Back to GetFilings.com

Table of Contents

United States

Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended January 31, 2005

OR

For the transition period from              to             

Commission File Number 0-20424

Hi-Tech Pharmacal Co., Inc.

(Exact name of registrant as specified in its charter)

369 Bayview Avenue, Amityville, New York 11701

(Address of principal executive offices)

631 789-8228

(Registrant’s telephone number including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act 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 Rule 12b-2 of the Securities Exchange Act).    Yes  x    No  ¨

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13, or 15(d) of the Securities Exchange Act subsequent to the distribution of securities under a plan confirmed by a court.    Yes  ¨    No  ¨

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:

Common Stock, $.01 Par Value —7,746,000 shares outstanding as of March 9, 2005.

Table of Contents

INDEX

HI-TECH PHARMACAL CO., INC.

2

Table of Contents

PART I. ITEM 1.

HI-TECH PHARMACAL CO., INC.

CONDENSED BALANCE SHEETS

See notes to condensed financial statements

3

Table of Contents

HI-TECH PHARMACAL CO., INC.

CONDENSED STATEMENTS OF OPERATIONS (unaudited)

See notes to condensed financial statements

4

Table of Contents

HI-TECH PHARMACAL CO., INC.

CONDENSED STATEMENTS OF CASH FLOWS (unaudited)

See notes to condensed financial statements

5

Table of Contents

HI-TECH PHARMACAL CO., INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS

January 31, 2005

BASIS OF PRESENTATION

The accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The preparation of the Company’s financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the balance sheet dates and the reported amounts of revenues and expense during the reporting periods. Actual results could differ from these estimates and assumptions. Operating results for the three and nine month periods ended January 31, 2005 are not necessarily indicative of the results that may be expected for the year ending April 30, 2005. For further information, refer to the financial statements and footnotes thereto for the year ended April 30, 2004 on Form 10-K.

REVENUE RECOGNITION

Revenue is recognized for product sales upon shipment and passing of risk to the customer and when estimates of discounts, rebates, promotional adjustments, price adjustments, returns, chargebacks, and other potential adjustments are reasonably determinable, collection is reasonably assured and the Company has no further performance obligations. These estimates are presented in the financial statements as reductions to net revenues and accounts receivable. Estimated sales returns, allowances and discounts are provided for. Contract research income is recognized as work is completed and billable costs are incurred. In certain cases, contract research income is based on attainment of designated milestones.

Net sales for generic pharmaceutical products, which include private label contract manufacturing, for the nine months ended January 31, 2005 and January 31, 2004 were $43,397,000 and $37,821,000, respectively. The Company’s Health Care Products division, which markets the Company’s branded products, for the nine months ended January 31, 2005 and January 31, 2004 had net sales of $6,647,000 and $5,131,000, respectively.

NAPRELAN^® LICENSE AGREEMENT

In June, 2004 Hi-Tech Pharmacal Co., Inc. acquired exclusive rights to market and distribute Naprelan^® (naproxen sodium) controlled-release tablets in the United States, its territories and Puerto Rico. Elan Pharmaceuticals, Inc. (“Elan”) had provided the underlying rights to Stat-Trade, Inc. (“STI”), a company providing biomedical product development support and regulatory services to biotechnology and pharmaceutical companies, and STI simultaneously assigned its rights to the license to the Company. The Agreement covers all FDA approved strengths of Naprelan^®. Under the terms of a supply agreement, Elan will manufacture Naprelan^® for Hi-Tech.

As consideration for the acquisition, the Company paid $3 million in cash and an additional approximately $400,000 for the existing product inventory, plus expenses related to the acquisition of approximately $231,000. The license and acquisitions costs are being amortized over the remaining life of the patent, a ten year period. For future consulting services, Hi-Tech will be paying STI an on-going fee based on net profits on the sales generated by Naprelan^®. Net sales of Naprelan^® for the nine month period ended January 31, 2005 were approximately $1,843,000.

CUSTOMER DEPOSITS AND CONTRACT RESEARCH INCOME

Contract research income is recognized as work is completed and as billable costs are incurred. In certain cases, contract research income is based on attainment of designated milestones. Advance payments may be received to fund certain development costs.

NET EARNINGS PER SHARE

Net income per common share is computed based on the weighted average number of common shares outstanding for basic earnings per share and on the weighted average number of common shares and share equivalents (stock options) outstanding for diluted earnings per share. For the three and nine months ended January 31, 2005, approximately 273,000 option shares have been excluded from the diluted earnings per share calculation as their effect is anti-dilutive.

WORKING CAPITAL REVOLVING LOAN

The Company has a three year $8,000,000 revolving credit facility dated October 23, 2002. The revolving credit facility bears interest at a rate selected by the Company equal to the Prime Rate or LIBOR plus 1.50%. Loans are collateralized by inventory, accounts receivable and other assets. The agreement contains covenants with respect to working capital, net worth and certain ratios, as well as other covenants, and prohibits the payment of cash dividends. For the nine months ended January 31, 2005 there were no borrowings under the credit facility.

INVENTORIES

The components of inventory consist of the following:

6

Table of Contents

FIXED ASSETS

The components of net plant and equipment consist of the following:

ACCOUNTS PAYABLE AND ACCRUED EXPENSES

The components of accounts payable and accrued expenses consist of the following:

COMMON STOCK

In August 2004, the Company’s Board of Directors authorized the repurchase of up to an additional $10 million of the Company’s common stock. Pursuant to the terms of a Rule 10b5-1 stock repurchase plan, these repurchases may be made from time to time in the open market or in private transactions as market conditions dictate. The Board of Directors previously authorized a total of $3 million for the Company’s repurchase program which has been fully utilized to repurchase approximately 440,000 shares of the Company’s common stock. During the nine months ended January 31, 2005 the Company repurchased an additional 369,000 shares of the Company’s common stock for a purchase price of approximately $5,902,000.

FREIGHT EXPENSE

Freight costs are included in selling, general, and administrative expense.

STOCK-BASED COMPENSATION:

Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”, encourages the use of the fair value based method of accounting for stock-based employee compensation. Alternatively, SFAS No. 123 allows entities to continue to apply the intrinsic value method prescribed by Accounting Principles Board (“APB”) Opinion 25, “Accounting for Stock Issued to Employees”, and related interpretations and provide pro forma disclosures of net income (loss) and earnings (loss) per share, as if the fair value based method of accounting had been applied to employee awards. The Company has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements as defined by APB Opinion 25 and provide the disclosures required by SFAS No. 123 and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, which was released in December 2002 as an amendment of SFAS No. 123. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions to stock-based employee compensation.

CONTINGENCIES AND OTHER MATTERS

The Company’s products and facilities are subject to regulation by a number of Federal and State governmental agencies. The Food & Drug Administration (“FDA”), in particular, maintains oversight of the formulation, manufacture, distribution, packaging and labeling of all of the Company’s products.

During the nine months ended January 31, 2005 the Company’s significant customers were McKesson, Walgreens, Cardinal and CVS, which accounted for approximately 14%, 13%, 11% and 10% of sales, respectively. At January 31, 2005, trade receivables from these customers were approximately 55% of total receivables.

The Company has a three year $8,000,000 revolving credit facility dated October 23, 2002. The revolving credit facility bears interest at a rate elected by the Company equal to the Prime Rate or the LIBOR plus 1.50%. Loans are collateralized by inventory, accounts receivable and other assets. The agreement contains covenants with respect to working capital, net worth and certain ratios, as well as other covenants and prohibits the payment of cash dividends. For the nine months ended January 31, 2005 there were no borrowings under the credit facility.

7

Table of Contents

The Company has a net investment of approximately $277,000 in Marco Hi-Tech, a joint venture, for the marketing and development of a nutritional supplement. In October 2004, the Company invested $88,600 in a Secured Convertible Note from Marco Hi-Tech at an interest rate of 12%, maturing October 1, 2007 which is included in the net investment. Mr. Reuben Seltzer, a director of the Company, has an interest in the joint venture. Mr. Reuben Seltzer is the son of Mr. Bernard Seltzer, Chairman Emeritus of the Board of Directors and the brother of Mr. David Seltzer, President and Chief Executive Officer of the Company.

On December 18, 2003, Daiichi Pharmaceutical Co., Ltd. filed a complaint against the Company in the United States District Court for the District of New Jersey alleging infringement of its patent for a drug known as Levofloxacin, which it has sublicensed exclusively to Santen Inc. for use in certain ophthalmic pharmaceutical preparations. The plaintiff seeks a permanent injunction against the Company from engaging in the marketing within the United States of Levofloxacin Ophthalmic Solution, described in the Company’s new drug application with the United States Food and Drug Administration. On February 17, 2004, the Company filed an Answer and Counterclaim to the Complaint denying infringement of any valid claim in the patent suit, seeking a judicial declaration that the patent is invalid and not infringed. Fact discovery is complete, but no trial date has been set. The Company believes it has meritorious defenses to the allegations in the Complaint. Legal costs in connection with this complaint are being paid for by a business partner.

On or about November 24, 2003 MedPointe Healthcare, Inc. (“MedPointe”) filed a Verified Complaint and Application for Order to Show Cause with Temporary Restraints against the Company in the United States District Court for the District of New Jersey, Trenton vicinage. The suit alleged willful infringement by the Company of MedPointe’s patent No. 6,417,206 as a result of the Company’s offering to sell its Tannate 12-D S product, as a generic equivalent to MedPointe’s Tussi-12^®D S. On December 1, 2003 the Court entered Temporary Restraints against the Company pending the return date of the Order to Show Cause. On March 1, 2004 the Court issued a preliminary injunction enjoining the Company from marketing its Tannate 12-D S product. On November 19, 2004 the U.S. Court of Appeals for the Federal Circuit vacated the preliminary injunction. As a result of this decision, the Company commenced shipment of the Tannate 12-D S product in the third quarter. The Company may still be subject to liability based on a claim of patent infringement for sales of Tannate 12-D S.

On or about October 28, 2002 an action was commenced in the United States District Court for the Northern District of Texas, Dallas Division, against the Company, Wyeth, Wyeth Consumer Healthcare, Bayer Corporation, Bayer A.G., Novartis Consumer Health, Inc., Novartis Pharmaceuticals Corporation, Schering-Plough Corporation, The Delaco Company and Chattem, Inc. The complaint alleges claims for permanent and debilitating injuries as a result of exposure to phenylpropanolamine (hereinafter referred to as “PPA”) through ingestion of PPA-containing products designed, formulated, marketed, distributed and/or sold by the Company and the other defendants. One plaintiff, Roger Grantham, claims he ingested a PPA-containing product manufactured by the Company. Mr. Grantham is a plaintiff in the Amanda Carrisalez case, which was originally filed in the United States District Court for the Northern District of Texas and was then transferred to the Multidistrict Litigation in Seattle. The plaintiffs, individually, seek compensatory damages in the amount of $15 million for actual damages, plus punitive damages. The Company has filed an answer to this action and depositions of the plaintiffs have been scheduled. The Company believes it has meritorious defenses. The Company’s defense costs, after its deductible, are being covered under its product liability policy which has a $5 million limit for defense costs and liability (“Product Liability Policy”). The last date of sale of the limited number of products containing PPA by the Company was December 2000.

In March 2001, the Center for Environmental Health (“CEH”) filed a lawsuit against several defendants alleging violations of California’s Proposition 65 and Unfair Trade Practices Act for failure to provide clear and reasonable warnings regarding the carcinogenicity and reproductive toxicity of lead and the reproductive toxicity of cadmium to the users of FDA-approved anti-diarrheal medicines. In May 2004, the Company signed a settlement agreement, which has been approved by the Court. The settlement agreement provides that the Company may sell a reformulated product or the original formulated product with certain warnings. The Company has paid a total of $40,000 to date and its remaining liability in this matter will not exceed an additional $20,000.

The Company believes that these litigation matters will not have a material effect on the financial position of the Company.

In December 2004, the Company learned that the staff of the Securities and Exchange Commission (“SEC”) has been conducting a formal investigation of certain trades in the Company’s common stock involving the Company and certain of its officers and directors during the period commencing on or about April 2003 to at least July 2003. The Company has also learned that the staff is investigating trades involving the Company’s common stock by other persons unaffiliated with the Company. While there can be no assurance regarding the outcome of the investigation, at this time, the Company does not believe the investigation will have a material impact on the management or operations of the Company. The staff has advised that at this time this is only a fact finding inquiry and no conclusion should be reached that the Company or person has violated any law. The Company and its officers and directors are fully cooperating with the SEC in this matter.

From time to time, the Company becomes involved in various legal matters in addition to the above described matters that the Company considers to be in the ordinary course of business. While the Company is not presently able to determine the potential liability, if any, related to such matters, the Company believes none of such matters, individually or in the aggregate, will have a material adverse effect on its financial position.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

With the exception of the historical information contained in this Form 10-Q, the matters described herein may include forward-looking statements (statements which are not historical facts) made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not promises or guarantees and investors are cautioned that all forward-looking statements involve risks and uncertainties, including but not limited to the impact of competitive products and pricing, product demand and market acceptance, new product development, the regulatory environment, including without limitation, the outcome of the SEC staff’s investigation and any conclusions reached by the staff which are adverse to the Company, its officers or directors, reliance on key strategic alliances, availability of raw materials, fluctuations in operating results and other results and other risks detailed from time to time in the Company’s filings with the Securities and Exchange Commission. These statements are based on management’s current expectations and are naturally subject to uncertainty and changes in circumstances. We caution you not to place undue reliance upon any such forward looking statements which speak only as of the date made. Hi-Tech is under no obligation to, and expressly disclaims any such obligation to, update or alter its forward-looking statements, whether as a result of new information, future events or otherwise.

RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED JANUARY 31, 2005 COMPARED TO NINE MONTHS ENDED JANUARY 31, 2004

Net sales for the nine months ended January 31, 2005 were $50,043,000, an increase of $7,091,000 or 17%, as compared to the net sales for the nine months ended January 31, 2004 of $42,952,000. Net sales of generic pharmaceutical products, which includes some private label contract manufacturing, for the nine months ended January 31, 2005 were $43,397,000, an increase of $5,576,000, approximately 15%, compared to the nine months ended January 31, 2004 sales of $37,821,000. The increase is primarily due to the introduction of Tannate 12 D S, Tannate V DM, Tannate DMP/DEX, Urealac, Naprelan^® , Ofloxacin Ophthalmic Solution and Promethazine Plain.

8

Table of Contents

The Health Care Products division, which markets the Company’s branded products, for the nine months ended January 31, 2005 and 2004 had net sales of $6,647,000 and $5,131,000, respectively, an increase of $1,516,000 or 30%. This increase is the result of increased sales of Diabetic Tussin^® and Diabetiderm^® products. Additionally, in the prior period, sales in the Health Care Products division were adversely affected by higher than usual product returns and exported products redirected to the United States market.

During the nine months ended January 31, 2005 the Company’s significant customers were McKesson, Walgreens, Cardinal and CVS, which accounted for approximately 14%, 13%, 11% and 10% of sales, respectively. At January 31, 2005, trade receivables from these customers were approximately 55% of total receivables.

Cost of sales, as a percentage of net sales, remained at 46% or $22,793,000 for the nine months ended January 31, 2005 and $19,970,000 for the nine months ended January 31, 2004.

Research and product development costs for the nine months ended January 31, 2005 increased to $3,738,000, or 7% of net sales, compared to $2,414,000 or 6% of net sales for the same period ended January 31, 2004 due to expenditures related to the development of a generic steroidal nasal spray. Contract research income decreased to $25,000 in the fiscal 2005 period compared to $479,000 in the fiscal 2004 respective period. The Company currently has 9 products under review at the FDA and 15 projects in active development.

Selling, general and administrative expenses increased to $13,748,000 from $12,448,000 but decreased as a percentage of net sales to 27% from 29% for the nine months ended January 31, 2005 and 2004, respectively. This was primarily the result of increased information technology spending, Sarbanes Oxley compliance costs and the amortization of the Naprelan^® license agreement, partially offset by decreased commission expenses.

Included in other income is a dividend of approximately $70,000 from the investment in Marco Hi-Tech, a joint venture.

Net income for the nine months ended January 31, 2005 and 2004 was $6,410,000 and $5,504,000, respectively, an increase of $906,000, or 16%. The overall increase is primarily due to the factors noted above.

Fully diluted earnings per share increased 19%, to $0.74 per share for the nine months ended January 31, 2005 compared to $0.62 for the nine months ended January 31, 2004.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JANUARY 31, 2005 COMPARED TO THREE MONTHS ENDED JANUARY 31, 2004

Net sales for the three months ended January 31, 2005 were $21,169,000, an increase of $3,134,000 or 17% as compared to the net sales of $18,035,000 for the three months ended January 31, 2004.

Net sales for generic pharmaceutical products, which include some private label contract manufacturing, for the three months ended January 31, 2005 were $18,540,000, an increase of $3,090,000, or 20%, compared to the fiscal 2004 respective period sales of $15,450,000. The increase is due to the introduction of Tannate 12 D S, Tannate V DM, Tannate DMP/DEX, Urealac and Naprelan, partially offset by declines in sales of in-line products.

The Health Care Products division, which markets the Company’s branded products, for the three months ended January 31, 2005 and 2004 had net sales of $2,629,000 and $2,585,000, respectively, an increase of $44,000 or 2%. The increase was primarily caused by increased sales of DiabetiDerm^® products.

During the quarter ended January 31, 2005 the Company’s significant customers were Walgreens, Cardinal Distribution L.P., McKesson, and CVS, which accounted for approximately 15%, 14%, 13% and 10% of sales, respectively. At January 31, 2005, trade receivables from these customers were approximately 55% of total receivables.

Cost of sales increased to $ 9,521,000 from $8,407,000, or a decrease of 2% of net sales to 45% in the three months ended January 31, 2005 from 47% in the three months ended January 31, 2004. The decrease in cost of sales as a percentage of net sales is due to the launch of four new products with higher gross margins during the current quarter.

Research and product development costs for the three months ended January 31, 2005 increased to $1,071,000, or 5% of net sales compared to $998,000 or 6% of net sales for the same period ended January 31,2004. There was no contract research income in the fiscal 2005 period compared to $56,000 in the fiscal 2004 respective period. Management expects research and development costs to be approximately 7% of expected net sales this fiscal year as the Company continues to emphasize spending on the development of new products.

Selling, general and administrative expense increased to $5,591,000 from $5,331,000, but decreased as a percentage of net sales to 26% from 30% for the three months ended January 31, 2005 and 2004. This was primarily the result of decreased commission expenses, partially offset by costs of Sarbanes-Oxley Section 404 compliance, amortization of the Naprelan^® license and increased information technology spending.

Net income for the three months ended January 31, 2005 and 2004 was $3,223,000 and $2,149,000, respectively, a increase of $1,074,000, or 50%. The overall increase is primarily due to the factors noted above.

Fully diluted earnings per share increased 58% to $0.38 per share for the three months ended January 31, 2005 compared to $0.24 for the three months ended January 31, 2004.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s operations are financed principally by cash flows from operations. Cash flows from operating activities for the nine months ended January 31, 2005 were $5,479,000 compared to $1,574,000 provided by operating activities for the same period in the prior fiscal year. During the nine months ended January 31, 2005, working capital decreased to $53,269,000 from $55,772,000 at April 30, 2004, a decrease of $2,503,000, which was primarily due to the acquisition of the Naprelan^® license agreement for $3,231,000, the purchase of fixed assets and the purchases of common stock. During the nine months ended January 31, 2005 the Company invested $2,307,000 in fixed assets and $5,902,000 in treasury stock. During the course of the conference call on March 10, 2005, discussing the results for the period, the cash flows from operations and investment in fixed assets were misstated. The information provided above and in the cash flow statement reflect the correct cash flows from operations.

The Company has a three year $8,000,000 revolving credit facility dated October 23, 2002. The revolving credit facility bears interest at a rate selected by the Company equal to the Prime Rate or the LIBOR plus 1.50%. Loans are collateralized by inventory, accounts receivable and other assets. The agreement contains covenants with respect to working capital, net worth and certain ratios, as well as other covenants and prohibits the payment of cash dividends. For the three months ended January 31, 2005, there were no borrowings under the credit facility.

During the nine months ended January 31, 2005, the Company repurchased 369,000 additional shares of the Company’s common stock for a purchase price of approximately $5,902,000. In August 2004, the Company’s Board of Directors authorized the repurchase of up to an additional $10 million of the Company’s common stock. Pursuant to the terms of a Rule 10b5-1 stock repurchase plan, these repurchases may be made from time to time in the open market or in private transactions as market conditions dictate. The Board of Directors previously authorized a total of $3 million for the Company’s repurchase program which has been fully utilized to repurchase approximately 440,000 shares of the Company’s common stock.

9

Table of Contents

The Company believes that its financial resources consisting of current working capital, anticipated future operating revenue and its credit line will be sufficient to enable it to meet its working capital requirements for at least the next 12 months.

SEASONALITY

Historically, the months of September through February account for a greater portion of the Company’s sales than the other months of the fiscal year. Accordingly, period-to-period comparisons within the same fiscal year are not necessarily meaningful and should not be relied on as indicative of future results.

CRITICAL ACCOUNTING POLICIES

In preparing financial statements in conformity with generally accepted accounting principles in the United States of America, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses for the reporting period covered thereby. Actual results could differ from those estimates. Our estimates for sales returns and allowances, the useful lives of property and equipment, determination of impairment of long-lived assets, impact of legal matters and the realization of deferred tax assets represent a significant portion of the estimates made by management.

Revenue is recognized for product sales upon shipment and passing of risk to the customer and when estimates of discounts, rebates, promotional adjustments, price adjustments, returns, chargebacks, and other potential adjustments are reasonably determinable, collection is reasonably assured and the Company has no further performance obligations. These estimates are presented in the financial statements as reductions to net revenues and accounts receivable. Estimated sales returns, allowances and discounts are provided for. Contract research income is recognized as work is completed and billable costs are incurred. In certain cases, contract research income is based on attainment of designated milestones.

Returns – Consistent with industry practice, the Company maintains a return policy that allows its customers to return product within a specified period. The Company’s estimate for returns is based upon its historical experience with actual returns. While such experience has allowed for reasonable estimation in the past, history may not always be an accurate indicator of future returns. The Company continually monitors its estimates for returns and makes adjustments when it believes that actual product returns may differ from the established accruals.

Chargebacks – The Company markets products directly to wholesalers, distributors, retail pharmacy chains, mail order pharmacies and group purchasing organizations. The Company also markets products indirectly to independent pharmacies, managed care organizations, hospitals, nursing homes and pharmacy benefit management companies, collectively referred to as “indirect customers.” The Company enters into agreements with its indirect customers and enters into agreements with its wholesalers to establish contract pricing for certain products. Indirect customers then independently select a wholesaler from which to actually purchase the products at these contracted prices. The Company will provide credit to the wholesaler for any difference between the contracted price and the wholesaler’s invoice price. Such credit is called a chargeback. The estimate for chargebacks is based on expected and historical sell-through levels by its wholesaler customers to contracted customers. The Company continually monitors its provision for chargebacks and makes adjustments when it believes that actual chargebacks may differ from established estimates.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of January 31, 2005 we are not involved in any material unconsolidated transactions.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company’s existing credit facility bears interest at a rate selected by the Company equal to the Prime Rate or LIBOR plus 1.50%. This facility is exposed to market rate fluctuations and may impact the interest paid on any borrowings under the credit facility. Currently, the Company has no borrowings under this facility; however, an increase in interest rates would impact interest expense on future borrowings.

The Company invests in U.S. treasury notes, government asset backed securities and corporate bonds, all of which are exposed to interest rate fluctuations. The interest earned on these investments may vary based on fluctuations in the interest rate.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures within 90 days of the filing date of this quarterly report, and, based on their evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On December 18, 2003, Daiichi Pharmaceutical Co., Ltd. filed a complaint against the Company in the United States District Court for the District of New Jersey alleging infringement of its patent for a drug known as Levofloxacin, which it has sublicensed exclusively to Santen Inc. for use in certain ophthalmic pharmaceutical preparations. The plaintiff seeks a permanent injunction against the Company from engaging in the marketing within the United States of Levofloxacin Ophthalmic Solution, described in the Company’s new drug application with the United States Food and Drug Administration. On February 17, 2004, the Company filed an Answer and Counterclaim to the Complaint denying infringement of any valid claim in the patent suit, seeking a judicial declaration that the patent is invalid and not infringed. Fact discovery is complete, but no trial date has been set. The Company believes it has meritorious defenses to the allegations in the Complaint. Legal costs in connection with this complaint are being paid for by a business partner.

On or about November 24, 2003 MedPointe Healthcare, Inc. (“MedPointe”) filed a Verified Complaint and Application for Order to Show Cause with Temporary Restraints against the Company in the United States District Court for the District of New Jersey, Trenton vicinage. The suit alleged willful infringement by the Company of MedPointe’s patent No. 6,417,206 as a result of the Company’s offering to sell its Tannate 12-D S product, as a generic equivalent to MedPointe’s Tussi-12^®D S. On December 1, 2003 the Court entered Temporary Restraints against the Company pending the return date of the Order to Show Cause. On March 1, 2004 the Court issued a preliminary injunction enjoining the Company from marketing its Tannate 12-D S product. On November 19, 2004 the U.S. Court of Appeals for the Federal Circuit vacated the preliminary injunction. As a result of this decision, the Company commenced shipment of the Tannate 12-D S product in the third quarter. The Company may still be subject to liability based on a claim of patent infringement for sales of Tannate 12-D S.

10

Table of Contents

On or about October 28, 2002 an action was commenced in the United States District Court for the Northern District of Texas, Dallas Division, against the Company, Wyeth, Wyeth Consumer Healthcare, Bayer Corporation, Bayer A.G., Novartis Consumer Health, Inc., Novartis Pharmaceuticals Corporation, Schering-Plough Corporation, The Delaco Company and Chattem, Inc. The complaint alleges claims for permanent and debilitating injuries as a result of exposure to phenylpropanolamine (hereinafter referred to as “PPA”) through ingestion of PPA-containing products designed, formulated, marketed, distributed and/or sold by the Company and the other defendants. One plaintiff, Roger Grantham, claims he ingested a PPA-containing product manufactured by the Company. Mr. Grantham is a plaintiff in the Amanda Carrisalez case, which was originally filed in the United States District Court for the Northern District of Texas and was then transferred to the Multidistrict Litigation in Seattle. The plaintiffs, individually, seek compensatory damages in the amount of $15 million for actual damages, plus punitive damages. The Company has filed an answer to this action and depositions of the plaintiffs have been scheduled. The Company believes it has meritorious defenses. The Company’s defense costs, after its deductible, are being covered under its product liability policy which has a $5 million limit for defense costs and liability (“Product Liability Policy”). The last date of sale of the limited number of products containing PPA by the Company was December 2000.

In March 2001, the Center for Environmental Health (“CEH”) filed a lawsuit against several defendants alleging violations of California’s Proposition 65 and Unfair Trade Practices Act for failure to provide clear and reasonable warnings regarding the carcinogenicity and reproductive toxicity of lead and the reproductive toxicity of cadmium to the users of FDA-approved anti-diarrheal medicines. In May 2004, the Company signed a settlement agreement, which has been approved by the Court. The settlement agreement provides that the Company may sell a reformulated product or the original formulated product with certain warnings. The Company has paid a total of $40,000 to date and its remaining liability in this matter will not exceed an additional $20,000.

The Company believes that these litigation matters will not have a material effect on the financial position of the Company.

In December 2004, the Company learned that the staff of the Securities and Exchange Commission (“SEC”) has been conducting a formal investigation of certain trades in the Company’s common stock involving the Company and certain of its officers and directors during the period commencing on or about April 2003 to at least July 2003. The Company has also learned that the staff is investigating trades involving the Company’s common stock by other persons unaffiliated with the Company. While there can be no assurance regarding the outcome of the investigation, at this time, the Company does not believe the investigation will have a material impact on the management or operations of the Company. The staff has advised that at this time this is only a fact finding inquiry and no conclusion should be reached that the Company or person has violated any law. The Company and its officers and directors are fully cooperating with the SEC in this matter.

From time to time, the Company becomes involved in various legal matters in addition to the above described matters that the Company considers to be in the ordinary course of business. While the Company is not presently able to determine the potential liability, if any, related to such matters, the Company believes none of such matters, individually or in the aggregate, will have a material adverse effect on its financial position.

11

Table of Contents

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

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

None

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934,

the registrant has duly caused this report to be signed on its behalf

by the undersigned thereunto duly authorized.

HI-TECH PHARMACAL CO., INC.

(Registrant)

12