing or information
before approving an NDA.

With respect to the branded pharmaceutical products that we acquire, we are
often able to reference the original NDA that we acquired along with the
marketing rights to the products. As a result, when improving these products or
developing product line extensions, we are permitted to file a supplemental new
drug application, enabling us to begin our development process for these
improvements or line extensions generally in the Phase III or late-stage Phase
II clinical trials. Because we are referencing earlier work performed with the
acquired drug, our development process for improvements to and line extensions
of our acquired branded products may be shorter and less costly than with
respect to any new products that we may select to develop.

Abbreviated New Drug Application Process for Generic Products. A generic
drug contains the same active ingredient as a specified brand name drug and
usually can be substituted for the brand name drug by the pharmacist. FDA
approval is required before a generic drug can be marketed. Approval of a
generic drug is obtained through the filing of an abbreviated new drug
application, or an ANDA. Submission and approval of an ANDA is subject to
certain patent and non-patent exclusivity rights applicable to the brand name
drug. When processing an ANDA, the FDA waives the requirement of conducting full
clinical studies, although it normally requires bioequivalence studies.
Bioavailability relates to the rate and extent of absorption and levels of
concentration of a drug active ingredient in the blood stream needed to produce
a therapeutic effect. Bioequivalence compares the bioavailability of one drug
with another that contains the same active ingredient, and when established,
indicates that the rate and extent of absorption and levels of concentration of
a generic drug in the body are the same as the previously approved brand name
drug. An ANDA may be submitted for a drug on the basis that it is the equivalent
to a previously approved drug or, in the case of a new dosage form or other
close variant, is suitable for use under the conditions specified.

The timing of final FDA approval of ANDAs depends on a variety of factors,
including whether the applicant challenges any listed patents for the brand name
drug and whether the brand-name manufacturer is entitled to one or more
non-patent statutory exclusivity periods, during which the FDA is prohibited
from accepting or approving applications for generic drugs.

The FDA may impose debarment and other penalties on individuals and
companies that commit certain illegal acts relating to the generic drug approval
process. In some situations, the FDA is required not to accept or review ANDAs
for a period of time from a company or an individual that has committed certain
violations. The FDA may temporarily deny approval of ANDAs during the
investigation of certain violations that could lead to debarment and also, in
more limited circumstances, suspend the marketing of approved generic drugs by
the affected company. The FDA also may impose civil penalties and withdraw
previously approved ANDAs. Neither we nor any of our employees have ever been
subject to debarment.

24

Manufacturing Requirements. Before approving a drug, the FDA also requires
that our procedures and operations conform to the cGMP regulations. We must
follow the cGMP regulations at all times during the manufacture of our products.
To help insure compliance with the cGMP regulations, we must continue to spend
time, money and effort in the areas of production and quality control to ensure
full technical compliance. If the FDA believes a company is not in compliance
with cGMP, sanctions may be imposed upon that company including: withholding new
drug approvals as well as approvals for supplemental changes to existing
approvals, preventing the company from receiving the necessary export licenses
to export its products, and classifying the company as an unacceptable supplier
and thereby disqualifying the company from selling products to federal agencies.
We believe we are currently in compliance with the cGMP regulations.

Post-approval Requirements. After initial FDA approval for the marketing
of a drug has been obtained, further studies, including Phase IV post-marketing
studies, may be required to provide additional data on safety. Also, the FDA may
require post-marketing reporting to monitor the adverse effects of the drug.
Results of post-marketing programs may limit or expand the further marketing of
the drug. Further, if there are any modifications to the drug, including changes
in indication, manufacturing process, or manufacturing facility, an application
seeking approval of the modifications must be submitted to the FDA or other
regulatory authority. Additionally, the FDA regulates post-approval promotional
labeling and advertising activities to assure that such activities are being
conducted in conformity with statutory and regulatory requirements.

HEALTH CARE FRAUD AND ABUSE LAWS

Federal and state health care fraud and abuse laws have been applied to
restrict certain marketing practices in the pharmaceutical industry in recent
years. These laws include antikickback statutes and false claims statutes. The
federal health care program antikickback statute makes it illegal for anyone to
knowingly and willfully make or receive "kickbacks" in return for any health
care item or service reimbursed under any federally financed healthcare program.
This statute applies to arrangements between pharmaceutical companies and the
persons to whom they market, promote, sell and distribute their products. In
August 1994, the Office of the Inspector General of the Department of Health and
Human Services issued a "Special Fraud Alert" describing pharmaceutical
companies' activities that may violate the statute. There are a number of
exemptions and safe harbors protecting certain common marketing activities from
prosecution. These include exemptions or safe harbors for product discounts,
payments to employees, personal services contracts, warranties, and
administrative fees paid to group purchasing organizations. These exemptions and
safe harbors, however, are drawn narrowly.

Federal false claims laws prohibit any person from knowingly making a false
claim to the federal government for payment. Recently, several pharmaceutical
companies have been prosecuted under these laws, even though they did not submit
claims to government healthcare programs. The prosecutors alleged that they were
inflating drug prices they report to pricing services, which are in turn used by
the government to set Medicare and Medicaid reimbursement rates. Pharmaceutical
companies also have been prosecuted under these laws for allegedly providing
free products to customers with the expectation that the customers would seek
reimbursement under federal programs for the products.

Additionally, the majority of states have laws similar to the federal
antikickback law and false claims laws. Sanctions under these federal and state
laws include monetary penalties, exclusion from reimbursement for products under
government programs, criminal fines and imprisonment.

We have internal policies and practices requiring and detailing compliance
with the health care fraud and abuse laws and false claims laws. Because of the
breadth of these laws and the narrowness of the safe harbors, however, it is
possible that some of our business practices could be subject to challenge under
one or more of these laws, which could have a material adverse effect on our
business, financial condition and results of operations.

25

EMPLOYEES

At December 31, 2001, we had approximately 1,200 full-time equivalent
employees, of which 95 hold Ph.D. or M.D. degrees, or the foreign equivalent. We
believe that our relations with our employees are good. None of our employees in
the U.S. are represented by a union. German and French law provide certain
representative rights to our employees in those jurisdictions.

Our continued performance depends on our ability to attract and retain
qualified professional, scientific and technical staff. The level of competition
among employers for these skilled personnel is high. We believe that our
employee benefit plans enhance employee morale, professional commitment and work
productivity and provide an incentive for employees to remain with aaiPharma. We
have experienced difficulty in attracting and retaining qualified staff in our
Research Triangle Park and Natick, Massachusetts locations where competition for
trained personnel is particularly strong. It is possible that as competition for
these skilled employees increases at our other locations, we could experience
similar problems there as well.

INTELLECTUAL PROPERTY

Our ability to successfully commercialize new branded products or
technologies is significantly enhanced by our ability to secure strong
intellectual property rights -- generally patents -- covering these products and
technologies. We intend to seek patent protection in the United States and
selected foreign countries and to vigorously prosecute patent infringements, as
we deem appropriate. We currently own 23 patents issued by the U.S. Patent and
Trademark Office, and we currently have 14 patent applications filed and pending
with the Patent and Trademark Office. Additionally, we have assigned or
transferred an additional six of our patents to third parties for value.

Our patents cover proprietary processes and techniques, or formulation
technologies, that may be applied to both new and existing products and chemical
compounds. Our patents also cover new chemical entities or compounds,
pharmaceutical formulations, and methods of using certain compounds. We also
seek to patent discoveries of new structures of known compounds, new physical
and chemical characteristics of known compounds, and previously unknown
compounds.

We have two exclusive licenses in the U.S. and some other countries to use
the patents, patent applications, and know-how associated with four
pharmaceutical formulation technologies for mutually acceptable drug candidates.
The ProSLO I and ProSLO II technologies are licensed from Osmotica Corporation.
The other three technologies, ProLonic, ProMelt and ProSpher are licensed from
Tanabe Seiyaku. Like our own formulation technologies mentioned above, these
technologies may be used to develop mutually acceptable new drug products or
improve the physical characteristics of mutually acceptable existing products
and compounds.

In addition to our patents, we rely upon trade secrets and unpatented
proprietary know-how where we believe the public disclosures and limited patent
life associated with obtaining patent protection would not be in our best
strategic interest. We seek to protect these assets as permitted under state or
federal law and by requiring our employees, consultants, licensees, and other
companies to enter into confidentiality and nondisclosure agreements and, when
appropriate, assignment of invention agreements.

In the case of strategic partnerships or collaborative arrangements
requiring the sharing of data, our policy is to disclose to our partner only
such data as relevant to the partnership or arrangement during its term and so
long as our partner agrees to keep that data confidential.

SPECIAL ITEM. EXECUTIVE OFFICERS.

The following information sets forth the name, age, principal occupation
and business experience for our executive officers.

Frederick D. Sancilio, Ph.D., age 51, has been a Director since 1979, and
is currently Chairman of the Board of Directors and Chief Executive Officer of
aaiPharma. Before founding aaiPharma in 1979,

26

Dr. Sancilio's experience in the pharmaceutical industry included various
positions with Burroughs-Wellcome Co., Schering-Plough Corporation, and
Hoffmann-LaRoche, Inc.

Philip S. Tabbiner, D.B.A., age 46, has served as President and Chief
Operating Officer of aaiPharma since February 2002, having previously served as
Executive Vice President of aaiPharma and President of NeoSan Pharmaceuticals
from November 2000 to January 2002. Prior to joining aaiPharma, Dr. Tabbiner
held various positions in the pharmaceutical industry over a twenty year career.
Dr. Tabbiner served from December 1998 to November 2000 as a Senior Vice
President at Bayer Diagnostics, Bayer Corporation, and as President of
International at Chiron Diagnostics from 1997 until Bayer acquired Chiron
Diagnostics in 1998. Prior to joining Chiron Diagnostics, Dr. Tabbiner served
from 1995 to 1997 as Vice President of Worldwide Sales and Marketing at the
Dupont Merck Pharmaceutical Company -- Radiopharm Division.

Gregory S. Bentley, age 52, has served as Executive Vice President, General
Counsel and Secretary of aaiPharma since June 1999. Prior to joining aaiPharma,
Mr. Bentley served from 1994 to 1999 as Vice President, Regulatory and Quality
for Siemens Medical Systems, Inc., a leading medical device company and a
subsidiary of Siemens Corporation. Prior to joining Siemens Corporation as
Associate General Counsel in 1986, Mr. Bentley practiced law with Shearman &
Sterling in New York.

William L. Ginna, Jr., age 49, has served as Executive Vice President and
Chief Financial Officer of aaiPharma since February 2000. Prior to joining
aaiPharma, Mr. Ginna served from 1995 to 1999 as Vice President and Chief
Financial Officer for London International Group, a medical and consumer
products distributor. Mr. Ginna, a Certified Public Accountant, also spent ten
years with Athlone Industries, Inc., a listed New York Stock Exchange
manufacturer of specialty steels and consumer products, where he most recently
served as Vice President and Controller.

David M. Hurley, age 42, has served as Executive Vice President of
aaiPharma and President of NeoSan Pharmaceuticals since February 2002. Prior to
joining aaiPharma, Mr. Hurley served from June 2000 to January 2002 as Chief
Executive Officer of HealthNexis, a healthcare exchange company. Prior to
joining HealthNexis, Mr. Hurley held executive level positions from 1994 to 2000
at two subsidiary companies of Novartis Corporation, serving as President, Chief
Executive Officer, and as a Director of Geneva Pharmaceuticals, Inc., a
specialty pharmaceutical company, and as President, Chief Executive Officer, and
as a Director from December 1997 to December 1998 and as Executive Vice
President from November 1994 to December 1997 at Novartis Nutrition Corporation,
a medical nutrition company.

David Johnston, Ph.D., age 51, has served as Executive Vice President and
Chief Operating Officer, Non-clinical Operations, of aaiPharma and as President
of AAI International since January 2000. Prior to joining aaiPharma, Dr.
Johnston served from March 1997 to August 1999 as President of Oread
Laboratories and Executive Vice President of Drug Development of Oread, Inc., a
contract research organization located in Lawrence, Kansas. Prior to joining
Oread, Dr. Johnston served from October 1994 to March 1997 as Vice President of
Pharmaceutical Product Development of Sanofi, a pharmaceutical company,
directing more than 50 scientists in the area of drug development.

George E. Van Lear, Ph.D., age 61, has served as Executive Vice President
of aaiPharma and as President of aaiResearch since June 2000, having previously
worked for aaiPharma in the 1980's. Dr. Van Lear has over 30 years of experience
in the pharmaceutical industry, most recently serving as President of Senetek
PLC, a biotech company, from April 1999 to June 2000 and as Vice President of
Research and Development from 1996 to 1999 at DPT Technologies, Inc, a
healthcare company.

William H. Underwood, age 53, is a Director and Executive Vice
President-Corporate Development of aaiPharma. He has served as a Director since
1996, as Chief Operating Officer from 1995 to 1997, as Executive Vice President
since 1992, and as Vice President from 1986 to 1992. He has held various
positions in the pharmaceutical and cosmetic industries prior to joining
aaiPharma in 1986, including Director of Quality Assurance and Director of
Manufacturing at Mary Kay Cosmetics, Inc. and Group Leader of Bacteriological
Quality Control at Burroughs-Wellcome Co.

27

ITEM 2. PROPERTIES

Our principal executive offices are located in Wilmington, North Carolina,
in a 73,000-square foot leased facility. Our primary U.S. facilities are located
in Wilmington, North Carolina; Research Triangle Park, North Carolina; North
Brunswick, New Jersey; Natick, Massachusetts; Charleston, South Carolina; and
Shawnee, Kansas. These facilities provide approximately 430,000 square feet of
total operational and administrative space. Our primary European facilities are
located in Neu-Ulm, Germany and include approximately 112,000 square feet of
operational and administrative space. This German facility is leased under
renewable leases expiring in 2008. We also have U.S. sales representatives based
in California, Illinois, Maine, Massachusetts, New Jersey and North Carolina and
foreign sales representatives based in Belgium, Canada, Italy, Japan,
Switzerland, Germany and the U.K. We believe that our facilities are adequate
for our current operations and that suitable additional space will be available
when needed.

PRIMARY OPERATING FACILITIES

- ------------

(1) Although our tax retention operating lease expires on September 30, 2002, we
intend to use a portion of the proceeds from our proposed new senior credit
facilities and senior subordinated notes to terminate this lease and
purchase the underlying properties.

(2) We are in negotiations to extend the lease by three years.

ITEM 3. LEGAL PROCEEDINGS

We are party to lawsuits and administrative proceedings incidental to the
normal course of our business. We do not believe that any liabilities related to
such lawsuits or proceedings will have a material adverse effect on our
financial condition, results of operations or cash flows. While we cannot
predict the outcomes of these suits, we intend to vigorously pursue all defenses
available. In cases where we have initiated an action, we intend to prosecute
our claims to the full extent of our rights under the law.

We are a party to a number of legal actions with generic drug companies. We
filed three cases in the United States District Court for the Eastern District
of North Carolina claiming infringement of certain of our

28

fluoxetine hydrochloride patents. Fluoxetine hydrochoride is an active
ingredient in the drug marketed by Eli Lilly as Prozac. Each of the defendants
in these three actions, Dr. Reddy's Laboratories Ltd., a pharmaceutical company
based in India, and its U.S. affiliate, Dr. Reddy's Laboratories, Inc. (formerly
Reddy-Cheminor, Inc.), Barr Laboratories, Inc., and PAR Pharmaceuticals, Inc.
sells a generic fluoxetine hydrochloride product in the United States.

In the first action, filed in August 2001, we alleged that the defendants
are infringing our fluoxetine hydrochloride Form A patent (U.S. Patent No.
6,258,853) and are seeking an injunction to prevent the sale of products that
infringe this patent, as well as compensatory and punitive damages and
attorney's fees. In the second case, filed in October 2001, we alleged that the
defendants are infringing three additional fluoxetine patents (U.S. Patent Nos.
6,310,250, 6,310,251 and 6,313,350) and are seeking an injunction to prevent the
defendants from selling infringing fluoxetine products, and monetary damages. In
the third action, filed in November 2001, we have brought similar claims against
the defendants regarding a fifth fluoxetine patent (U.S. Patent No. 6,316,672).
In each case, the defendants have filed counterclaims alleging patent
invalidity, violations of the North Carolina Unfair Trade Practices Act and
tortious interference with the defendants' distribution agreements. We have
denied the substantive allegations of their claims. These cases are all in the
initial stages and discovery is just beginning. It is possible that the patents
subject to these lawsuits will be found invalid or unenforceable.

We are also involved in three actions centered on our omeprazole-related
patents. Omeprazole is the active ingredient found in Prilosec, a drug sold by
AstraZeneca. Two cases have been filed against us by Dr. Reddy's Laboratories
Ltd. and Dr. Reddy's Laboratories, Inc. in the United States District Court for
the Southern District of New York in July 2001 and November 2001. These
plaintiffs have sought but, as of March 1, 2002 have not obtained, approval from
the FDA to market a generic form of Prilosec. The plaintiffs in these cases are
challenging the validity of five patents that we have obtained relating
omeprazole (U.S. Patent Nos. 6,262,085, 6,262,086, 6,268,385, 6,312,712 and
6,312,723) and are seeking a declaratory judgment that their generic form of
Prilosec does not infringe these patents. Additionally, they have alleged
misappropriation of trade secrets, tortious interference, unfair competition and
violations of the North Carolina Unfair Trade Practice Act. We have denied the
substantive allegations made in these cases. Both cases are in the initial
stages and discovery has not been commenced.

The third case involving our omeprazole patents was brought in August 2001
by Andrx Pharmaceuticals, Inc. in the United States District Court for the
Southern District of New York. Andrx has received FDA approval for its generic
omeprazole product. However, to our knowledge, it is not currently marketing
this drug in the U.S. Andrx is challenging the validity of three of our
omeprazole patents (U.S. Patent Nos. 6,262,085, 6,262,086, and 6,268,385), and
is also seeking a declaratory judgment that its generic omeprazole product does
not infringe these patents. Furthermore, Andrx claims violations of federal and
state antitrust laws with respect to the licensing of these omeprazole patents
and is seeking injunctive relief and unspecified treble damages. We have denied
the substantive allegations made by Andrx. This case is in the initial stages of
discovery. It is possible that the patents subject to these lawsuits will be
found invalid or unenforceable.

29

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

The price range of the our common stock, which is traded on the NASDAQ
market under the symbol "AAII," is listed below by quarter for the years ended
December 31, 2001 and 2000:

We estimate there were approximately 1,400 holders of record for our common
stock as of January 31, 2002. No cash dividends were declared during 2001 or
2000.

In 2001, we issued warrants to purchase an aggregate of 114,905 shares of
our common stock to affiliates of the arranger of our senior credit facilities
in connection with the increase in the amount of the facility. The warrants are
exercisable at a price of $0.001 per share and expire in 2011. Our issuance of
these securities was made in reliance on the exemption from registration under
the Securities Act of 1933 set forth in Section 4(2) of that act and Rule 506
promulgated under that act.

30

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.

The following table sets forth our selected historical consolidated
financial data as of and for each of the five fiscal years ended December 31,
2001, 2000, 1999, 1998 and 1997 and have been derived from our consolidated
financial statements, which have been audited by Ernst & Young LLP, independent
auditors.

The selected historical financial data set forth below are not necessarily
indicative of the results of future operations and should be read in conjunction
with "Management's Discussion and Analysis of Financial Conditions and Results
of Operations" and our consolidated financial statements and related notes and
other financial information appearing elsewhere in this report.

- ------------

(1) In connection with our merger with Medical & Technical Research Associates,
Inc., we recorded a $6.4 million unusual item in 1999 (see note 3 of notes
to our consolidated financial statements appearing elsewhere in this
report).

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

You should read the following discussion and analysis of our financial
condition and results of operations together with our consolidated financial
statements and related notes included elsewhere in this report. The notes to our
consolidated financial statements set forth our critical accounting policies,
including polices relating to revenue recognition, research and development
expense, and use of estimates. These policies are summarized below under
"-- Critical Accounting Policies."

OVERVIEW

aaiPharma Inc. is a specialty pharmaceutical company focused on the
acquisition, development, enhancement and commercialization of branded
pharmaceutical products. Historically, the majority of our net revenues have
been in our research revenues business, with an increasing portion of our
resources devoted to our product sales and product development businesses. Major
customers for our pharmaceutical products are large well-established medical
wholesalers and distributors. Major customers for our research revenues and
product development businesses are pharmaceutical and biotechnology companies.

Product Sales

Our product sales business unit, NeoSan Pharmaceuticals, is focused on
acquiring established, branded pharmaceutical products, developing improved
products and product line extensions, and marketing and promoting these
products. We currently market products under the M.V.I., Aquasol and Brethine
brand names, as a result of our product line acquisitions in 2001. Product sales
also include the commercial manufacturing of low volume products marketed and
sold by other pharmaceutical companies. The principal costs of this business
include manufacturing costs under agreements with third-party manufacturers,
selling expense of our contract sales force, and research and development
expense for product improvements and line extensions.

Our results of operations can be influenced by the timing of purchases made
by customers of NeoSan. These customers are wholesalers and may increase their
purchases if they anticipate a price increase. Wholesalers may anticipate a
price increase due to the timing of prior increases, the acquisition of a
product by a new supplier, our announcement of an increase or other reasons. Any
increase in revenues during one period due to an anticipated price increase may
likely be offset by decreased revenues in subsequent periods. However, there may
be some volatility of NeoSan's revenue in future periods due to the timing of
its customers' purchasing decisions.

Product Development

Our product development business unit, aaiResearch, uses our research and
development expertise and capabilities to study and develop new drug-delivery
technologies and improve existing pharmaceutical products. We license the
developed technologies and products to customers, usually before the development
is complete. We generally receive payments for our efforts and innovations upon
the occurrence of defined events, known as milestones, which are intended to
help cover the costs of development. These milestone payments are not
refundable. In most cases, we also receive royalties on the eventual sales of
the product.

32

Because of the long-term nature of these projects, we may recognize revenues
from milestone payments or royalties in one period and the associated expenses
in prior periods. The principal expense of this business is research and
development expense, which consists primarily of labor costs and costs for
clinical trials. In some cases, these costs may be directly reimbursed by our
customers.

Research Revenues

Our research revenues business unit, AAI International, provides research
services through two primary groups, a non-clinical group and a clinical group.
The non-clinical group analyzes and tests various chemical compounds and
provides small scale manufacturing of chemical compounds to be used for human
clinical trials. The services performed by the non-clinical group also include
chemical analysis, chemical synthesis, drug formulation, bio-analytical testing,
product life cycle management studies, and regulatory and compliance consulting.
All of these non-clinical services involve either laboratory work or consulting
services. The clinical group performs testing for customers of new
pharmaceutical products in humans under controlled conditions as part of the
regulatory approval process for pharmaceutical products. These clinical services
involve conducting human clinical studies and the statistical analysis relating
to these studies.

Both the non-clinical and clinical groups receive requests for services
from customers, often on a competitive basis. These projects vary in length from
one month to several years. In general, our customers may cancel a project upon
30 days' notice. The principal expenses of this business are labor and
depreciation of capital equipment.

ACQUISITIONS

M.V.I. and Aquasol Product Lines

On August 17, 2001, we acquired the M.V.I. and Aquasol branded lines of
critical care injectable and oral nutritional products from AstraZeneca for up
to $100 million payable over three years. Of this amount, we paid $52.5 million
at closing. We funded this purchase price with increased borrowings under our
existing senior credit facilities, which are described in "-- Liquidity and
Capital Resources." Future guaranteed payments of $1.0 million each are due in
August 2002 and 2003. Future contingent payments of $2.0 million and $43.5
million are potentially due in August 2003 and 2004, respectively, but are
contingent upon certain obligations being completed by AstraZeneca, and have not
yet been recorded as a liability on our consolidated balance sheet. The M.V.I.
and Aquasol product lines did not have separable assets and liabilities
associated with them other than inventory, therefore we allocated the remaining
purchase price to acquired identifiable intangible assets, with the excess of
the purchase price over the identifiable intangible assets recorded as goodwill.

Brethine Product Line

On December 13, 2001, we acquired the Brethine branded line of products
from Novartis for $26.6 million. We used borrowings of $25.0 million under our
existing senior credit facilities and cash on hand to pay this purchase price.
The Brethine product line did not have separable assets and liabilities
associated with it, therefore we allocated the purchase price to acquired
identifiable intangible assets, with the excess of the purchase price over the
identifiable intangible assets recorded as goodwill.

CRITICAL ACCOUNTING POLICIES

Revenue Recognition

Net Revenues. Our net revenues represent our total revenues less
allowances for customer credits, including estimated discounts, product returns
and non-research and development expenses reimbursed by customers. We accept
returns of expired products.

Product Sales. We recognize revenues for product sales at the time our
products are shipped.

Product Development. We recognize licensing revenues upon completion of
interim contract milestones. Revenues from upfront licensing fees are deferred
and amortized over the term of the associated
33

agreement or as on-going services are performed. We recognize revenues for
achieving contract milestones when achieved and royalty revenues as earned based
on sales of the underlying products. We bear the risk that some of the
development projects may not be approved or that the eventual sales of a
royalty-generating product may not meet expectations.

Research Revenues. We recognize revenues from fee-for-service contracts on
a percentage-of-completion basis as the work is performed or on a time and
materials basis in accordance with the specific contract terms. Revenues
recognized prior to contract billing terms are recorded as work-in-progress.
Provisions for losses on contracts, if any, are recognized when identified.

SAB 101. In December 1999, the Securities and Exchange Commission, or the
SEC, issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements." This bulletin specifically addresses revenue recognition issues
related to certain upfront payments or fees. Under this bulletin, certain
upfront fees and payments recognized as income in prior periods are required to
be deferred and are being amortized into revenues over the terms of the relevant
agreements or as the on-going services are performed. We implemented Staff
Accounting Bulletin No. 101 in the fourth quarter of 2000 and the cumulative
effect of a change in accounting principle was retroactively adopted as of the
beginning of the first quarter of 2000. During the year ended December 31, 2000,
we recorded a charge of $1.5 million ($1.0 million after tax), or a loss of
($0.05) per share for the cumulative effect of this change in accounting
principle. We recognized $0.5 million in 2001 and $0.7 million in 2000 of
revenues related to the amortization of these deferred amounts.

Research and Development Expense

Research and development expense consists of salaries of research and
development personnel, raw material expenses, third-party consulting and testing
costs, and indirect costs such as management and administrative overhead and
facilities costs. Research and development costs are charged to expense as
incurred.

RESEARCH AND DEVELOPMENT ARRANGEMENTS

Research and development expense was 8% of our net revenues in 2001, and we
expect research and development activities to account for between 8% and 10% of
budgeted annual net revenues in 2002. The following product development table
identifies, for each of our major development programs in 2001, the stage of
development at December 31, 2001 of the lead product in each program, research
and development spending on each program in 2001, cumulative research and
development spending on each program from inception through December 31, 2001,
an estimate of the additional research and development expense to complete the
development of the lead product in the program, and the year in which we
anticipate completing the lead product in the program. The estimated additional
expense to complete the lead product and the timing of completion represent our
estimates. As we continue these development programs and evaluate our interim
results and other information, we may decide to change the scope and direction
of a program and we may change how we allocate our research and development
spending to pursue more promising product candidates. In addition, our actual
costs in developing these products may be materially different from our
estimates due to uncertainties inherent in product development. Moreover,
because of these inherent

34

uncertainties, we may not be able to successfully develop, commercialize or
license the products or technologies included in the table within the time
periods specified, if at all.

- ---------------
(1) Includes an allocation of $4.1 million of indirect costs, primarily
management and administrative overhead and facilities costs, based on
direct research and development costs in 2001.

(2) Includes research and development expense incurred in connection with
development of our patented ProSorb technology, which is being applied to
the lead product in this development program.

(3) The lead product in this program, a liquid form of M.V.I. Pediatric, is
undergoing stability testing. Under FDA regulations, we believe that
approval of this product will not require any clinical studies.

(4) This product is being developed for a customer pursuant to a development
agreement.

(5) Excludes research and development expense incurred in connection with the
development of our patented ProSorb technology.

(6) We are developing additional identified products using our technologies for
licensing to customers and anticipate an additional $3.5 million to $4.0
million of research and development expense to complete the development of
these products.

In addition to the specifically identified programs named in the table, we
have targeted additional product development programs or projects. These other
programs or projects may require significant research and development spending
in future periods.

There is a risk that any specific research and development program or
project may not produce revenues. We believe that the potential profit margins
from successful development programs or projects will compensate for costs
incurred for unsuccessful projects. We are currently involved in many
pharmaceutical and technology development programs or projects and believe that
these activities help to diversify our portfolio and manage our risk. See "Risk
Factors -- We may incur substantial expense to develop products that we never
successfully commercialize" contained elsewhere in this report.

SIGNIFICANT DEVELOPMENT AGREEMENT

We have a development agreement with a customer that provides for us to
receive contingent periodic payments based on sales of the customer's product
and obligates the customer to use us on a fee-for-service basis for a product
life cycle management project related to the product. The development agreement
relates to a product with respect to which we have licensed intellectual
property that we developed in the past. We have recognized product development
royalty revenues under this agreement for the periodic payments based on product
sales, and have recognized research revenues related to the product life cycle
management project. Product development revenues from this agreement were $14.9
million in 2001, $3.5 million in 2000 and $1.5 million in 1999. We recognized no
research and development expense in 2001 and 2000 associated with

35

the royalty payments we received in 2001 and 2000. The expense of our work
associated with these royalty revenues was recognized primarily in 1999, 1998
and 1997. We do not anticipate incurring significant expense associated with the
product development revenues under this agreement in future periods. Research
revenues associated with this agreement were $6.3 million in 2001, $12.6 million
in 2000 and $2.7 million in 1999. Because of the research and development nature
of our activities in this product life cycle management project and the
potential that these activities could result in continuation of product
development revenues into the future, we have recorded our costs incurred in
this project as research and development expense -- $2.3 million in 2001, $4.4
million in 2000 and $0.8 million in 1999. Accordingly, for our research revenues
business unit, we have recognized no expense associated with the research
revenues arising under this agreement, as this expense was recognized by our
product development business unit.

We amended this agreement in December 2001. As amended, the agreement
provides that, if we remain available to provide the customer with development
and formulation services for an identified class of pharmaceutical products on
an exclusive basis in a calendar quarter, we will be entitled to fees based on
the level of sales over a prior monthly period of the product that was the
subject of our development work. The customer is obligated to make these
quarterly payments based on whether defined market events have occurred in the
prior measurement month -- e.g., if the defined market events have not occurred
during three consecutive months, we would be entitled to fees in three
consecutive quarters, with, for example, the amount of the fees in the first
quarter being based on product sales in the first month. However, if we do not
continue to provide these development and formulation services on an exclusive
basis in any quarter, we will not be entitled to these fees for that quarter and
all subsequent quarters. Under the agreement, we have the right, at any time, to
terminate our obligation to provide the development and formulation services on
an exclusive basis. Accordingly, we will not recognize product development
revenues under this agreement in any quarter until we have satisfied the
exclusivity requirement for that quarter.

We believe that we will be entitled to product development fees in each
quarter of 2002 if we continue to provide the development services to the
customer on an exclusive basis during those periods. The amount of the fees due
in the first quarter of 2002 is approximately $1.4 million. Although we do not
yet have sufficient data to calculate with precision the amounts that would be
due in the remaining quarters of 2002, we believe that the aggregate amount for
2002, including the first quarter, will be in the range of $14 million to $18
million, although the actual amount could be higher or lower. Although we may
also be entitled to receive similar fees in subsequent periods, neither we nor
our customer control whether the market events will occur. We believe there is
significant risk that the market events will occur, and that as a result we will
not be entitled to receive product development fees in 2003 or subsequent future
periods.

The development agreement requires the customer to use a minimum amount of
our research services at standard rates on the product life cycle management
project in specified calendar quarters. In 2000, the amount of research work we
performed for the customer on this project was significantly greater than the
minimum amount, and during 2001 the project wound down to the minimum
contractual levels. The customer is obligated to continue the project at minimum
levels through 2002, and may be obligated to continue the project at further
reduced levels for subsequent periods if the market events associated with
terminating our right to receive product development fees described above do not
occur.

36

RESULTS OF OPERATIONS

The following table presents the net revenues for each of our business
units and our consolidated expenses and net income (loss) and each item
expressed as a percentage of consolidated net revenues:

Year Ended December 31, 2001 Compared to Year Ended December, 31 2000

Our net revenues for the year ended December 31, 2001 increased 35% to
$141.1 million, from $104.2 million in 2000. This increase is primarily due to
the acquisition by our NeoSan business unit of the M.V.I., Aquasol and Brethine
branded products and an increase of $5.1 million of net revenues associated with
our significant development agreement described above.

Net revenues from product sales increased 274% in 2001 to $27.4 million,
from $7.3 million in 2000, due to sales of our M.V.I., Aquasol and Brethine
products after we acquired them. Because these acquired product lines will
contribute revenues for the full year ending December 31, 2002, we have planned
for significantly increased net revenues and expenses from these product lines
for 2002. Net revenues from product sales in 2000 and prior periods consist of
revenues from commercial manufacturing of products marketed by other
pharmaceutical companies. Net revenues from commercial manufacturing contributed
$9.9 million to net revenues from product sales in 2001.

Net revenues from product development increased 106% in 2001 to $20.4
million, from $9.9 million in 2000, primarily due to a 325% increase, or an
increase of $11.4 million, of product development net revenues under our
significant development agreement described above in "-- Significant Development
Agreement." Our expenses associated with the development work performed under
this agreement were recognized primarily in 1999, 1998 and 1997. No significant
expense was associated with the product development revenues recognized in 2001
or 2000, and we do not anticipate incurring significant expense associated with
product development revenues from this agreement in future periods.

Net revenues from our research revenues business increased 7% in 2001 to
$93.2 million, from $87.0 million in 2000. Non-clinical research revenues
increased by 2% in 2001 to $64.3 million, an increase of $1.4 million over the
prior year. Clinical research revenues increased by 20% in 2001 to $28.9
million, from $24.2 million in 2000. This increase was primarily attributable to
revenues generated from significant new Phase III clinical trial contracts that
we entered into in the second half of 2000, including amendments to those
contracts, in 2001. Net revenues from our research revenues business associated
with our significant development agreement described above decreased 50% in 2001
to $6.3 million, from $12.6 million in 2000.

37

Gross margin dollars, or net revenues less direct costs, increased $17.4
million, or 33%, to $70.7 million, from $53.3 million in 2000, reflecting our
increased net revenues in 2001 over the prior year. As a percentage of net
revenues, gross margin dollars decreased slightly to 50% in 2001 from 51% in
2000. Gross margin dollars from our product sales business increased $12.3
million in 2001, from $1.2 million in 2000, with a gross margin percentage of
49% in 2001. Additionally, gross margin dollars from our product development
business increased 106% to $20.4 million in 2001 from $9.9 million in 2000,
benefitting significantly from the $14.9 million of product development revenues
from our significant development agreement described above. These higher margins
generated by our product sales and product development businesses were offset by
the lower gross margin percentage of our research revenues business in 2001,
reflecting a significant increase in lower-margin clinical revenues and decrease
in higher-margin non-clinical revenues, including fee-for-service revenues under
our significant development agreement described above.

Selling expenses increased 18% in 2001 to $14.0 million, from $11.9 million
in 2000. This increase is primarily due to additional selling expenses incurred
by our product sales business associated with marketing and promoting our new
products, maintaining and enhancing distribution channels, and developing our
product sales force.

General and administrative costs increased 12% in 2001 to $30.5 million,
from $27.1 million in 2000. This increase was primarily due to increases in
employee benefits, including healthcare, vacation costs and employee performance
awards, and increases in legal fees related to protecting our intellectual
property rights.

Research and development expenses were approximately 8% of net revenues, or
$10.9 million, in 2001, a decrease from 12% of net revenues, or $12.2 million,
in 2000. This decrease is primarily attributable to the winding down in 2001 of
a significant product life cycle management project associated with the
significant development agreement described above. In general, we target annual
research and development expenses to be approximately 8% to 10% of our estimated
net revenues.

The direct pharmaceutical start-up costs of $2.1 million in 2001 represent
costs of developing NeoSan's organizational and marketing infrastructure. These
costs were incurred prior to our acquisition of any product lines and were
expensed as incurred in accordance with the American Institute of Certified
Public Accountants' Statement of Position 98-5, "Reporting on the Costs of
Start-Up Activities." Upon the acquisition of our first product line in August
2001, we began classifying similar costs as selling or general and
administrative costs, as appropriate.

Net interest expense increased 71% in 2001 to $3.6 million, from $2.1
million in 2000. This $1.5 million increase is primarily attributable to the
borrowings in 2001 that funded our product line acquisitions in August and
December. We have planned for significantly higher net interest expense in 2002
associated with the debt incurred to fund the acquisitions of the M.V.I.,
Aquasol and Brethine product lines. Completion of the pending acquisition of the
Darvon and Darvocet product lines will also significantly increase interest
expense in 2002. See "-- Liquidity and Capital Resources."

Income from operations was $13.2 million in 2001, an $11.2 million increase
over the prior year. This increase is primarily attributable to the expansion of
our product sales business and an increase in product development revenues (with
low associated expenses) from our significant development agreement described
above. This increase was offset by a decrease in income from operations in our
research revenues business caused by the changing mix of revenues in that
business. We recorded income from operations for our product sales business of
$7.7 million in 2001, compared to $0.3 million in the prior year. This increase
is primarily attributable to our acquisitions of the M.V.I., Aquasol and
Brethine product lines during 2001.

We recorded income from operations for our product development business of
$9.8 million in 2001, compared to a loss from operations of $3.5 million in
2000. This resulted from increases in net revenues related to our significant
development agreement described above.

Unallocated corporate expenses increased by 14% in 2001 to $13.0 million,
from $11.3 million in 2000. This higher level was attributable to additions to
our corporate infrastructure to accommodate the expansion of our overall
business.

38

We recorded income from operations for our research revenues business of
$8.7 million in 2001, compared to $16.6 million in 2000. This decrease is
primarily due to the changing mix of research revenues, with a significant
increase in lower-margin clinical revenues and a decline in higher margin
product life cycle management revenues.

We recorded a tax provision of $3.2 million in 2001, based on an effective
tax rate of 35%. This rate is slightly higher than the statutory rate due
principally to permanent differences of $0.4 million. We recorded a net deferred
tax asset of $3.6 million at December 31, 2001, which we expect to utilize.

Year Ended December 31, 2000 Compared to Year Ended December 31, 1999

Our net revenues for the year ended December 31, 2000 grew 2% to $104.2
million, compared to $102.2 million in 1999, primarily due to an increase in
revenues from our research revenues business, offset by lower product sales
revenues.

Net revenues from our research revenues business increased 10% to $87.0
million, from the $79.4 million recorded in 1999. Non-clinical research revenues
increased 22% to $62.8 million in 2000, from $51.7 million in 1999. Non-clinical
research revenues increased primarily due to the increased revenues associated
with our significant development agreement described above. Clinical research
revenues declined 13% in 2000 to $24.2 million, down from $27.7 million in 1999.

Net revenues from product sales decreased 42% in 2000 to $7.3 million, from
$12.7 million in 1999. These net revenues are solely from our manufacturing of
low volume products for other pharmaceutical companies. This decrease is
primarily due to higher manufacturing volume in the fourth quarter of 1999 in
connection with the commercial launch of an azathioprine product manufactured by
us and marketed by another pharmaceutical company.

Net revenues from product development decreased 2% in 2000 to $9.9 million,
compared to $10.1 million in 1999.

Gross margin dollars increased 16% to $53.3 million in 2000, from $46.0
million in 1999. Gross margin dollars as a percentage of net revenues increased
from 45% in 1999 to 51% in 2000. The higher gross margin percentage in 2000
reflects an increase in higher-margin non-clinical revenues from our significant
development agreement described above and the full-year effect of
cost-containment programs that we initiated in late 1999.

Selling expenses decreased 2% in 2000 to $11.9 million, from $12.2 million
the prior year. As a percentage of net revenues, selling expense decreased to
approximately 11% in 2000 compared to 12% in 1999. This decrease was primarily
related to the realignment of our workforce in Europe related to our merger with
Medical & Technical Research Associates, Inc.

General and administrative costs increased 8% in 2000 to $27.1 million,
from $25.2 million in 1999. This increase is primarily due to expanding our
management team and costs associated with organizing NeoSan.

Research and development expenses were $12.2 million in 2000, or
approximately 12% of net revenues, compared with approximately 11% in 1999. This
increase is consistent with our strategy of long-term product development and
our continuing commitment to our development pipeline.

Income from operations was $2.0 million in 2000, compared to a loss of $8.8
million in 1999. This improvement was due in part to the impact on gross margin
dollars of a more favorable revenue mix and the $6.4 million pre-tax charge in
1999 for costs associated with our merger with Medical & Technical Research
Associates, Inc. and subsequent restructuring.

Income before the cumulative effect of a change in accounting principle was
$0.6 million, or $0.03 per diluted share, compared to a loss of $7.9 million, or
($0.46) per diluted share in 1999.

39

Our effective tax benefit rate in 2000 was different from the statutory
rate primarily due to $1.2 million in permanent differences offset by a $2.0
million benefit resulting from the benefit of foreign net operating losses. We
had recorded a net deferred tax asset of $2.5 million at December 31, 2000.

LIQUIDITY AND CAPITAL RESOURCES

Historically, we have funded our businesses with cash flows provided by
operations and proceeds from borrowings. Cash flow provided by operations in
2001 was $20.4 million, up from $14.7 million in 2000. This increase is
primarily due to our improved management of working capital, which was strongly
influenced by the timing of transactions, including our receipt of $14.9 million
of product development payments associated with our significant development
agreement described above and the collection of a significant receivable
associated with this agreement. Our working capital improvement was partially
offset by additional working capital needed to acquire the M.V.I., Aquasol and
Brethine product lines.

Cash used in investing activities was $81.8 million in 2001, which is
primarily related to our acquisition of branded product lines. Our initial
payment to AstraZeneca to acquire the M.V.I. and Aquasol product lines was $52.5
million. Future guaranteed payments of $1.0 million each are due in August 2002
and 2003. Future contingent payments of $2.0 million and $43.5 million are
potentially due in August 2003 and 2004, respectively. In addition, we paid
$26.6 million to acquire the Brethine product line and made an initial payment
of $0.9 million to acquire a sterile manufacturing facility located in
Charleston, South Carolina. Additional contingent payments of up to $5.0 million
plus additional royalties may be due in increments through June 30, 2006 based
on the level of manufacturing revenues at the Charleston facility during this
period. These contingent payment obligations, including the contingent payments
potentially due in connection with the acquisition of the M.V.I. and Aquasol
product lines, have not yet been recorded as a liability on our balance sheet.

Capital expenditures were $6.3 million during 2001. Capital assets
purchased during 2001 were primarily related to our upgrading and replacing
pharmaceutical development and information technology equipment.

Cash provided by financing activities during 2001 was $66.6 million,
primarily representing net proceeds of $78.9 million in borrowings to fund our
product line acquisitions and $5.1 million of cash proceeds from the exercise of
stock options, offset by repayments under our revolving credit facility of $16.3
million.

In 2000, $14.7 million of cash was provided by operations, benefiting from
net cash generated under our significant development agreement and improved
working capital management. During 2000, net cash used in investing activities
was $3.9 million, primarily consisting of capital expenditures of $4.6 million.
Cash used in financing activities during 2000 was $11.5 million, of which $10.7
million represented repayments of borrowings.

In 1999, $12.7 million of cash was used in operations, $5.7 million of
which represented restructuring payments. During 1999, purchases of property and
equipment were $13.5 million. Major capital assets purchased during 1999
included equipment for a new corporate facility in Wilmington, North Carolina
and continued implementation of a financial and operations enterprise management
information system. These uses of cash were funded through cash provided by net
financing activities of $16.2 million.

In August 2001, we amended our loan agreement with bank lenders. Following
such amendment, the loan agreement provided for borrowings of up to $85 million,
consisting of a term loan of $60 million and a revolving credit facility of up
to $25 million. In December 2001, we amended the loan agreement to provide for
an additional $25 million term loan. In December 2001, we re-paid $7 million of
the initial term loan. The revolving credit facility under the loan agreement is
based upon a borrowing base. At December 31, 2001, the entire $25.0 million of
the revolving credit facility was available for borrowing based on our eligible
accounts receivable and inventory. The loan agreement provides for variable
interest rates based on LIBOR or Base Rate, at our option, and is secured by a
security interest on substantially all of our domestic assets, all of the stock
of our domestic subsidiaries and 65% of the stock of our material foreign
subsidiaries directly owned by us or one of our domestic subsidiaries. At
December 31, 2001, 30-day LIBOR was 1.87%.

40

The loan agreement expires in January 2003. We have the option to extend
the term of the loan agreement to December 31, 2006, if we satisfy specific
financial and operating conditions. If the extension option has not been
exercised by January 2003, any outstanding balances under this facility must be
repaid. Scheduled maturities of long-term debt in 2003 are $78.9 million. If we
extend the loan agreement, quarterly principal payments on the term loans will
begin in March 2003. If the loan agreement is not refinanced by September 30,
2002, or the option to extend the term to December 31, 2006 is not exercised by
such date, we are obligated to pay an aggregate fee equal to 1.0% of the
outstanding term loans and revolving credit commitments under the loan agreement
on such date. An additional aggregate 1.0% fee on the outstanding term loans and
revolving credit commitments will be due on December 31, 2002 if our loan
agreement is not refinanced (or the option to extend the maturity is not
exercised) by such date. The loan agreement requires the payment of certain
commitment fees based on the unused portion of the revolving line of credit.
Under the terms of the credit agreement, we are required to comply with various
covenants including, but not limited to, those pertaining to maintenance of
certain financial ratios and incurring additional indebtedness. We were in
compliance with the financial covenants under this credit agreement at December
31, 2001.

In March 2001, we completed a sale/leaseback transaction on manufacturing
equipment, which provided cash of $3.1 million. The lease has a five-year term
and provides for payment of approximately $0.6 million annually.

We currently lease two significant facilities, including our corporate
headquarters in Wilmington, North Carolina, under the terms of a tax retention
operating lease. The lease for these facilities expires on September 30, 2002.
At the end of the term, we may elect to purchase the facilities at fair market
value or sell the properties.

On February 18, 2002, we entered into an agreement with Eli Lilly to
acquire the U.S. rights to the Darvon and Darvocet branded product lines for the
treatment of mild to moderate pain and related inventory for $211.4 million in
cash, subject to reduction based on sales of these products before and after the
closing of the acquisition. We anticipate completing this acquisition by the end
of the first half of 2002. We are currently seeking senior secured and senior
subordinated debt financing of an aggregate of $350 million to fund the
acquisition of these product lines, to repay indebtedness outstanding under our
existing loan agreement, to terminate our tax retention operating lease and
purchase the underlying properties, and pay related fees and expenses. Our
obligation to complete the acquisition of these product lines is contingent on
obtaining this permanent debt financing.

Our proposed senior secured credit facilities consist of a $75.0 million
five-year revolving credit facility and a $100 million five-year term loan
facility. As proposed, the term loan facility amortizes over the full five-year
term, with amortization of $5.0 million, $15.0 million, $20.0 million, $25.0
million and $35.0 million, respectively, in years one through five of the
facility. The revolving credit facility is not tied to a borrowing base. Our
proposed senior credit facilities will provide for variable interest rates based
on LIBOR or Base Rate, at our option. Such facilities will be guaranteed by all
of our domestic subsidiaries and secured by a security interest on substantially
all of our domestic assets, all of the stock of our domestic subsidiaries and
65% of the stock of our material foreign subsidiaries directly owned by us or
one of our domestic subsidiaries. The proposed senior credit facilities will
require the payment of certain commitment fees based on the unused portion of
the revolving credit facility. Under the terms of the credit agreement for the
proposed senior credit facilities, we will be required to comply with various
covenants including, but not limited to, those pertaining to maintenance of
certain financial ratios and incurrence of additional indebtedness. The proposed
senior credit facilities may be optionally prepaid at any time without a
premium.

Our proposed issuance of senior subordinated debt consists of $175 million
of senior subordinated notes due 2010. The notes will have a fixed interest rate
to be established prior to the closing of the acquisition of Darvon and
Darvocet. The notes will be guaranteed on a subordinated basis by all of our
existing domestic subsidiaries and all of our future domestic subsidiaries of
which we and/or our subsidiaries own 80% or more of the equity interests. The
notes will not be secured. Prior to the third issuance of the notes, up to 35%
of the notes are redeemable with the proceeds of qualified sales of equity at a
premium redemption price. On or after the fourth anniversary of the date of
issuance of the notes, all or any portion of the notes will be

41

redeemable at a premium redemption price. Under the terms of the indenture for
the notes, we will be required to comply with various covenants including, but
not limited to, a covenant relating to incurrence of additional indebtedness.

Our liquidity needs increased significantly during 2001 and will increase
further upon the completion of our pending acquisition of the Darvon and
Darvocet product lines. After giving effect to our completed and pending branded
product line acquisitions, our annual net interest expense may exceed $30
million in 2002. We may have to make contingent payments in the next several
years of $47 million in connection with our product line acquisitions and $5.0
million in connection with the purchase of our Charleston manufacturing
facility. Additionally, we will have $3.3 million of principal repayments due in
2002 under our proposed new senior credit facilities.

We believe that our credit facilities and cash flow provided by operations
will be sufficient to fund near-term growth and fund our guaranteed and
contingent payment obligations arising from our acquisitions of the M.V.I. and
Aquasol product lines and the Charleston, South Carolina manufacturing facility.
We may require additional financing to pursue other acquisition opportunities or
for other reasons. We may from time-to-time seek to obtain additional funds
through the public or private issuance of equity or debt securities. While we
remain confident that we can obtain additional financing if necessary, we cannot
assure you that additional financing, including the proposed debt financing
described above, will be available or that the terms will be acceptable to us.

First Quarter Non-recurring Charges

Upon successful completion of these proposed senior credit facilities and
senior subordinated notes, we will record approximately $4.2 million of expense,
net of tax, from our writing off deferred financing costs associated with our
current debt facilities. This one-time write-off will significantly reduce our
net income for the quarter in which we complete these debt financing
transactions.

Prior to the completion of the offering of the proposed senior subordinated
notes, we plan to repurchase outstanding redeemable warrants to purchase shares
of our common stock. Based on the closing price per share of our common stock on
the Nasdaq Stock Market on March 8, 2002 of $32.50, the cost to purchase all of
these warrants would be approximately $3.7 million and we would recognize a
charge of $0.9 million.

RELATED PARTY TRANSACTIONS

In 1994, as part of our internal development program, we organized Endeavor
Pharmaceuticals, Inc. to continue development of products that we had been
developing on our own and to permit investors to directly invest in the
development of these products. We assigned our rights to these products to
Endeavor in return for approximately 47% of Endeavor's fully diluted equity. As
a result of additional issuances of equity by Endeavor to third party investors,
our fully diluted ownership interest in Endeavor has been reduced to
approximately 13%. As of December 31, 2001, Dr. Frederick D. Sancilio, our
Chairman and Chief Executive Officer, owned 0.8% of Endeavor's fully diluted
equity and an affiliate of James L. Waters, one of our directors, owned 0.6%. We
had net revenues for development services provided to Endeavor at our standard
rates of approximately $0.2 million in 2001, $0.7 million in 2000, and $2.8
million in 1999. We had approximately $79,000 and $147,000 in related accounts
receivable at December 31, 2001 and 2000, respectively.

We organized Aesgen, Inc. with an affiliate of the Mayo Clinic in 1994 and
funded it in 1995 with an affiliate of the Mayo Clinic, MOVA Pharmaceutical
Corporation and certain other investors to combine our development capabilities
with the medical expertise of the Mayo Clinic and to permit investors to
directly invest in the development of these products. We distributed our initial
common stock investment in Aesgen to our shareholders prior to our initial
public offering in 1996. As a result, some of our directors, executive officers
and holders of 5% or more of common stock who held our stock prior to the
initial public offering beneficially own common equity of Aesgen. In the
aggregate they own less than 10% of Aesgen's fully diluted common equity. At
January 31, 2002, we held convertible preferred shares of Aesgen that represent
approximately 3.8% of Aesgen's fully diluted common equity. In October 2001, we
agreed to provide
42

research services to Aesgen, through AAI International, at our standard rates in
exchange for $1.1 million of Aesgen convertible preferred stock, which at
December 31, 2001 would represent an additional 10.4% of Aesgen's fully diluted
common equity. Through December 31, 2001, we had performed $86,000 of services
under the agreement.

In December 2001, we acquired rights, title and interest to some of the
products being developed by Aesgen. These products include five products for
which abbreviated new drug applications have been approved by the FDA, and two
other products under development. As consideration for the purchase of these
products, we waived all claims to amounts due from Aesgen. At December 31, 2001,
the approximate book value of these assets was $700,000.

In February 2002, we purchased a generic injectable vitamin D nutritional
product from Aesgen for payments of $1.0 million in cash and additional
contingent milestone payments of up to $1.5 million. If we receive approval from
the FDA, we intend to market this product as an extension of our Aquasol product
line. Under this agreement, we are obligated to pay royalty payments for the
eight-year period following the first commercial sale of this product.

We recognized net revenues of approximately $86,000, $100,000 and $100,000
from Aesgen for the years ended December 31, 2001, 2000 and 1999, respectively.
We had no related accounts receivable or work-in-progress at December 31, 2001,
and had approximately $248,000 of related accounts receivable and $377,000 of
related work-in-progress at December 31, 2000.

We have engaged Cetan Technologies, Inc. to provide us with computer
scanning and indexing services, as well as FDA-mandated computer validation
services. The principal stockholders of Cetan include three of our directors,
including Dr. Frederick Sancilio, our Chairman and Chief Executive Officer. We
paid Cetan approximately $4,000, $308,000, and $277,000 for the years ended
December 31, 2001, 2000 and 1999, respectively, for scanning and validation
services. In addition, two of our directors serve as directors of Cetan
Technologies, Inc.

See "Certain Relationships and Related Transactions" and note 9 to our
consolidated financial statements included elsewhere in this report for a more
detailed description of these related party transactions.

INFLATION

We believe that the effects of inflation generally do not have a material
adverse effect on our consolidated results of operations or financial condition.

EURO CONVERSION

On January 1, 1999, the European Union began denominating significant
financial transactions in a new monetary unit, the euro. The euro is intended to
replace the traditional currencies of the individual European Union member
countries. Our operations in Europe converted to the euro as a functional
currency on August 12, 2001. Our significant operations all have multi-currency
capable systems and have accounted for euro-denominated transactions without
additional modification or difficulty.

NEW ACCOUNTING STANDARDS

In July 2001, Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards No. 141, "Business Combinations," or
SFAS No. 141, and Statement of Financial Accounting Standards No. 142, "Goodwill
and Other Intangible Assets," or SFAS No. 142. SFAS No. 141 requires that all
business combinations be accounted for under the purchase method only and that
certain acquired intangible assets in a business combination be recognized as
assets apart from goodwill. SFAS No. 141 is effective for all business
combinations subsequent to June 30, 2001. Under SFAS No. 142, goodwill and
intangible assets with indefinite lives will no longer be amortized, but must be
reviewed at least annually for impairment. SFAS No. 142 also states that
goodwill and intangible assets with indefinite lives acquired after June 30,
2001 should not be amortized. The statement is effective for fiscal years
beginning after December 15, 2001. We will adopt SFAS No. 142 in fiscal year
2002 and are in the process of assessing the
43

impact that it will have on our consolidated results of operations and financial
position. During 2001, we accounted for business combinations consummated
subsequent to June 30, 2001 in accordance with SFAS No. 141 and SFAS No. 142.

In October 2001, FASB issued Statement of Financial Accounting Standards
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," or
SFAS No. 144. SFAS No. 144 provides guidance and addresses significant
implementation questions on the accounting for the impairment or disposal of
long-lived assets. The statement is effective for fiscal years beginning after
December 15, 2001. We do not expect that the adoption of SFAS No. 144 will have
a significant impact on our consolidated results of operations, financial
position or cash flows.

On an ongoing basis, we assess the recoverability of our goodwill,
intangibles and other long-lived assets by determining the ability of these
assets to generate future cash flows sufficient to recover the unamortized
balances over the remaining useful lives. We will write off goodwill,
intangibles and other long-lived assets determined to be unrecoverable based on
future cash flows in the period in which we make such a determination.

FORWARD LOOKING STATEMENTS, RISK FACTORS AND "SAFE HARBOR" LANGUAGE

This report contains certain forward-looking statements, within the meaning
of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. For purposes of illustration, those
forward-looking statements include statements relating to:

- our anticipated future revenues, operating results and financial
condition and the general commercial success of our company or its
business units;

- our ability to service debt;

- our ability to make future acquisitions of branded product lines or
pharmaceutical businesses;

- anticipated future performance of any of our acquired or internally
developed pharmaceutical products;

- anticipated regulatory approvals or issuances of patents or other
exclusive intellectual property rights;

- the projects on which we spend research and development dollars and how
much we spend;

- our ability to successfully develop products, improvements to products,
or product line extensions; and

- our ability to successfully commercialize any selected products.

All statements that include the words "may," "will," "estimate," "intend,"
"project," "target," "objective," "goal," "should," "could," "might,"
"continue," "believe," "expect," "plan," "anticipate" and other similar words
are intended to be forward-looking statements. We assume no obligation to update
forward-looking statements, or any other statements, contained in this report.

Although we believe that the expectations underlying any of our
forward-looking statements are reasonable, these expectations may prove to be
incorrect and all of these statements are subject to risks and uncertainties.
Should one or more of these risks and uncertainties materialize, or should
underlying assumptions, projections or expectations prove incorrect, actual
results, performance or financial condition may vary materially and adversely
from those anticipated, estimated or expected. We have identified below some
important factors that could cause our forward-looking statements to differ
materially from actual results, performance or financial condition:

- We have recently transitioned our company to a specialty pharmaceutical
company with challenges and risks that we have not historically faced in
our fee-for-services and product development businesses;

- We may devote significant operational and financial resources to develop
products that we may never be able to successfully commercialize;

- We have increased our sales and net income through a series of
acquisitions of branded products, and we intend to seek more acquisition
opportunities; we may have overpaid, or may overpay in the future,
44

for a branded product line that may not produce sufficient cash flow to
repay our debt, including indebtedness incurred in connection with that
acquisition;

- We are dependent on third parties for essential business functions and
problems with these third-party arrangements could materially adversely
affect our ability to manufacture and sell products and our financial
condition and results of operations;

- Competition from the sale of generic products and the development by
other companies of new branded products could cause the revenues from our
branded products to decrease significantly;

- We may be unable to obtain government approval for our products or comply
with government regulations relating to our business; and

- Monthly net sales of the Darvon and Darvocet products that we will
acquire from Eli Lilly and Company decreased significantly for the three
months ended January 31, 2002 compared to average monthly sales in 2001,
2000 and 1999.

For a more comprehensive discussion of risks relating to our capital structure
and business, we strongly urge you to carefully read the sections entitled "Risk
Factors," "Additional Risk Factors" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" contained elsewhere in this
report.

We assume no obligation to update these forward-looking statements, or
other statements, contained in this report. Additional factors that may cause
the actual results to differ materially are discussed in Exhibits 99.1 and 99.2
to this report hereto and incorporated herein by reference and in our recent
filings with the SEC, including, but not limited to, our Quarterly Report on
Form 10-Q filed with the SEC on November 13, 2001, including the exhibits
thereof, Form 8-K reports, and other periodic filings.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a result of global operating activities, we are exposed to risks
associated with changes in foreign exchange rates. As foreign exchange rates
change, the U. S. Dollar equivalent of revenues and expenses denominated in
foreign currencies change and can have an adverse impact on our operating
results. To seek to minimize its risk from foreign exchange movement, we may use
local debt to fund our foreign operations. If foreign exchange rates were to
increase by 10%, our operating results would have been lower by $7,000 in 2001
due to the reduction in reported results from European operations.

We are also exposed to fluctuations in interest rates on variable rate debt
instruments and leases tied to LIBOR. If interest rates were to increase by 1%,
annual interest expense on variable rate debt and leases tied to interest rates
would increase by approximately $481,000.

45

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT AUDITORS

Board of Directors and Stockholders
aaiPharma Inc.

We have audited the accompanying consolidated balance sheets of aaiPharma Inc.
as of December 31, 2001 and 2000, and the related consolidated statements of
operations, stockholders' equity, comprehensive income (loss) and cash flows for
each of the three years in the period ended December 31, 2001. Our audits also
included the financial statement schedule listed in the Index at Item 14(a).
These financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
aaiPharma Inc. at December 31, 2001 and 2000, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

As disclosed in Note 1 to the consolidated financial statements, as of January
1, 2000 the Company changed its method of recognizing revenue for certain
up-front fees and milestone payments.

/s/ ERNST & YOUNG LLP

Raleigh, North Carolina
February 18, 2002

46

AAIPHARMA INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

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

47

AAIPHARMA INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

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

48

AAIPHARMA INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

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

49

AAIPHARMA INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(IN THOUSANDS)

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

50

AAIPHARMA INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2001
- --------------------------------------------------------------------------------

1. SIGNIFICANT ACCOUNTING POLICIES AND OTHER MATTERS

ORGANIZATION
aaiPharma Inc. ("aaiPharma" or the "Company") is a specialty
pharmaceutical company focused on the development, acquisition,
enhancement and commercialization of branded pharmaceutical products. The
Company also has a comprehensive range of pharmaceutical development
capabilities primarily in the United States and Europe. Historically, the
majority of the Company's net revenues have been earned in the
fee-for-service business as explained in note 13, with an increasing
portion of the Company's resources devoted to the sale of commercial
pharmaceutical products and to developing new products or improving
existing products. Major customers for the Company's pharmaceutical
products are large, well-established medical wholesalers and distributors.
Major customers for the fee-for-service and product development businesses
are large and small pharmaceutical and biotechnology companies.

BASIS OF PRESENTATION AND CONSOLIDATION
The consolidated financial statements include the accounts of aaiPharma
Inc. and its wholly-owned subsidiaries. All material intercompany
transactions have been eliminated. The Company has ownership of
approximately 13%, on a fully diluted basis, of Endeavor Pharmaceuticals,
Inc. ("Endeavor") which is accounted for under the cost method and had no
carrying value at December 31, 2001 and 2000. Certain balances in the
prior year's consolidated balance sheet have been reclassified to conform
to the December 31, 2001 presentation.

REVENUE RECOGNITION
Revenues for product sales are recognized at the time the products are
shipped. Research revenues from fee-for-service contracts are recognized
on a percentage-of-completion basis as the work is performed or on a time
and materials basis in accordance with the specific contract terms.
Product development revenues consist of licensing revenues and royalty
revenues. Licensing revenues are recognized upon completion of interim
contract milestones. Royalty revenues are recognized as earned in
accordance with contract terms. Revenues from upfront licensing fees are
deferred and amortized over the term of the relevant agreement or as
on-going services are performed. Contract milestones based on product
approval are recognized when the applicable product is approved.
Work-in-progress represents revenues recognized prior to contract billing
terms. Provisions for losses on contracts, if any, are recognized when
identified.

In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements". SAB 101 specifically addresses revenue recognition issues
related to certain upfront payments or fees. Under SAB 101, certain
upfront fees and payments recognized as income in prior periods are
required to be deferred and amortized into revenue over the terms of the
relevant agreements or as the on-going services are performed. Although
the Company implemented SAB 101 in the fourth quarter of 2000, the
cumulative effect of a change in accounting principle has been
retroactively adopted as of the beginning of the first quarter of 2000.
For the year 2000, the Company recorded a charge of $1,456,000 ($961,000
after tax) for the cumulative effect of this change in accounting
principle. In 2001 and 2000, the Company recognized $500,000 and $733,000,
respectively, of revenue related to the amortization of these deferred
amounts.

INCOME TAXES
Income taxes have been accounted for using the liability method in
accordance with Financial Accounting Standards Board ("FASB") Statement of
Financial Accounting Standards No. 109 "Accounting for Income Taxes".
Deferred tax assets and liabilities are recognized for the expected

51

tax consequences of temporary differences between the tax bases of assets
and liabilities and their reported amounts.

RESEARCH AND DEVELOPMENT COSTS
The Company engages in numerous research and development ("R&D") projects
with the objective of growth and utilization of a portfolio of proprietary
technologies and patent and intellectual property rights to bring products
to market or to license or sell these technologies to others. R&D expenses
represent direct salaries of R&D personnel, raw material expenses,
third-party consulting and testing costs, along with an allocation of
indirect costs such as management and administrative overhead costs and
facilities costs. R&D costs are charged to expense as incurred. Although
there is a risk that any specific R&D project may not produce revenues,
the Company believes that the potential profit margins from successful
development projects will compensate for costs incurred for unsuccessful
projects. The Company is currently involved in many pharmaceutical and
technology development projects and believes that these activities help to
diversify its R&D portfolio and manage its risk.

EARNINGS (LOSS) PER SHARE
Basic earnings (loss) per share are based on the weighted average number
of common shares outstanding during the year. Diluted earnings (loss) per
share are computed assuming that the weighted average number of common
shares was increased by the conversion of stock options issued to
employees and members of the Company's Board of Directors. The diluted per
share amounts reflect a change in the number of shares outstanding (the
"denominator") to include the options as if they were converted to shares
and issued. In each year presented, the net income (loss) (the
"numerator") is the same for both basic and diluted per share
computations. The following table provides a reconciliation of the
denominators for the basic and diluted earnings (loss) per share
computations:

CONCENTRATION OF CREDIT RISK
The Company is subject to a concentration of credit risk with respect to
its accounts receivable balance, all of which is due from wholesalers,
distributors and large and small pharmaceutical and biotechnology
companies. Approximately 19% of the accounts receivable balance at
December 31, 2000 represented amounts due from one customer. At December
31, 2001, no single customer accounted for more than 10% of the Company's
accounts receivable balance. The Company performs ongoing credit
evaluations of its customers and maintains reserves for potential
uncollectible accounts. Actual losses from uncollectible accounts have
been minimal.

One customer accounted for approximately 15% of the Company's revenue in
both 2001 and 2000. No single customer accounted for more than 10% of the
Company's revenue in 1999.

CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with a
maturity of three months or less to be cash equivalents.

52

WORK-IN-PROGRESS
Work-in-progress represents revenues recognized prior to contract billing
terms.

INVENTORIES
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market.

PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the
assets. Depreciable lives are 31.5 years for buildings and improvements
and 3 to 15 years for equipment. Leasehold improvements are amortized over
the lesser of the asset life or the lease term.

GOODWILL AND OTHER INTANGIBLES, NET
Goodwill, the excess of the purchase price over the fair value of the net
assets of acquired businesses, is amortized over 20 years for purchase
business combinations consummated prior to June 30, 2001. For purchase
business combinations consummated subsequent to June 30, 2001, goodwill is
not amortized, but is evaluated for impairment on an annual basis or as
impairment indicators are identified, in accordance with Statement of
Financial Accounting Standards No. 141, "Business Combinations" ("SFAS No.
141"). At December 31, 2001 and 2000, the amounts for accumulated
amortization of goodwill were approximately $2.9 million and $2.5 million,
respectively. Other identifiable intangible assets are amortized, if
applicable (see note 2), on a straight-line basis over their estimated
useful lives, which range from 3 to 20 years. At December 31, 2001 and
2000, the amounts of accumulated amortization of other intangibles were
approximately $0.8 million and $0.7 million, respectively.

On an ongoing basis, the Company assesses the recoverability of its
goodwill, intangibles and other assets by determining its ability to
generate future cash flows sufficient to recover the unamortized balances
over the remaining useful lives. Goodwill, intangibles and other
long-lived assets determined to be unrecoverable based on future cash
flows would be written-off in the period in which such determination is
made.

FOREIGN CURRENCY TRANSLATION
The financial statements of foreign subsidiaries have been translated into
U.S. dollars in accordance with FASB Statement No. 52 "Foreign Currency
Translation". All balance sheet accounts have been translated using the
exchange rates in effect at the balance sheet dates. Income statement
amounts have been translated using the average exchange rates for the
respective years. The gains and losses resulting from the changes in
exchange rates from year to year have been reported in accumulated other
comprehensive income (loss) included in the consolidated statements of
stockholders' equity.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In July 2001, the FASB issued SFAS No. 141 and Statement of Financial
Accounting Standards No. 142, "Goodwill and Other Intangible Assets"
("SFAS No. 142"). SFAS No. 141 requires that all business combinations be
accounted for under the purchase method only, and that certain acquired
intangible assets in a business combination be recognized as assets apart
from goodwill. SFAS No. 141 is effective for all business combinations
subsequent to June 30, 2001. Under SFAS No. 142, goodwill and intangible
assets with indefinite lives will no longer be amortized, but must be
reviewed at least annually for impairment. SFAS No. 142 also states that
goodwill and intangible assets with indefinite lives acquired after June
30, 2001 should not be amortized. The statement is effective for fiscal
years beginning after December 15, 2001. The Company will adopt SFAS No.
142 in fiscal year 2002 and is in the process of assessing the impact that
it will have on the results of its operations and consolidated financial
position. During 2001, the Company's business combinations consummated
subsequent to June 30, 2001 were accounted for in accordance with SFAS No.
141 and SFAS No. 142.

In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144 provides guidance and
addresses significant implementation questions on the accounting for the
impairment or disposal of long-lived assets. The statement is effective
for fiscal years beginning

53

after December 15, 2001. The Company does not expect that the adoption of
SFAS No. 144 will have a significant impact on its results of operations,
consolidated financial position or cash flows.

EMPLOYEE STOCK-BASED COMPENSATION
The Company has elected to continue to follow Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25")
and related Interpretations in accounting for its employee stock options
as permitted by SFAS No. 123 "Accounting for Stock-Based Compensation" and
make the required pro forma disclosures required by SFAS No. 123 (see note
8). Under APB No. 25, if the exercise price of the Company's stock options
is not less than the estimated fair market value of the underlying stock
on the date of grant, no compensation expense is recognized.

FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying values of cash and cash equivalents, accounts receivable,
work-in-progress, current liabilities and long-term debt approximate fair
values as of December 31, 2001 and 2000.

USE OF ESTIMATES
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts
reported in the consolidated financial statements and accompanying notes.
Actual results could differ from such estimates and changes in such
estimates may affect amounts reported in future periods.

2. BUSINESS COMBINATIONS

In August 2001, the Company completed the acquisition of a line of
critical care injectable and oral nutrition products from AstraZeneca AB,
an affiliate of AstraZeneca PLC, in a business combination accounted for
as a purchase. The product lines acquired are marketed under the M.V.I.
and Aquasol brand names. The Company acquired these product lines and
related intangible assets for payments of up to $100 million over three
years. To finance the initial payment for this acquisition of $52.5
million, which included $3.7 million of inventory, the Company used the
proceeds from the term loan, as described in note 7. Future guaranteed
payments of $1.0 million each are due in August 2002 and 2003. Future
contingent payments of $2.0 million and $43.5 million are potentially due
in August 2003 and 2004, respectively, but are contingent upon certain
obligations being completed by AstraZeneca, and have not yet been recorded
as a liability on the Company's balance sheet. Revenues from the sales of
these products are included in the Company's results of operations
beginning on the acquisition date. The M.V.I. and Aquasol product lines
did not have separable assets and liabilities associated with them,
therefore the Company allocated the purchase price, including acquisition
related expenses, to acquired identifiable intangible assets in the amount
of $32.0 million, with the excess of the purchase price over the
identifiable intangible assets recorded as goodwill in the amount of $19.2
million.

In December 2001, the Company acquired from Novartis Pharmaceutical
Corporation and Novartis Corporation a line of asthma products used in the
prevention and reversal of bronchospasm in patients age 12 and older with
asthma and reversible bronchospasm associated with bronchitis and
emphysema, in a business combination accounted for as a purchase. The
product line acquired is marketed under the Brethine brand name. The
Company acquired this product line and related intangible assets for $26.6
million. To finance this acquisition, the Company used the proceeds from
the additional $25 million term loan, as described in note 7, and used
working capital to pay the remainder of the purchase price. Revenues from
the sales of these products are included in the Company's results of
operations beginning on the acquisition date. The Brethine product line
did not have separable assets and liabilities associated with it,
therefore the Company allocated the purchase price, including acquisition
related expenses, to acquired identifiable intangible assets in the amount
of $9.9 million, with the excess of the purchase price over the
identifiable intangible assets recorded as goodwill in the amount of $16.7
million.

The acquisitions of these product lines were the first steps taken by the
Company toward achieving its goal of acquiring, improving, and marketing
branded pharmaceutical products.

54

In connection with the M.V.I. and Aquasol acquisition, the Company
recorded $32.0 million in intangible assets which meet the criteria for
having an indefinite life. In accordance with SFAS No. 142, these
intangible assets are not being amortized. The intangible assets recorded
in connection with this acquisition represents the trademarks, technology
and know-how associated with the product lines. In addition, the value
recorded as goodwill is not being amortized and will be evaluated for
impairment on an annual basis in accordance with SFAS No. 142.

During July 2001, the Company made an initial payment of $0.9 million to
acquire a sterile manufacturing facility located in Charleston, South
Carolina. Additional contingent payments of up to $5.0 million plus
additional royalties may become due in increments through June 30, 2006
based on the level of manufacturing revenues at the Charleston facility
during this period. These contingent payment obligations have not yet been
recorded as a liability on our consolidated balance sheet.

PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma consolidated financial information
reflects the results of operations for the years ended December 31, 2001
and 2000 as if the above acquisitions had occurred on January 1, 2000.

These pro forma results have been prepared for comparative purposes only
and do not purport to be indicative of what operating results would have
been had the acquisitions taken place on January 1, 2000. In addition,
these results are not intended to be a projection of future results and do
not reflect any synergies that might be achieved from the combined
operations.

MEDICAL & TECHNICAL RESEARCH ASSOCIATES, INC.
In March 1999, the Company merged with Medical & Technical Research
Associates, Inc. ("MTRA"), a clinical research organization located near
Boston, Massachusetts, in exchange for approximately 1.3 million shares of
aaiPharma stock, including conversion of MTRA stock options. The MTRA
merger was accounted for as a pooling-of-interests, and accordingly, all
prior period consolidated financial statements have been restated to
include the results of operations, financial position, and cash flows of
MTRA as though MTRA had always been a part of aaiPharma.

3. TRANSACTION, INTEGRATION AND RESTRUCTURING COSTS

In connection with the MTRA merger in March 1999, the Company recorded a
$6.4 million nonrecurring charge to operating income reflecting the costs
to complete the transaction, integrate the businesses and realign its
workforce to its combined operating structure.

Transaction costs were comprised of amounts owed to investment bankers and
advisors as a percentage of the total merger consideration and other
expenses directly related to the completion of the transaction, including
financial reviews and legal fees. Personnel costs included the separation
of approximately 58 employees in the U.S. and Europe to combine the
clinical operations of the companies and realign the workforce in the
combined organization. Facility and equipment costs included lease
payments required under non-cancelable leases for vacant properties and
the write-off of leasehold improvements and equipment that became
redundant or obsolete due to the transaction.

55

Other costs included integration costs directly related to the merger and
costs resulting from actions taken to merge the operations.

All transaction, integration and restructuring costs were incurred in 1999
and settled prior to January 1, 2001.

4. ACCOUNTS RECEIVABLE, NET

The following table presents the components of accounts receivable:

5. INVENTORIES

The following table presents the components of inventories:

6. PROPERTY AND EQUIPMENT, NET

The following table presents the components of property and equipment:

Depreciation expense was approximately $7.0 million, $6.6 million, and
$6.5 million for the years ended December 31, 2001, 2000 and 1999,
respectively.

56

7. DEBT AND CREDIT LINE

The following table presents the components of current maturities of
long-term debt and short-term debt:

The following table presents the components of long-term debt:

In August 2001, the Company entered into the Second Amended and Restated
Loan Agreement (the "Loan Agreement"), which expires in January 2003. The
Company has the option to extend the Loan Agreement to December 31, 2006,
subject to certain financial conditions. The Loan Agreement provides for
borrowings of up to $85 million, consisting of a term loan of $60 million
and a revolving credit facility of up to $25 million. In December 2001,
the Company amended the Loan Agreement to provide for an additional $25
million term loan. In December 2001, the Company re-paid $7 million of the
initial term loan. The revolving credit amount is based upon a borrowing
base consisting of portions of accounts receivable and inventories. The
Loan Agreement provides for variable interest rates based on LIBOR and is
secured by a security interest on substantially all assets of the Company.
At December 31, 2001, 30-day LIBOR was 1.87% and the interest rate
applicable to borrowings under the Loan Agreement was 6.62%. If the Loan
Agreement is not refinanced or extended by December 31, 2002, the Company
is obligated to pay additional fees up to 2.0% of the outstanding balances
under this term loan and the revolving credit facility. If the extension
option has not been exercised by the end of the credit period, any
outstanding balances under this facility must be repaid. Scheduled
maturities of long-term debt in 2003 are $78.9 million. If the Loan
Agreement is extended, quarterly principal payments on the term loans will
begin in March 2003. The Loan Agreement requires the payment of certain
commitment fees based on the unused portion of the line of credit. At
December 31, 2001, the Company qualified for the entire $25.0 million
borrowing base of the revolving credit facility.

Under the terms of the Loan Agreement, the Company is required to comply
with various covenants including, but not limited to, those pertaining to
maintenance of certain financial ratios, and incurring additional
indebtedness. The Company was in compliance with the financial covenants
at December 31, 2001.

The bank term loans include $78.0 million and $1.0 million with U.S. banks
as of December 31, 2001 and 2000, respectively. The loans have variable
interest rates based on LIBOR. The weighted average interest rate on these
loans was approximately 7.5% and 8.7% for 2001 and 2000, respectively.

57

Scheduled maturities of long-term debt as of December 31, 2001, if the
Company exercises the extension option under the Loan Agreement, would be
as follows:

2002...................................................... $ --
2003...................................................... 16,478
2004...................................................... 16,575
2005...................................................... 20,475
2006...................................................... 25,350
-------
Total..................................................... $78,878
=======

Under the Loan Agreement, the Company placed in escrow redeemable warrants
to purchase 186,372 shares of common stock. The warrants are issued to the
lenders or may be returned to the Company depending upon the occurrence of
certain events, including the Company's exercise of its extension option
or obtaining alternate financing and the full payment of its outstanding
obligations under the Loan Agreement. The warrants have an exercise price
of $0.001 per share, are issued in tranches through June 2002 and expire
ten years from date of issuance. The fair value of the warrants at the
time of issuance was recorded as additional financing costs to be
amortized over the remaining term of the loan. These warrants contain
certain "put" rights providing the holder with an option to require the
Company to redeem the warrants, in part or in their entirety, at any time
after the date of issuance unless the Company maintains an effective
registration statement to cover the resale of the shares of common stock
available under these warrants. If the holder exercises the put option,
the warrants are redeemable at a value based on the current fair market
value of the Company's common stock. The carrying value of the warrants is
adjusted to market value each reporting period. At December 31, 2001, the
Company had issued warrants to purchase 114,905 shares that were
exercisable and represented a potential redemption value of $2.9 million.

8. STOCKHOLDERS' EQUITY

The authorized capital stock of the Company at December 31, 2001 and 2000
was 100 million shares of voting common stock, $0.001 par value per share,
and 5 million shares of preferred stock, $0.001 par value per share. The
preferred stock is issuable in one or more series by the Company's Board
of Directors without further stockholder approval. No preferred stock was
outstanding at December 31, 2001 or 2000. The Company has reserved
3,244,402 shares of common stock for issuance under the stock option plans
at December 31, 2001.

STOCK OPTION AND AWARD PLANS
The Company has five stock option plans: the 2000 Stock Option Plan for
Non-Employee Directors (the "2000 Plan"), the 1997 Stock Option Plan (the
"1997 Plan"), the 1996 Stock Option Plan (the "1996 Plan"), the 1995 Stock
Option Plan (the "1995 Plan") and the 1996 Incentive and Non-Qualified
Stock Option Plan (the "MTRA Plan"). Under the 1995 Plan, the Board of
Directors initially could grant options to purchase up to 242,538 shares
of common stock. However, the Company has no obligation to issue the
shares upon exercise of such options until it has purchased an equal
number of shares from certain existing stockholders. Under the 2000 Plan,
the 1997 Plan and the 1996 Plan, the Board of Directors initially could
grant options to purchase up to 410,000, 2,644,000 and 495,627,
respectively, of newly issued shares of common stock. aaiPharma adopted
the MTRA Plan in March 1999 after the MTRA merger (see note 2).
aaiPharma's Board of Directors reserved 517,500 shares to cover the
exercise of the options under the MTRA Plan. The plans require that the
exercise price of options cannot be less than either 100% (2000 Plan, 1997
Plan and MTRA Plan) or 75% (1996 and 1995 Plans) of the estimated fair
market value of the Company's shares of common stock on the date of grant.

58

The combined activity from all plans is presented in the following table:

Information regarding stock options outstanding and options exercisable at
December 31, 2001 is summarized in the table below:

The Company has adopted the disclosure-only provisions of SFAS No. 123.
The fair value for stock options was estimated at the date of grant using
a Black-Scholes pricing model with the following weighted average
assumptions:

For purposes of pro forma disclosures, the estimated fair value of the
stock options is amortized to expense over the vesting period. The grant
date Black-Scholes weighted average fair value of options was $13.35,
$4.93 and $11.28 per share for 2001, 2000 and 1999, respectively.

59

The Company applies APB Opinion No. 25 and related Interpretations in
accounting for its stock option plans; therefore, compensation expense has
not been recognized for options granted at fair value. If compensation
cost for the Company's plans had been determined based on the fair value
at the grant dates for awards under those plans consistent with the method
of SFAS No. 123, the Company's net income (loss) and earnings (loss) per
share would have been changed to the pro forma amounts indicated below:

9. RELATED PARTY TRANSACTIONS

Prior to the Company's merger with MTRA in March 1999, MTRA's president
was the recipient of two loans from MTRA totaling $680,000. A promissory
note, which accrued interest at 6%, was secured by shares of the Company's
common stock owned by this executive. In 2001, the loans were fully
repaid.

CETAN TECHNOLOGIES, INC.
In 1999, the Company advanced $300,000 to Cetan Technologies, Inc.
("Cetan"), formerly known as PharmComm, Inc., a company whose principal
stockholders include Dr. Frederick Sancilio, Mr. James Waters and Mr.
William Underwood, all directors of aaiPharma. One other stockholder of
Cetan is a member of aaiPharma management.

The advance payment was for services to be rendered by Cetan during 1999
and 2000 for scanning and indexing services required as part of
aaiPharma's regulatory compliance and record retention policies. aaiPharma
has engaged Cetan to perform these services since 1996 and has compensated
Cetan pursuant to written agreements for the services. Cetan also provides
computer validation services to aaiPharma, which are required for
compliance with regulatory requirements.

Total payments for scanning and validation services provided to aaiPharma
by Cetan were approximately $4,000, $308,000, and $277,000 (excluding the
advance payment) for the years ended December 31, 2001, 2000 and 1999,
respectively. At December 31, 2000, the advance payment had been fully
utilized.

ENDEAVOR PHARMACEUTICALS, INC.
In 1994, aaiPharma organized Endeavor Pharmaceuticals, Inc. with Berlex
Laboratories, Inc. and several other investors to fund the development of
hormone pharmaceutical products, initially focusing on several generic
hormone products already under development by the Company. The Company has
also agreed to permit Endeavor, under certain circumstances, the first
right to purchase additional proprietary hormone pharmaceutical products
developed by aaiPharma. aaiPharma obtained a 47% equity interest in
Endeavor through the contribution of its accumulated product research and
development and technical know-how. The other investors contributed cash
in exchange for their interests which, for all investors, was in the form
of convertible preferred stock. Based on a subsequent cash infusion by a
new investor in 1995, the Company's interest in Endeavor was reduced to
approximately 35%, on a fully diluted basis. In November 2000, Endeavor
raised $46 million through the issuance of additional convertible
preferred stock. At December 31, 2001, aaiPharma

60

owned approximately 13% of the fully diluted common equity of Endeavor.
Subsequent to the reduction in ownership percentage and its reduced
influence over the Endeavor operations, the Company ceased accounting for
this as an equity method investment and began to account for it under the
cost method.

Endeavor has accumulated significant losses since inception and this
investment has been recorded at zero value since 1995.

The Company had net sales to Endeavor for product development services of
approximately $0.2 million, $0.7 million, and $2.8 million for the years
ended December 31, 2001, 2000 and 1999, respectively. aaiPharma had
approximately $79,000 and $147,000 in related accounts receivable at
December 31, 2001 and 2000, respectively.

AESGEN, INC.
Aesgen, Inc. ("Aesgen") was formally organized with an affiliate of the
Mayo Clinic and MOVA Pharmaceutical Corporation and funded in 1995 through
the issuance of approximately $11 million of nonconvertible, nonvoting,
mandatorily redeemable, preferred stock. The Company made a cash
investment of $1.6 million in such preferred stock, which is carried at
cost, and is included in other noncurrent assets on the consolidated
balance sheets.

In October 2001, the Company entered into a Service Agreement and a
Subscription Agreement with Aesgen, whereby the Company will perform
certain clinical work for Aesgen and has agreed to receive Aesgen
preferred stock in lieu of cash for the services performed. The Company
has subscribed to $1.1 million of preferred stock, and will receive up to
10,829 shares of such stock, in lieu of cash. Through December 31, 2001,
the Company has performed services under the agreement of $86,000. The
preferred shares are to be issued in accordance with a timetable
established by the Subscription Agreement.

In December 2001, the Company entered into a Product Sales Agreement with
Aesgen. Under this agreement, Aesgen sold its rights, title and interest
to certain products to the Company. These products include five products
for which abbreviated new drug applications have been filed with the
United States Food and Drug Administration, and two products under
development. As consideration for the purchase of these products, the
Company waived all claims to amounts due from Aesgen and terminated the
development and licensing agreement, as described below. At December 31,
2001, the approximate book value of these assets was $700,000.

In February 2002, the Company purchased a proprietary product from Aesgen
for payments of $1.0 million in cash and additional contingent milestone
payments of up to $1.5 million. The Company intends to market this product
as an extension of the Aquasol product line. Under this agreement, the
Company is obligated to pay royalty payments, equal to 30% of the net
revenues of this product less certain costs incurred in its manufacture
and marketing, for the eight-year period following the first commercial
sale of the product.

In 1996, the Company sold to Aesgen marketing rights to a product under
development by the Company. Under the agreement, Aesgen paid a license fee
and would have paid additional royalties upon marketing the product.
aaiPharma recognized net revenues of approximately $86,000, $100,000 and
$100,000 from Aesgen for the years ended December 31, 2001, 2000 and 1999,
respectively. aaiPharma had no related accounts receivable or
work-in-progress at December 31, 2001, and had approximately $248,000 of
related accounts receivable and $377,000 of related work-in-progress at
December 31, 2000. aaiPharma had the right, under its development
agreement with Aesgen, to provide certain product development and support
services to Aesgen with respect to some generic drugs currently being
developed by Aesgen, provided that aaiPharma's fees for such services were
comparable to those of a competitor. In addition, under such development
agreement, the Company had agreed not to develop, for its own account or
any other person, a formulation of any of the generic products currently
under development for Aesgen and any additional drugs that aaiPharma
agrees to develop in the future for Aesgen.

61

10. INCOME TAXES

The following table presents the components for the provision for (benefit
from) income taxes:

The following table presents the reconciliation of the provision for
income taxes to the amount computed by applying the U.S. federal statutory
income tax rate:

Deferred income taxes arise from temporary differences between the tax
bases of assets and liabilities and their reported amounts in the
financial statements. Deferred taxes are included in prepaids and

62

other current assets and other accrued liabilities. The following table
presents the deferred tax assets and deferred tax liability:

Valuation allowances have been provided for certain assets resulting from
accumulated net operating losses from foreign entities since realization
of such assets cannot be predicted with reasonable certainty at this time.
As of December 31, 2001, the Company had approximately $40.0 million of
state net operating loss carryforwards with the following expirations:
$4.7 million in 2011, $10.5 million in 2014, $12.8 million in 2015, and
$12.0 million in 2016.

11. EMPLOYEE BENEFIT PLAN

The Company provides retirement benefits for all domestic aaiPharma
employees with one year of service through a defined contribution plan
qualified under section 401(k) of the Internal Revenue Code of 1986, as
amended. Participants may elect to contribute a portion of their annual
compensation, subject to limitations. The Company makes matching
contributions in aaiPharma stock equal to 50% of a participant's
contribution up to a certain amount. Additionally, the Company makes
profit-sharing contributions at the discretion of the Board of Directors.
The Company has expensed $788,000, $880,000, and $607,000 for the years
ended December 31, 2001, 2000 and 1999, respectively, for this benefit
plan.

12. COMMITMENTS AND CONTINGENCIES

The Company leases land, buildings and equipment under renewable lease
agreements classified as operating leases. Rent expense under these
agreements for the years ended December 31, 2001, 2000 and 1999 was $6.9
million, $4.9 million, and $4.3 million, respectively. As of December 31,
2001, future minimum rentals due under non-cancelable operating lease
agreements with initial terms of one year or more are: $7.1
million -- 2002; $5.6 million -- 2003; $5.6 million -- 2004; $5.2
million -- 2005; $3.7 million in 2006 and $12.7 million -- thereafter.

The Company currently leases two significant facilities, including its
headquarters facility in Wilmington, North Carolina, under the terms of a
tax retention operating lease. The lease for these facilities covered an
initial period of three years with two one-year renewal periods. At the
end of the initial period, the Company elected to extend the lease under
the first renewal period. At the end of the renewal term, the Company may
elect to purchase the facilities at fair market value, extend the lease or
the properties may be sold.

The Company is party to a number of legal actions with companies that
market generic drugs. The Company filed three cases in the United States
District Court for the Eastern District of North Carolina claiming
infringement of certain of its fluoxetine hydrochloride patents.
Fluoxetine hydrochloride is an active ingredient in the drug marketed by
Eli Lilly as Prozac. Each of the defendants in these three actions, Dr.
Reddy's Laboratories Ltd., a pharmaceutical company based in

63

India, and its U.S. affiliate, Dr. Reddy's Laboratories, Inc. (formerly
Reddy-Cheminor, Inc.), Barr Laboratories, Inc., and PAR Pharmaceuticals,
Inc. sell a generic fluoxetine hydrochloride product in the United States.

The Company is also involved in three actions centered on its
omeprazole-related patents. Omeprazole is the active ingredient found in
Prilosec, a drug sold by AstraZeneca AB. Two cases have been filed against
the Company by Dr. Reddy's Laboratories Ltd. and Dr. Reddy's Laboratories,
Inc. in the United States District Court for the Southern District of New
York. In these cases, the plaintiffs are seeking a declaratory judgment
that their omeprazole products do not infringe the Company's patents and
in addition, they are challenging the validity of five of the Company's
omeprazole patents. They also seek to recover costs and attorney's fees.
Furthermore, in the second case, filed in November 2001, the plaintiffs
are seeking damages for alleged misappropriation of trade secrets,
tortious interference, unfair competition and violations of the North
Carolina Unfair Trade Practice Act.

The third case involving the Company's omeprazole patents was brought in
August 2001 by Andrx Pharmaceuticals, Inc. ("Andrx") in the United States
District Court for the Southern District of New York. Andrx is challenging
the validity of three of the Company's omeprazole patents, and is also
seeking a declaratory judgment that its generic omeprazole product does
not infringe these patents. Furthermore, Andrx claims violations of
federal and state antitrust laws with respect to the licensing of these
omeprazole patents and is seeking injunctive relief and unspecified treble
damages.

The Company may be party to other lawsuits and administrative proceedings
incidental to the normal course of its business which are not considered
material.

13. FINANCIAL INFORMATION BY BUSINESS SEGMENT AND GEOGRAPHIC AREA

The Company operates in three business segments consisting of a product
sales business, primarily comprised of the NeoSan Pharmaceuticals business
unit, a product development business, primarily the aaiResearch business
unit, and a fee-for-service business, primarily the AAI International
business unit. The product sales business provides for the sales of
M.V.I., Aquasol and Brethine product lines and for the commercial
manufacturing of small quantity products outsourced by other
pharmaceutical companies. In the product development segment, the Company
internally develops drugs and technologies with the objective of licensing
marketing rights to third parties in exchange for license fees and
royalties. The core services provided on a fee-for-service basis to
pharmaceutical and biotechnology industries worldwide include
comprehensive formulation, testing and manufacturing expertise, in
addition to the ability to take investigational products into and through
human clinical trials. The majority of the Company's non-U.S. operations
are located in Germany.

Corporate income (loss) from operations includes general corporate
overhead costs and goodwill amortization, which are not directly
attributable to a business segment. Financial data by segment and
geographic region are as follows:

14. FINANCIAL RESULTS BY QUARTER (UNAUDITED)

15. SUBSEQUENT EVENT

On February 18, 2002, the Company entered into an agreement with Eli Lilly
and Company to acquire the U.S. rights to the Darvon and Darvocet branded
product lines for the treatment of mild to moderate pain for $211.4
million in cash, subject to reduction based on net sales of these products
before and after the closing of the acquisition. The Company anticipates
completing this acquisition by the end of the first half of 2002. The
Company is currently seeking senior secured and senior subordinated debt
financing of an aggregate of $350 million to fund the acquisition of these
product lines, to repay indebtedness outstanding under its existing loan
agreement, to terminate its outstanding tax retention operating lease, as
discussed in note 12, and purchase the underlying properties, and related
fees and expenses.

16. FINANCIAL INFORMATION FOR SUBSIDIARY GUARANTORS AND NON-GUARANTORS

The Company intends to issue, late in the first quarter of 2002, senior
secured notes and subordinated debentures (the "Notes"), as discussed in
note 15, which will be guaranteed by the Company's domestic subsidiaries.

The following presents condensed consolidating financial information for
the Company, segregating: (1) aaiPharma Inc., which will issue the Notes
(the "Issuer"); (2) the domestic subsidiaries which will guarantee the
Notes (the "Guarantor Subsidiaries"); and (3) all other subsidiaries (the
"Non-Guarantor Subsidiaries"). The guarantor subsidiaries are wholly-owned
direct subsidiaries of the Company and their guarantees are full,
unconditional and joint and several. Wholly-owned subsidiaries are
presented on the equity basis of accounting. Certain reclassifications
have been made to conform all of the financial information to the
financial presentation on a consolidated basis. The principal eliminating
entries eliminate investments in subsidiaries and inter-company balances
and transactions.

66

The following information presents consolidating statements of operations,
balance sheets and cash flows for the periods and as of the dates
indicated:

74

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Our directors and their business experience are set forth in our proxy
statement for our 2002 annual meeting of stockholders (the "Proxy Statement"),
under the heading "Election of Directors", and that information is incorporated
herein by reference. A discussion of executive officers is included in Part I
under "Executive Officers."

ITEM 11. EXECUTIVE COMPENSATION

A description of the compensation of our executive officers is set forth
under the heading "Executive Compensation" in the Proxy Statement and is
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

A description of the security ownership of certain beneficial owners and
management is set forth under the heading "Principal Stockholders"' on the Proxy
Statement and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

We have certain relationships, and have engaged in transactions, with
related parties. These transactions may raise conflicts of interest and,
although we do not have a formal policy to address conflicts of interest, we
evaluate relationships and transactions involving conflicts of interest on a
case by case basis.

In November 1995, GS Capital Partners II, L.P., G.S. Capital Partners II
Offshore, L.P., Bridge Street Fund 1995, L.P., Stone Street Fund, L.P., and
Goldman Sachs & Co. Verwaltungs GmbH, each an investment partnership managed by
an affiliate of The Goldman Sachs Group Ltd., purchased shares of preferred
stock of aaiPharma. All outstanding shares of preferred stock were converted
into aaiPharma common stock in conjunction with our public offering of common
stock in September 1996. These Goldman Sachs investment partnerships own
2,276,832 shares of our common stock. Pursuant to a stockholder agreement
entered into in connection with their 1995 investment, the Goldman Sachs
investment partnerships have the right to designate one member of our board of
directors for so long as they and their affiliates (which include Goldman, Sachs
& Co.) beneficially own 10% or more of the outstanding shares of our common
stock. Pursuant to the stockholders agreement, Joseph Gleberman, a managing
director of Goldman, Sachs & Co., serves as one of our directors.

In connection with the 1995 investment, we agreed that so long as the
Goldman Sachs investment partnerships beneficially own 5% or more of the
outstanding shares of our common stock, we will retain Goldman, Sachs & Co. or
an affiliate to perform all investment banking services for us for which an
investment banking firm is retained, and to serve as managing underwriter of any
offering of our capital stock on customary terms, consistent with an
arm's-length transaction. If we cannot agree to the terms of an engagement with
Goldman, Sachs & Co. or their affiliates after good faith discussions, the
agreement permits us to engage any other investment banking firm. However,
Goldman, Sachs & Co. would be entitled to serve as co-managing underwriter in
any underwritten offering of our capital stock.

In addition, in that 1995 investment transaction, we granted to the Goldman
Sachs investment partnerships, and other stockholders including Frederick
Sancilio, James Waters and William Underwood, all current directors of
aaiPharma, rights to cause us to register for sale the shares of common stock
they beneficially owned at that time.

In 1994, as part of our internal development program, we organized Endeavor
Pharmaceuticals, Inc. to continue development of products that we had been
developing on our own. We assigned our rights to these
75

products to Endeavor in return for approximately 47% of Endeavor's fully diluted
equity. We also entered into a contract with Endeavor to continue product
development and clinical supply manufacture and granted to Endeavor, under
certain circumstances, the first right to purchase additional proprietary
hormone pharmaceutical products that we develop. Although this contract
terminates in April 2001, Endeavor's right to purchase internally developed
hormone products that we develop survives through April 2004. As the result of
subsequent investment in Endeavor by third parties, including the Goldman Sachs
investment partnerships, our ownership interest in Endeavor has been diluted to
approximately 13% of the common stock of Endeavor outstanding on a fully diluted
basis at December 31, 2001. At December 31, 2001, the Goldman Sachs investment
partnerships beneficially owned approximately 13.9% of Endeavor's common stock
on a fully diluted basis, while we owned 13.2%, Dr. Frederick D. Sancilio owned
0.8% and the Waters Foundation, an affiliate of James L. Waters, one of our
directors, owned 0.6%. Pursuant to an agreement among the Endeavor stockholders,
we have the right to designate one of the eight members of Endeavor's board of
directors. David Johnston, one of our executive officers, currently serves as
our designee on Endeavor's board.

Pursuant to our product development and supply agreements with Endeavor, we
had net sales to Endeavor of approximately $0.2 million in 2001, $0.7 million in
2000 and $2.8 million in 1999. These amounts were charged at our commercial
rates similar to those charged to other clients. We had approximately $79,000
and $147,000 in related accounts receivable from Endeavor at December 31, 2001
and 2000, respectively. In February 2000, we purchased product rights to an
estradiol product and validated manufacturing equipment from Endeavor as
consideration for reducing Endeavor's outstanding receivable and
work-in-progress balances. Endeavor assigned to us the rights to this estradiol
product, a generic version of estradiol approved by the FDA, and the related
commercialization contract between Endeavor and a third party. Under the
commercialization agreement, we will be entitled to certain minimum royalties if
the third party manufactures and distributes estradiol. Endeavor also sold a
piece of manufacturing equipment and related accessories to us. As consideration
for these product and contract rights and equipment, we agreed to reduce
Endeavor's outstanding receivable balance from approximately $2.9 million,
including work-in-progress, to $950,000. The terms of this transaction resulted
from negotiations between Endeavor and us. We believe this transaction was fair
to us based on our estimate of the value of the outstanding receivable and
work-in-process balances we reduced compared to the value of the rights and
equipment we acquired.

We organized Aesgen, Inc. with an affiliate of the Mayo Clinic in 1994 and
funded it in 1995 with an affiliate of the Mayo Clinic, MOVA Pharmaceutical
Corporation and certain other investors. Our initial common stock investment in
Aesgen was distributed to our shareholders prior to our initial public offering
in 1996. As a result, our directors and executive officers beneficially own the
following percentages of the fully diluted common equity of Aesgen as of January
31, 2002: Dr. Sancilio, 4.1%, Mr. Waters, 5.0% and Mr. Underwood, 0.3%. In
addition, the Goldman Sachs investment partnerships own 1.8% of the fully
diluted common equity of Aesgen as of January 31, 2002. In January 2001, the
terms of the non-convertible, redeemable preferred stock we received in
connection with our 1995 investment in Aesgen were amended to make that class of
stock convertible into Aesgen common stock. In October 2001 we agreed to provide
research services to Aesgen, through AAI International, in exchange for up to
$1.1 million of Aesgen convertible preferred stock. Through December 31, 2001,
the Company has performed $86,000 of services under the agreement but had not
been issued any shares of convertible preferred stock. As of January 31, 2002,
we owned approximately 3.8% of the common equity of Aesgen on a fully diluted
basis. If all $1.1 million of services are performed, we expect to own 14.2% of
Aesgen on a fully diluted basis.

At the time of our 1995 investment in Aesgen, we entered into a development
agreement with Aesgen. Under this agreement, we had the right to provide product
development and support services to Aesgen with respect to the generic drugs
being developed by Aesgen, provided that our fees for such services were
comparable to those of a competitor. In addition, we were obligated not to
develop for our own account or for any other person, any formulation of the
generic products then under development by Aesgen. In 1996, we sold to Aesgen
marketing rights to a pharmaceutical product that we were developing. Under the
agreement, Aesgen paid a license fee and will pay additional royalties upon
marketing the product. In December 2001 we agreed to purchase from Aesgen a
number of generic product development projects including the rights to
associated abbreviated new drug applications that have been filed with or
approved by the FDA. In exchange

76

for the rights to these products, we agreed to terminate the 1995 development
agreement and the 1996 license agreement with Aesgen described above, and to
release Aesgen from any and all liabilities owed to us under these contracts,
including approximately $0.7 million of work in progress and accounts
receivable. Furthermore, as a result of this transaction, we will have the right
to receive royalties that were formerly payable to Aesgen by MOVA Pharmaceutical
Corporation with respect to the abbreviated new drug applications we acquired
from Aesgen. The terms of this transaction resulted from negotiations between
Aesgen and us. We believe this transaction was fair to us.

In February 2002, we purchased a generic injectable vitamin D product from
Aesgen that we intend to market and promote under our Aquasol brand name as
Aquasol D. We made an initial payment of $1.0 million for this product and
agreed to make additional contingent milestone payments of up to $1.5 million
and royalty payments equal to 30% of the net sales of Aquasol D, less costs
incurred in its manufacture and marketing, for the eight-year period following
the first commercial sale of this product.

We recognized net revenues of approximately $86,000, $100,000, and $100,000
from Aesgen in 2001, 2000, and 1999, respectively. We had no accounts receivable
or work-in-progress at December 31, 2001, and had approximately $248,000 of
accounts receivable and $377,000 of work-in-progress at December 31, 2000.

In 1999, we advanced $300,000 to Cetan Technologies, Inc., formerly
PharmComm, Inc., a company whose principal stockholders include Dr. Sancilio,
Mr. Waters and Mr. Underwood. The advance payment was for scanning and indexing
services to be rendered by Cetan Technologies during 1999 and 2000 as required
as part of our regulatory compliance and record retention policies. The services
were performed by Cetan Technologies at market rates after considering the
timing of the advance payment. We have engaged Cetan Technologies to perform
these services since 1996 and have compensated Cetan Technologies pursuant to
written agreements for the services. Cetan Technologies also provides computer
validation services to us at market rates. These validation services are
required for compliance with regulatory requirements. We stopped using the
services of Cetan Technologies in 2001. Total payments for scanning and
validations services provided to us by Cetan Technologies were approximately
$277,000 in 1999, $308,000 in 2000 and $4,000 in 2001 respectively. At December
31, 2001, the $300,000 advance had been fully utilized. In addition, two of our
directors serve as directors of Cetan Technologies, Inc.

Mr. Waters and Dr. Sancilio have agreed to sell us up to a total of 242,539
shares of our common stock to provide the shares for issuance pursuant to our
1995 Stock Option Plan. Upon the exercise of a stock option awarded under the
1995 plan, we are entitled to purchase from them the same number of shares at
the exercise price of the option, $8.35 per share. As of December 31, 2001,
options to acquire 6,225 shares of our common stock were outstanding under our
1995 Stock Option Plan. We acquired from Mr. Waters 26,132 shares in 2001 for
$218,202, 2,778 shares in 2000 for $23,296, and 3,154 shares in 1999 for
$26,336, and we acquired from Dr. Sancilio 31,940 shares in 2001 for $266,699,
3,396 shares in 2000 for $28,356, and 3,856 shares in 1999 for 32,198.

77

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)(1) and (2) -- The response to this portion of Item 14 is submitted as a
separate section of this report and reference is hereby made to Item 8.

(b) During the fourth quarter of 2001, we did not file any current reports
on Form 8-K.

(c) Exhibits -- A list of the exhibits required to be filed as part of this
Report on Form 10-K is set forth in the "Exhibit Index", which immediately
precedes such exhibits, and is incorporated herein by reference.

(d) FINANCIAL STATEMENT SCHEDULE

Schedules not included herein have been omitted because they are not
applicable or the required information is shown in the consolidated financial
statements or notes thereto.

78

SCHEDULE II
AAIPHARMA INC.

VALUATION AND QUALIFYING ACCOUNTS

(IN THOUSANDS)

- ------------

(1) Represents restructuring reserve usage

(2) Represents amounts written off as uncollectible accounts receivable

(3) Represents allowance on accounts assumed in acquisition

79

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.

/s/ FREDERICK D. SANCILIO, PH.D. Chairman of the Board and Chief March 6, 2002
------------------------------------------------ Executive Officer
Frederick D. Sancilio, Ph.D.

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, or in their behalf by
their duly appointed attorney-in-fact, on behalf of the Registrant in the
capacities and on the date indicated.

80

AAIPHARMA INC.

EXHIBIT INDEX