UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

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

Commission File Number 0-21185

AAIPHARMA INC.

(910) 254-7000
(Registrant’s telephone number, including area code)

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 whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)    Yes    [X]    No    [  ]

The number of shares of the registrant’s common stock outstanding as of July 1, 2004 was 28,585,582 shares.

The terms “we”, “us” or “our” in this Form 10-Q 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. Our Internet address is www.aaipharma.com. We make available through our Internet website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

At June 30, 2004, we owned the following registered and unregistered trademarks referenced herein: Darvocet^®, Darvon^®, Darvon-N^®, Darvocet-N^®, Darvocet A500™, Brethine^®, ProSorb-D™, Oramorph^® SR, Roxicodone^®, AzaSan^®, aaiPharma^® and AAI^®. AzaSan^® is a registered trademark owned by us and licensed to Salix Pharmaceuticals. Unless the context otherwise requires, references in this document to Darvon are to Darvon^® and Darvon-N^®, collectively, and references to Darvocet are to Darvocet-N^® and Darvocet A500™, collectively. We also reference trademarks owned by other companies. M.V.I.^®, M.V.I.-12^®, M.V.I. Pediatric^®, M.V.I. Adult™, Aquasol^®, Aquasol A^® and Aquasol E^® are registered and unregistered trademarks owned by Mayne Pharma (USA) Inc. Prilosec^® is a registered trademark owned by AstraZeneca. Unless the context otherwise requires, references to M.V.I. are to M.V.I.-12^®, M.V.I. Pediatric^® and M.V.I. Adult™, collectively, and references to Aquasol are to Aquasol A^® and Aquasol E^®, collectively. Duraclon^® is a registered trademark owned by Fujisawa Healthcare, Inc. and licensed to us. All references in this document to any of these terms lacking the “^®” or “™” symbols are defined terms that reference the products, technologies or businesses bearing the trademarks with these symbols.

aaiPharma Inc.
Table of Contents

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PART I. FINANCIAL INFORMATION

aaiPharma Inc.

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

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aaiPharma Inc.

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

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aaiPharma Inc.

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

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aaiPharma Inc.

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

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aaiPharma Inc.

1. Basis of presentation and other matters

aaiPharma Inc. (“aaiPharma” or the “Company”) is a science-based pharmaceutical company focused on acquiring, improving and marketing well-known, branded medicines in pain management and critical care. The Company also offers comprehensive drug development services to the pharmaceutical, biotechnology, generic and device industries through its development services division. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and applicable Securities and Exchange Commission regulations for interim financial information. These financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for annual financial statements. The consolidated financial information as of December 31, 2003 has been derived from audited financial statements; certain amounts from the three and six months ended June 30, 2003 have been reclassified for consistent presentation with current year financial statements. It is presumed that users of this interim financial information have read or have access to the audited financial statements for the preceding fiscal year, which were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 (the “2003 Form 10-K”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included in these interim financial statements. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the full year.

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.

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for its stock option plans; therefore, compensation expense has not been recognized for options granted at fair value. Under APB 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. 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 fair value method of Statement of Financial Accounting Standards No. 123 “Accounting for Stock Based Compensation”, the Company’s net income (loss) and income (loss) per share would have been changed to the pro forma amounts indicated below:

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2. Recent developments

Special Committee

On February 27, 2004, the Company’s Board of Directors appointed a committee consisting of all of the non-employee members of the Board of Directors (the “Special Committee”) to conduct an inquiry into unusual sales in the Brethine and Darvocet product lines during the second half of 2003. King & Spalding LLP, an independent law firm, and Deloitte & Touche USA LLP, as independent forensic accountants, were engaged to assist the Special Committee in this inquiry.

In connection with the Special Committee’s inquiry, the Company determined that certain matters identified by the Special Committee, along with certain other adjustments identified by the Company, required material adjustments to the 2003 financial information included in the Company’s February 5, 2004 press release and the financial information for the periods ended March 31, June 30, and September 30, 2003. The Company also restated financial information for all periods of 2002. The Special Committee’s investigation, along with these adjustments, are discussed in greater detail in the 2003 Form 10-K, in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and in Note 1 of Notes to Consolidated Financial Statements. The restated quarterly information can be found in the Company’s Quarterly Reports on Form 10-Q/A for the periods ended March 31, 2003, June 30, 2003 and September 30, 2003.

NASDAQ Listing Status

The Company received notice on March 30, 2004 from the NASDAQ Stock Market that, due to the delay in filing of its 2003 Form 10-K, the Company was not in compliance with certain NASDAQ marketplace rules and that its common stock would be subject to delisting at the opening of business on April 8, 2004, unless the Company requested a hearing pursuant to NASDAQ rules. The Company requested and participated in a hearing before a NASDAQ listing qualifications panel on April 29, 2004 in which it committed to filing the Company’s 2003 Form 10-K on or before June 15, 2004 and to filing amended Quarterly Reports on Form 10-Q for each of the first three quarters of 2003 and its Quarterly Report on Form 10-Q for the period ended March 31, 2004 on or before June 30, 2004. On May 18, 2004, the Company received notice from the NASDAQ Stock Market that the Company was delinquent in the filing of this Quarterly Report on Form 10-Q for the period ended March 31, 2004.

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The 2003 Form 10-K was filed on June 15, 2004. On June 21, 2004, NASDAQ notified the Company that the listing qualifications panel has determined to continue the listing of the Company’s common stock if the Company met certain conditions, including providing NASDAQ with additional information, filing the Quarterly Reports on Form 10-Q/A for each of the first three quarters of 2003 and the Quarterly Report on Form 10-Q for the first quarter of 2004 by the June 30, 2004 deadline, and filing on a timely basis all periodic reports for reporting periods ending on or before June 30, 2005. The amended Quarterly Reports on Form 10-Q for 2003 were filed on June 24, 2004, the Quarterly Report on Form 10-Q for the period ended March 31, 2004 was filed on June 25, 2004 and the Company provided NASDAQ the required additional information on June 30, 2004. As a result, NASDAQ notified us that we were in compliance and would continue to be listed subject to the conditions identified in its June 21, 2004 notification.

Senior Credit Agreement and Indenture Defaults

aaiPharma did not file its 2003 Form 10-K in the time required by the federal securities laws. This failure to file the 2003 Form 10-K constituted an event of default under its former senior credit agreement, dated as of March 28, 2002, with Bank of America, N.A. as administrative agent (in such capacity, the “Administrative Agent”). Due to this and other events of default under that senior credit agreement, the Company was advised by the Administrative Agent that the Company was not permitted to make any borrowings under the $100 million revolving credit facility portion of the credit agreement.

On April 23, 2004, aaiPharma refinanced that credit agreement with $140 million of senior credit facilities with a syndicate of lenders, Silver Point Finance LLC as collateral agent, and Bank of America, N.A., as administrative agent. These new senior credit facilities consist of a two-year, $125 million senior secured term loan facility (which was fully drawn at closing) and a two-year, $15 million senior secured revolving credit facility.

Under the terms of the indenture for its senior subordinated notes due 2010 (described in Note 10 below), the Company was required to comply with various covenants, including, but not limited to, a covenant relating to incurrence of additional indebtedness. The Company was in compliance with the indenture covenants at June 30, 2004.

Royalties Receivable

The Company entered into a definitive agreement to receive a prepayment of certain royalties receivable (the “Accelerated Royalties”) that would otherwise have been paid to it quarterly through the second quarter of 2005 pursuant to the significant development agreement discussed in the 2003 Form 10-K. These royalties would have aggregated $15.4 million. The agreement to receive a prepayment of these royalties discounted the Accelerated Royalties by 5% per annum from the date originally due to the advance payment date. The Company received approximately $15.0 million in gross proceeds from the Accelerated Royalties in April 2004.

Termination of Interest Rate Hedging Obligation

aaiPharma was a party to an interest rate hedging agreement to effect a swap of its fixed interest rate on a notional amount of the Company’s 11% senior subordinated notes (see Note 10) to a floating interest rate. The Company terminated the interest rate hedging agreement. The Company’s termination obligations under this interest rate hedging agreement were approximately $9.4 million, which were paid

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in full on April 26, 2004 and will be expensed as additional interest over the life of the senior subordinated notes.

Governmental Investigations and Litigation

In April 2004, the Company received subpoenas for document production and potential testimony issued by a grand jury of the U.S. District Court for the Western District of North Carolina related primarily to 2002 and 2003 financial information, certain loans obtained by it, extensions of credit, and other information. The Company has also been advised by the Office of the United States Attorney for the Western District of North Carolina and the Securities and Exchange Commission (“SEC”) that it may receive a subpoena from the SEC. A former officer of the Company, David M. Hurley, has been advised by the U.S. Attorneys Office that he is a target of the investigation. The Company and the Special Committee have agreed to cooperate fully with the government investigations, and the Special Committee has agreed to share all results of its investigation with the SEC and the U.S. Attorneys Office. To that end, three meetings between outside counsel and attorneys for the U.S. Attorneys Office and the SEC have taken place and numerous documents as requested by these government agencies have been voluntarily produced. The Company and the Special Committee intend to facilitate any interviews of employees or officers that may be requested by these government agencies.

In addition, the Company and certain of its current and former officers and employees have been named as defendants in multiple purported class action lawsuits commenced by stockholders and retirement plan participants beginning in February 2004 alleging violations of federal securities laws and ERISA.

On April 15, 2004, the Company filed a lawsuit against Athlon Pharmaceuticals, Inc. seeking a declaratory judgment that it was entitled to terminate the Service Agreement (the “Athlon Service Agreement”) dated July 16, 2003, as amended, between the Company and Athlon as well as damages and injunctive relief for material breaches of the Athlon Service Agreement by Athlon. The Athlon Service Agreement incorporated the terms and conditions pursuant to which representatives of Athlon would promote the sale of the Company’s Darvocet A500 product to physicians. The Company initially paid Athlon $3,350,000 to build its sales force to promote the sale of Darvocet A500, and the terms of the Athlon Service Agreement would require the Company to pay Athlon an additional $1,200,000 each month for such services for the contract period of 36 months, commencing in October 2003, subject to Athlon’s compliance with certain representations, warranties and covenants. Athlon has asserted several counterclaims, including breach of an implied covenant of good faith in fair dealing and anticipatory breach of the contract. The Company has filed a reply denying these allegations.

In May 2004, the Company ceased making payments under the Athlon Service Agreement, and on June 4, 2004, the Company sent a notice of termination of agreement to Athlon. On July 7, 2004, the Company amended the lawsuit to assert claims of fraud and breaches of contract and implied covenants, seeking to recover compensatory and punitive damages and attorneys’ fees. Athlon has amended its counterclaim to assert fraud claims and to seek punitive damages.

Generic Competition

In 2004, the Food and Drug Administration approved generic versions of the Company’s Roxicodone and Brethine injectable products. In the first quarter, a generic version of Roxicodone was introduced, and in April 2004, the first of three generic versions of injectable Brethine was approved for sale.

3. M.V.I. and Aquasol Product Line Sale and Contingent Payment

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On April 26, 2004, the Company sold its M.V.I. and Aquasol product lines to Mayne Pharma (USA) Inc. for $105 million, subject to adjustments based on inventory levels at closing and other post-closing obligations (the “M.V.I. and Aquasol Sale”). A portion of the closing payment is held in escrow to satisfy post-closing obligations under the agreement. The M.V.I. and Aquasol Sale resulted in a gain of $37.5 million that the Company recorded in the second quarter of 2004. The gain on the sale was based on the net cash received from the sale less the book value of the intangible assets, inventories and other items related to the product lines sold.

The Company’s M.V.I. and Aquasol product line acquisition agreement with AstraZeneca AB, as amended, provided for a future contingent payment of $43.5 million potentially due in August 2004, depending on the status of certain reformulation activities being carried out by the seller and regulatory approval of the reformulations by the U.S. Food and Drug Administration. The amount of the $43.5 million contingent payment was to be reduced by $1 million per month if the conditions for the contingent payment had not occurred by December 31, 2002. The amount of the contingent payment had decreased by $12.0 million by December 31, 2003. Such conditions were satisfied in January and February 2004, fixing the previously contingent liability under the amendment at $31.5 million. The Company recorded this expense in the first quarter of 2004. As a result of an amendment to the original acquisition agreement, the Company was precluded from recognizing this obligation (the “M.V.I. Contingent Payment”) as additional purchase price for the M.V.I. and Aquasol product lines under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” and No. 141, “Business Combinations”; therefore, this adjustment was expensed in the first quarter of 2004. As discussed above, the Company sold its M.V.I. and Aquasol product lines on April 26, 2004. Because the $31.5 million contingent payment was not included in the basis of the assets sold, the gain from the sale transaction in the second quarter of 2004 offsets the expense discussed in this Note in determining the net loss for the six months ended June 30, 2004. Concurrently with the closing of the M.V.I. and Aquasol Sale on April 26, 2004, the Company paid to AstraZeneca AB the M.V.I. Contingent Payment, which was discounted to approximately $31.0 million as a result of the early payment.

4. Income taxes

The Company recorded a tax expense of approximately $3 million in the second quarter of 2004. This expense was offset by a tax benefit from the utilization of net operating loss carryforwards from the first quarter of 2004 resulting in net $0.2 million tax expense. The Company recorded a tax benefit of approximately $17 million in the six months ended June 30, 2004 as a result of current period operating losses, offset by a valuation allowance for the entire amount because it is more likely than not that the deferred tax asset resulting from this benefit will not be realized. The Company’s effective tax rates for both the three and six months ended June 30, 2004 was less than 1%. Its effective tax rates for the three and six months ended June 30, 2003 was 41% and 44%, respectively.

5. 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, unless their inclusion would be anti-dilutive. During the six months ended June 30, 2004, approximately 360,000 options were exercised for aggregate proceeds to

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the Company of $3.6 million. In the three and six months ended June 30, 2004, 4.6 million and 3.5 million options, respectively, were excluded as they were anti-dilutive. In the three and six months ended June 30, 2003, 1.7 million and 1.6 million options, respectively, were excluded as they were anti-dilutive. In each period 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 denominator for the basic and diluted earning per share computations (in thousands):

6. 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 pharmaceuticals division, a product development business, primarily the research and development business unit, and a development services business, primarily the AAI Development Services business unit. The product sales business provides for the sales of the Company’s pharmaceutical product lines. In the product development segment, the Company internally develops drugs and technologies for future sales by the product sales business or with the objective of licensing marketing rights to third parties in exchange for license fees and royalties. The core services provided by the development services business 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 which are not directly attributable to a business segment. Financial data by segment and geographic region are as follows (in thousands):

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7. Transactions with related parties

The Company has revenue, accounts receivable and work-in-progress with Aesgen, Inc. (“Aesgen”) and Endeavor Pharmaceuticals, Inc. (“Endeavor”). Both Endeavor and Aesgen were organized by aaiPharma Inc., its principal shareholders and others. Aesgen was a related party as of June 30, 2004, and continues to be a related party. Endeavor was a related party until the fourth quarter of 2003, when Endeavor filed articles of dissolution and made a liquidating distribution to its stockholders, including the Company. No revenues were recognized from Aesgen for the three and six months ended June 30, 2004 and 2003, respectively. Services performed by the Company for Aesgen are covered by a Subscription Agreement, whereby the Company has agreed to receive Aesgen preferred stock in lieu of cash for the services performed. In February 2002, the Company acquired a calcitriol product from Aesgen, under an agreement which included potential royalty payments. The Company launched its calcitriol product in March 2003; however, no revenues or royalty expenses were recorded for this product during the first quarter of 2003. Calcitriol is shipped to wholesalers and revenues are recorded under the consignment model; therefore no revenue or expenses were recognized until the product was shipped by those wholesalers. The Company expensed royalties of $0.1 million and $0.2 million under that agreement in the three and six months ended June 30, 2004 and expensed $0.1 million in the second quarter of 2003. Revenues recognized from Endeavor totaled $0.3 million and $0.6 million for the three and six months ended June 30, 2003. Certain services performed by the Company for Endeavor were covered by a Securities Payment Agreement between the Company and Endeavor, whereby the Company would receive Endeavor preferred stock in lieu of cash for services performed. At June 30, 2004, the Company had no accounts receivable or work-in-progress related to Aesgen.

8. Accounts receivable, net

The following table presents the components of accounts receivable (in thousands):

Accounts receivable are presented net of an allowance for uncollectible accounts and net of an allowance for customer credits, including discounts, rebates, chargebacks, product returns and other allowances. The net accounts receivable balance at June 30, 2004 has been reclassed to other current liabilities.

9. Inventories, net

The following table presents the components of inventories (in thousands):

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10. Debt

The following table presents the components of current maturities of long-term debt (in thousands):

The following table presents the components of long-term debt (in thousands):

In March 2002, the Company entered into a $175 million senior secured credit facility consisting of a $75 million five-year revolving credit facility and a $100 million five-year term loan facility. The term loan facility was scheduled to be amortized over the full five-year term. The senior facility was subsequently reduced due to early repayments made under the term loan facility. In December 2003, the remaining term loan facility of $40 million was repaid and a new term loan facility was entered into. As part of this transaction, the Company recorded a $1.5 million loss for the early extinguishment of debt related to the write-off of financing fees associated with the original term loan. The December 2003 term loan was a $160 million facility which amortized over a six-year term. The net proceeds from this facility were used to fund the acquisition of certain pain management products in December 2003. In December 2003, the revolving credit facility was amended and increased to $85 million, which was subsequently increased to $100 million in January 2004. The availability of borrowings under the revolving credit facility was not limited by a borrowing base. Both the term loans and the revolving credit facility provided for variable interest rates based on LIBOR or an alternate base rate, at the Company’s option. The senior secured credit facility was guaranteed by all domestic subsidiaries and secured by a security interest on substantially all domestic assets, all of the stock of domestic subsidiaries and 65% of the stock of material foreign subsidiaries. The facility required the payment of certain commitment fees based on the unused portion of the revolving credit facility and could be prepaid at any time without a premium.

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Also in March 2002, the Company issued $175 million of senior subordinated notes due April 1, 2010. The proceeds from the issuance of these notes were $173.9 million, which was net of the original issue discount. This discount will be charged to interest expense over the term of the notes. These notes had a fixed interest rate of 11% per annum and are guaranteed on a subordinated basis by all existing domestic subsidiaries and all future domestic subsidiaries that are owned 80% or more by the Company. When issued, the notes were not secured. Prior to the third anniversary of the date of issuance of the notes, up to 35% of the notes are redeemable with the proceeds of qualified sales of equity at 111% of par value. On or after the fourth anniversary of the date of issuance of the notes, all or any portion of the notes are redeemable at declining premiums to par value, beginning at 105.5%.

Concurrent with the issuance of the senior subordinated notes, the Company entered into an interest rate hedging agreement to effectively convert interest expense on a portion of the senior subordinated notes for the term of the notes from an 11% fixed annual rate to a floating annual rate equal to 6-month LIBOR plus a base rate. In 2003, the Company sold the then outstanding interest rate hedging agreement and replaced it with a similar interest rate hedging agreement. In April 2004, the Company paid $9.4 million to terminate the interest rate hedging agreement. The amounts received, less the termination payment and the interest benefits earned through the dates of sale, have been recorded as premiums to the carrying amount of the notes and are being amortized into interest income over their remaining life.

As a result of aaiPharma’s failure to timely file the 2003 Form 10-K, among other matters, aaiPharma was in default of its senior secured credit facility. On April 23, 2004, aaiPharma refinanced this facility with a portion of the proceeds from the M.V.I. sale and with $140 million of senior credit facilities with a syndicate of lenders, Silver Point Finance LLC (“Silver Point”) as collateral agent, and Bank of America, N.A., as administrative agent. The Company’s new senior credit facilities consist of a two-year, $125 million senior secured term loan facility (which was fully drawn at closing) and a two-year, $15 million senior secured revolving credit facility, of which the entire amount was available for borrowing at closing. The outstanding loans under the Company’s new senior credit facilities are payable in full on the two-year anniversary date of the closing of the facilities. The Company’s new senior credit facilities are secured by a security interest on substantially all domestic assets, all of the stock of domestic subsidiaries and 65% of the stock of material foreign subsidiaries. As part of this transaction, the Company recorded a $6.2 million loss for the early extinguishment of debt related to the write-off of financing fees related to the previous senior credit facility. Subject to exceptions set forth in the definitive documentation, loans under the Company’s new senior credit facilities are also required to be prepaid with a negotiated percentage of:

•		excess cash flow, as defined;
•		non-ordinary course assets sales;
•		net proceeds from the sale of subordinated indebtedness;
•		net proceeds from equity issuances; and
•		extraordinary receipts, as defined.

Optional reductions in revolving credit commitments and optional prepayments of term loans are subject to a prepayment fee equal to 3% for the first 9 months of the term of the facilities, 1.5% for the subsequent 9 months of such term, and 0.75% for the next 3 months of such term (with no prepayment penalty payable for the last 3 months of the term). Outstanding loans under the facilities

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bear interest at a rate per annum equal to a defined LIBOR rate (with a floor of 2%), plus 6.25%, or a defined reference rate (with a floor of 4%), plus 5.25%, in each case payable monthly in arrears. An additional 1% per annum unused line fee is payable on unused revolving credit commitments, payable quarterly in arrears. At June 30, 2004, the Company’s applicable interest rate on its term loan was 8.25% and on its revolving credit facility was 9.25%.

The proceeds of the loans were used, together with the net cash proceeds from the sale of the M.V.I. and Aquasol product lines, to (i) fund payment of termination obligations with respect to the Company’s interest rate hedging agreement (discussed above), (ii) refinance the Company’s then-existing senior credit facility, (iii) fund the April 2004 interest payment due on the Company’s senior subordinated notes due 2010, (iv) provide for ongoing working capital and general corporate needs, and (v) pay for fees, costs and expenses in connection with the new senior credit facilities and other corporate transactions.

On August 9, 2004, the Company entered into an amendment to its senior secured credit facility to, among other things, increase the amount of the term loans by up to $10 million, extend the maturity date of the facilities by one year to April 21, 2007, increase the interest rate on the loans by an additional 1.5% subject to potential incremental reduction based on the Company’s financial performance, and adjust certain covenants under the facilities. Under the amended credit facility, the Company is permitted to borrow up to an additional $10 million in term loans on August 13, 2004. Subject to availability limitations under the revolving credit facility, until December 31, 2004 the Company may pay the additional 1.5% incremental interest amount by delivery of promissory notes, having the same terms as the notes evidencing the loans under the facilities. The amendment adjusted both the percentages of proceeds of certain transactions that are required to be applied to prepay the loans and the fees to be paid upon optional reductions of the credit facility. As amended, optional reductions in revolving credit commitments and optional prepayments of term loans are subject to a prepayment fee equal to 3.5% until August 9, 2005, 2.5% for the subsequent 12 months, and 1.5% for the next 6 months (with no prepayment penalty payable for the remainder of the term).

As of June 30, 2004, scheduled maturities of long-term debt for the years ending December 31, 2004 through 2010 were as follows (in thousands):

The Company’s new senior credit facilities, as amended, include customary representations and warranties and customary affirmative and negative covenants, including limitations on liens, indebtedness, fundamental transactions, dispositions of assets, changes in the nature of the Company’s business, investments, acquisitions, capital and operating leases, capital expenditures, dividends, redemptions or other acquisitions of capital stock, redemptions or prepayments of other debt,

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transactions with affiliates, issuances of capital stock, modifications of indebtedness, organizational documents and other agreements, and retention of excess cash. The facilities also provide for financial covenants, including a minimum fixed charge ratio, a maximum total debt to trailing twelve-month EBITDA ratio, and a covenant requiring a certain level of cash and revolver availability. At June 30, 2004, the Company was in compliance with the covenants under the new senior credit facilities. As amended, the Company’s new senior credit facilities include a covenant requiring the Company to maintain availability under the revolving credit facility and cash and cash equivalents in the aggregate amount of $5.0 million plus certain other amounts related to payables, bank overdrafts and interest payments on the loans paid in the form of additional notes. Events of default under the facilities include, among others, nonpayment of principal, interest or fees, violations of covenants, inaccuracy of representations and warranties, a cross-default to the Company’s senior subordinated notes due 2010 and other material indebtedness, bankruptcy events, and a change in control.

On March 31, 2004, the lenders under the Company’s then-existing credit agreement, which was then in default as described above, exercised their right to block the Company from making the interest payment due on April 1, 2004 to holders of the Company’s senior subordinated notes. Accordingly, aaiPharma did not make that interest payment on April 1, 2004. In addition, the Company’s failure to timely file the 2003 Form 10-K constituted a default under the indenture governing the senior subordinated notes.

On April 20, 2004, aaiPharma completed a solicitation seeking the consent from holders of the Company’s senior subordinated notes to approve a refinancing or replacement of the Company’s then-existing credit facilities with the Company’s new senior credit facilities and certain amendments to, and waivers under, the indenture governing the senior subordinated notes to, among other things:

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grant a lien to secure the Company’s obligations under the senior subordinated notes, which lien is junior to the liens securing the Company’s new senior credit facilities but covers the same collateral;

•

increase the interest rate of the senior subordinated notes from 11% per annum to 11.5% per annum effective April 1, 2004;

•

suspend the Company’s obligation under the indenture to file periodic reports with the SEC until the earlier of the date that the Company’s 2003 Form 10-K is filed with the SEC or September 30, 2004 and suspend the Company’s obligation to furnish annual written statements of the Company’s accountants until the fifth day after the earlier of the date that the Company’s 2003 Form 10-K is filed with the SEC and September 30, 2004;

•

further limit the Company’s ability to grant liens to secure certain obligations unless the liens are subordinate to the liens securing the senior subordinated notes or are otherwise permitted under the indenture; and

•

limit the Company’s ability to incur up to $10 million of indebtedness, and to grant liens to secure that amount of indebtedness, not otherwise specifically permitted by the indenture, until the Company’s 2003 Form 10-K is filed with the SEC or unless the indebtedness is incurred to fund an interest payment with respect to the senior subordinated notes.

Following the completion of a consent solicitation, aaiPharma entered into a supplemental indenture to effect these amendments and waivers and made the interest payments that had been due on April 1, 2004, together with default interest.

20

The Company made an interest payment on the senior subordinated notes of $9.7 million in April 2004. The April 2004 interest payment was offset by approximately $1.7 million received under the Company’s interest rate hedging agreement, described above.

11. Restructuring Charges

In June 2004, the Company announced and implemented a work force reduction intended to rationalize the expense base in relation to its revenue. The Company recorded a $3.4 million expense in the three months ended June 30, 2004, representing severance costs and related employee-benefit expenses for those affected by the reduction. The related liability is included in other current liabilities on the Company’s consolidated balance sheet. Substantially all of this restructuring liability will be paid during the second half of 2004. As part of the restructuring plan, the Company announced it would close its New Jersey facility in August 2004. On-going lease and facility costs for this location are not included in this quarter’s restructuring charge, and the Company is currently seeking to sub-lease all or a portion of this facility. In accordance with Statement of Financial Accounting Standard No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), the Company will record facility closure costs in the third quarter of 2004.

12. Commitments and Contingencies

The Company may have to make contingent payments of $4.7 million over three years in connection with the purchase of its Charleston, South Carolina manufacturing facility, based on the level of manufacturing revenues at this facility. At June 30, 2004, these contingent payment obligations are not liabilities and have not been recorded on the Company’s consolidated balance sheet.

The Company made interest payments on the senior subordinated notes of $9.6 million in October 2003 and $9.7 million in April 2004, and payments of $10.1 million will be due in October 2004 and April 2005.

For additional information about other contingencies to which the Company is subject, including litigation and governmental investigations, see Part II, Item 1, “Legal Proceedings,” below, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Commitments and Contingencies” in the Company’s 2003 Form 10-K.

13. Financial information for subsidiary guarantors and non-guarantors

In the first quarter of 2002, the Company issued senior subordinated notes which are guaranteed by certain of the Company’s subsidiaries.

The following presents condensed consolidating financial information for the Company, segregating: (1) aaiPharma Inc., which issued the notes (the “Issuer”); (2) the domestic subsidiaries, which 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 adjusting entries eliminate investments in subsidiaries and inter-company balances and transactions.

21

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

22

aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands)

23

aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands)

24

aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands)

25

aaiPharma Inc.
CONSOLIDATING STATEMENT OF OPERATIONS
(In thousands)