- Quarterly Report (10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark one)


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

For the quarterly period ended April 30, 2009


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

For the transition period from to

Commission File Number 0-17521

Zila, Inc.

(Exact Name of Registrant as Specified in its Charter)


Delaware		86-0619668
(State or Other Jurisdiction of Incorporation)		(I.R.S. Employer Identification No.)

16430 North Scottsdale Road, Suite 450, Scottsdale, Arizona, 85254-1770
(Address of Principal Executive Offices) (Zip Code)

(602) 266-6700
(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, and (2) has been subject to such filing requirements for the past 90 days. Yes þ . No o .

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ . No o .

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer þ

Non-accelerated filer o
(Do not check if a smaller reporting company)

Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of June 5, 2009, 10,440,583 shares of the registrant’s common stock were outstanding.

TABLE OF CONTENTS


		PAGE

PART I — FINANCIAL INFORMATION

Item 1.	Financial Statements.
Condensed Consolidated Balance Sheets as of April 30, 2009 (unaudited) and July 31, 2008		2
Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended April 30, 2009 and 2008		3
Unaudited Condensed Consolidated Statement of Shareholders’ Equity for the Nine Months Ended April 30, 2009		4
Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended April 30, 2009 and 2008		5
Notes to Unaudited Condensed Consolidated Financial Statements		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34
Item 4.	Controls and Procedures	35

PART II — OTHER INFORMATION

Item 1.	Legal Proceedings	35
Item 1A.	Risk Factors	35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	42
Item 3.	Defaults Upon Senior Securities	42
Item 4.	Submission of Matters to a Vote of Security Holders	42
Item 5.	Other Information	42
Item 6.	Exhibits	42
Signatures		43
EX-10.1
EX-10.2
EX-10.3
EX-31.1
EX-31.2
EX-32.1

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

ZILA, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS


	April 30,			July 31,
	2009			2008
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	3,064,408		$	4,462,328
Trade receivables — net of allowances of $249,000 and $229,000		4,114,682			5,252,215
Inventories — net		2,551,592			3,107,152
Prepaid expenses and other current assets		1,448,181			1,853,373


Total current assets		11,178,863			14,675,068

Property and equipment — net		4,458,263			5,317,061
Goodwill		—			10,171,351
Purchased technology — net		2,276,067			8,860,475
Trademarks and other intangible assets — net		2,220,222			9,533,024
Other assets		1,169,469			1,813,512


Total assets	$	21,302,884		$	50,370,491


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,870,607		$	3,843,262
Accrued liabilities		3,663,846			4,059,017
Current portion of deferred gain on sale leaseback		—			75,659
Short-term borrowings and current portion of long-term debt		9,849,968			71,252
Current liabilities of discontinued operations		48,476			67,532


Total current liabilities		16,432,897			8,116,722

Long-term debt — net of current portion		500,000			8,974,048


Total liabilities		16,932,897			17,090,770


Shareholders’ equity:
Preferred stock — Series B, $.001 par value — 2,500,000 shares authorized, 100,000 shares issued and outstanding, liquidation preference of $650,000		462,500			462,500
Common stock, $.001 par value — 30,000,000 shares authorized, 10,438,965 and 9,953,818 shares issued and outstanding		10,439			69,677
Additional paid-in capital		126,619,725			125,901,682
Accumulated deficit		(122,040,636	)		(92,471,235	)
Accumulated other comprehensive loss		(130,970	)		(131,832	)
Treasury stock, at cost (31,202 common shares)		(551,071	)		(551,071	)

Total shareholders’ equity		4,369,987			33,279,721


Total liabilities and shareholders’ equity	$	21,302,884		$	50,370,491

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

ZILA, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


	Three Months Ended April 30,						Nine Months Ended April 30,
	2009			2008			2009			2008

Net revenues	$	8,466,627		$	11,244,786		$	26,620,312		$	33,175,880
Cost of products sold		3,458,175			4,437,621			11,006,614			13,263,824

Gross profit		5,008,452			6,807,165			15,613,698			19,912,056

Operating costs and expenses:
Marketing and selling		3,164,984			6,046,250			10,884,287			16,563,524
General and administrative		1,773,543			3,281,067			5,809,796			9,883,070
Impairment of goodwill and other intangible assets		—			—			23,192,967			—
Research and development		90,121			246,597			334,527			2,237,265
Depreciation and amortization		308,194			952,241			1,842,991			2,810,965

Total operating costs and expenses		5,336,842			10,526,155			42,064,568			31,494,824

Loss from operations		(328,390	)		(3,718,990	)		(26,450,870	)		(11,582,768	)


Other income (expense):
Interest income		—			26,116			15,816			223,617
Interest expense		(1,100,479	)		(786,289	)		(2,916,796	)		(2,353,816	)
Derivative expense		—			—			—			(23,600	)
Other income (expense)		(20,621	)		2,049			(110,731	)		(991	)


Other expense — net		(1,121,100	)		(758,124	)		(3,011,711	)		(2,154,790	)


Loss from continuing operations before income taxes		(1,449,490	)		(4,477,114	)		(29,462,581	)		(13,737,558	)
Income tax benefit (expense)		(31,978	)		33,979			(45,175	)		22,387


Loss from continuing operations		(1,481,468	)		(4,443,135	)		(29,507,756	)		(13,715,171	)
Loss from discontinued operations, net of income tax expense of nil		(3,656	)		(1,858	)		(32,395	)		(320,892	)


Net loss		(1,485,124	)		(4,444,993	)		(29,540,151	)		(14,036,063	)
Preferred stock dividends		9,750			9,750			29,250			29,250

Net loss attributable to common shareholders	$	(1,494,874	)	$	(4,454,743	)	$	(29,569,401	)	$	(14,065,313	)


Basic and diluted net loss per common share:
Loss from continuing operations	$	(0.14	)	$	(0.50	)	$	(2.89	)	$	(1.56	)
Loss from discontinued operations		—			—			—			(0.04	)


Net loss attributable to common shareholders	$	(0.14	)	$	(0.50	)	$	(2.89	)	$	(1.60	)


Weighted average common shares outstanding — basic and diluted		10,407,090			8,838,961			10,248,628			8,794,807

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

ZILA, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
For the Nine Months Ended April 30, 2009


																	Accumulated
											Additional						Other						Total
	Preferred Stock				Common Stock						Paid-in			Accumulated			Comprehensive			Treasury			Shareholders’
	Shares		Amount		Shares			Amount			Capital			Deficit			Loss			Stock			Equity

Balance — July 31, 2008		100,000	$	462,500		9,953,818		$	69,677		$	125,901,682		$	(92,471,235	)	$	(131,832	)	$	(551,071	)	$	33,279,721

Stock-based compensation expense		—		—		54,047			215			442,883			—			—			—			443,098
Common shares withheld for income taxes		—		—		(15,040	)		(53	)		(32,904	)		—			—			—			(32,957	)
Issuance of common stock under employee stock purchase plan		—		—		11,057			47			3,284			—			—			—			3,331
Effect of reverse stock split approved on September 12, 2008		—		—		—			(59,882	)		59,882			—			—			—			—
Shares issued for payment of interest		—		—		435,083			435			244,898			—			—			—			245,333
Foreign currency translation		—		—		—			—			—			—			862			—			862
Preferred stock dividends		—		—		—			—			—			(29,250	)		—			—			(29,250	)
Net loss		—		—		—			—			—			(29,540,151	)		—			—			(29,540,151	)


Balance — April 30, 2009		100,000	$	462,500		10,438,965		$	10,439		$	126,619,725		$	(122,040,636	)	$	(130,970	)	$	(551,071	)	$	4,369,987

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

ZILA, INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Nine Months Ended April 30,
	2009			2008
Cash flows from operating activities:
Net loss	$	(29,540,151	)	$	(14,036,063	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		2,167,150			3,154,531
Non-cash amortization of financing costs		670,176			293,576
Non-cash amortization of debt discounts		1,331,381			1,336,259
Non-cash interest		245,333			485,334
Non-cash derivative expense		—			23,600
Non-cash stock-based compensation expense		443,705			1,381,420
Impairment of goodwill and other intangible assets		23,192,967			—
Other non-cash items — net		(1,017	)		40,386
Changes in operating assets and liabilities:
Trade receivables		1,137,533			(1,209,934	)
Inventories		555,560			(39,707	)
Prepaid expenses and other assets		572,596			(277,146	)
Accounts payable and accrued liabilities		(1,415,650	)		85,891

Net cash used in operating activities		(640,417	)		(8,761,853	)


Cash flows from investing activities:
Additions to property and equipment		(198,131	)		(630,753	)
Additions to intangible assets		(323,792	)		(310,855	)
Proceeds from sale of assets		11,196			11,495

Net cash used in investing activities		(510,727	)		(930,113	)


Cash flows from financing activities:
Principal payments on debt		(220,250	)		(269,268	)
Payment of obligation to repurchase common stock and warrants		—			(1,399,993	)
Dividends paid to preferred stockholders		(29,250	)		(29,250	)
Proceeds from issuance of common stock		2,724			71,909

Net cash used in financing activities		(246,776	)		(1,626,602	)

Net decrease in cash and cash equivalents		(1,397,920	)		(11,318,568	)
Cash and cash equivalents — beginning of period		4,462,328			14,859,159

Cash and cash equivalents — end of period	$	3,064,408		$	3,540,591

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

ZILA, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Description of Business and Basis of Presentation

Nature of Business Activities and Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include the accounts of Zila, Inc. and its wholly owned subsidiaries (collectively, “Zila,” “the Company,” “we,” “us” or “our”). Zila is a diagnostic company dedicated to the prevention, detection and treatment of oral cancer and periodontal disease. We manufacture and market ViziLite ^® Plus with TBlue ^® (“ViziLite ^® Plus”), our flagship product for the early detection of oral abnormalities that could lead to cancer. ViziLite ^® Plus is an adjunctive medical device cleared by the U.S. Food and Drug Administration (“FDA”) for use in a population at increased risk for oral cancer. In addition, Zila designs, manufactures and markets a suite of proprietary products sold exclusively and directly to dental professionals for periodontal disease, including the Rotadent ^® Professional Powered Brush, the Pro-Select Platinum ^® ultrasonic scaler and a portfolio of oral pharmaceutical products for both in-office and home-care use. Our products are marketed and sold in the United States and Canada primarily through our direct field sales force and telemarketing organization. Our products are marketed and sold in other international markets through the sales forces of third party distributors. Historically, our marketing programs have reached most U.S. dental offices by direct marketing efforts and various media outlets. However, because of cost control and cash preservation initiatives, during fiscal 2009 we have significantly reduced our marketing efforts, which has impacted our reach to new and existing customers. We are an approved American Dental Association continuing education provider and recently submitted our renewal application to the Academy of General Dentistry to continue as an approved continuing education provider.

These unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). All significant intercompany transactions and accounts have been eliminated. Certain information related to our organization, significant accounting policies and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted. The accounting policies followed in the preparation of these unaudited condensed consolidated financial statements are consistent with those followed in our annual consolidated financial statements for the year ended July 31, 2008, as filed on Form 10-K. In the opinion of management, these unaudited condensed consolidated financial statements contain all material adjustments, consisting only of normal recurring adjustments, necessary to fairly state our financial position, results of operations and cash flows for the periods presented and the presentations and disclosures herein are adequate when read in conjunction with our Form 10-K for the year ended July 31, 2008. The results reported in these interim condensed consolidated financial statements should not be regarded as being necessarily indicative of results that might be expected for the full year. Certain reclassifications have been made to the prior period financial statement amounts to conform to the current presentation.

On September 12, 2008, our shareholders approved a one for seven reverse split of our common stock. As a result of the reverse split, each holder of seven outstanding shares of common stock received one share of common stock. Fractional shares resulting from this reverse split have been issued to our shareholders as applicable, and accordingly, we did not make any cash payments in lieu of the issuance of fractional shares. The reverse split has been retroactively applied to all applicable information to the earliest period presented.

The preparation of financial statements in conformity with GAAP 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 date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include: (i) useful lives of intangibles; (ii) impairment analyses; (iii) depreciable lives of assets; (iv) income tax valuation allowances; (v) contingency and litigation reserves; (vi) inventory valuation; (vii) allowances for accounts receivable, cash discounts, sales incentives and sales returns; and (viii) valuation assumptions for share-based payments.

Basic net income (loss) per common share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period before giving effect to stock options, stock warrants, restricted stock units and convertible securities outstanding, which are considered to be dilutive common stock equivalents. Diluted net income (loss) per common share is calculated based on the weighted average number of common and potentially dilutive shares outstanding during the period after giving effect to convertible preferred stock, convertible debt, stock options, warrants and restricted stock units. Contingently issuable shares are included in the computation of basic earnings (loss) per share when issuance of the shares is no longer contingent. Due to the losses from continuing operations for the three and nine months ended April 30, 2009 and 2008, basic and diluted loss per common share were the same, as the effect of potentially dilutive securities would have been anti-dilutive.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Potentially dilutive securities not included in the diluted loss per share calculation, due to net losses from continuing operations, are as follows (unaudited) (in thousands):


	Three Months Ended April 30,				Nine Months Ended April 30,
	2009		2008		2009		2008

Options and warrants to purchase common shares		—		—		9		5
Common stock awards		—		1		7		8
Convertible preferred stock		100		100		100		100

Total potentially dilutive securities		100		101		116		113

As of April 30, 2009 and 2008, we had approximately $12.0 million of Third Amended and Restated Secured Notes (the “Senior Secured Convertible Notes”) outstanding that are convertible into 779,221 shares of our common stock and are excluded from the above table. The conversion price of these notes is more than the quoted market price of our common stock on such dates. As of April 30, 2009, 1,818,003 stock options and warrants were antidilutive as the strike price of these securities was more than the market price of our common stock. As of April 30, 2008, 2,599,125 stock options and warrants were antidilutive as the strike price of these securities was more than the market price of our common stock.

Liquidity

The accompanying condensed consolidated financial statements have been prepared on a going concern basis, which assumes that Zila will be able to meet its obligations and continue its operations for the next twelve months. We have historically sustained recurring losses and negative cash flows from operations as we changed our strategic direction to focus on the growth and development of ViziLite ^® Plus and our periodontal product lines. Our liquidity needs have typically arisen from the funding of our research and development program and the launch of our new products, such as ViziLite ^® Plus, working capital and debt service requirements, and strategic initiatives. In the past, we have met these cash requirements through our cash and cash equivalents, working capital management, the sale of non-core assets and proceeds from certain private placements of our securities.

To reduce operating losses, beginning in the second half of fiscal 2008, we took steps to reduce costs in non-direct sales force areas through workforce reductions, furloughs of certain personnel and discontinuing research and development projects, and have implemented profit enhancement initiatives. We also took steps to improve revenues and gross profit through the implementation of selective price increases and implementing initiatives to reduce our cost of goods. As a result of these steps, during the fourth quarter of fiscal 2008, we achieved positive cash flow from operations and achieved compliance with the Defined EBITDA covenant contained in our Senior Secured Convertible Notes, which is discussed in further detail elsewhere herein. Although these initiatives proved to be effective in our meeting the Defined EBITDA covenant contained in our Senior Secured Convertible Notes during the fourth quarter of fiscal 2008, some of these initiatives, such as reducing or deferring salaries, benefits and other operating costs, are not sustainable into future periods.

During fiscal 2009, our revenues have been negatively impacted as a result of the severity of the global economic downturn and its impact on discretionary spending on our products. Our revenues have also been affected as a result of customer concern about our viability as an ongoing business. Concerns about our financial viability have also contributed to increased turnover in our field sales force and other key staff areas and have led to a reduction in our marketing effectiveness and our reach to new and existing customers. We would expect these factors to cause near term future operating results to be less favorable than our financial results for the fourth quarter of fiscal 2008 and those previously anticipated for fiscal 2009. To address the impact of this revenue decline, during fiscal 2009 we have (i) continued salary reductions for a number of management personnel; (ii) eliminated additional personnel, including an approximately 15% reduction of our field sales force as a result of the realignment of our sales territories; (iii) eliminated the employee stock purchase plan and its associated costs; (iv) furloughed certain manufacturing production personnel; (v) reduced the number of seminar programs and streamlined the cost structure of these programs; and (vi) reduced tradeshow expenditures. Excluding the effect of the $23.2 million non-cash impairment charge for goodwill and other intangible assets recognized during December 2008, these actions significantly narrowed our operating loss over the same periods in the prior year. The impairment loss is more fully described in Note 5, Goodwill and Other Intangible Assets. To address the impact of the economic downturn on our revenues, we continue to identify cost-reduction and working capital initiatives to reduce the impact on future cash flows from operations and results of operations.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

While we have continued to execute a number of cost reduction strategies, the decline in our revenues has caused our cash utilization to exceed previously planned levels. As of April 30, 2009, we had approximately $3.1 million of cash and cash equivalents, compared to $2.5 million, $3.2 million and $4.5 million at January 31, 2009, October 31, 2008 and July 31, 2008, respectively. As a result of the reclassification of the Senior Secured Convertible Notes to a current liability, as of April 30, 2009 and January 31, 2009, we had working capital deficits of $5.3 million and $4.3 million, respectively, compared to positive working capital of $5.7 million and $6.6 million at October 31, 2008 and July 31, 2008, respectively. In order to continue as a going concern and fund our current level of operations over the next twelve months, we will require additional funding and need to restructure or retire our Senior Secured Convertible Notes. If we are unable to execute these strategies, we will likely be forced to file for protection under Chapter 11 of the Federal Bankruptcy Code or liquidate the Company under Chapter 7 of the Federal Bankruptcy Code. We have retained financial and legal advisors to assist us in our numerous continuing efforts to restructure our Senior Secured Convertible Notes, raise capital and explore possible strategic opportunities.

Our efforts to seek additional funding have included discussions with numerous potential financial and strategic investors as well as with the holders of the Senior Secured Convertible Notes. All potential investors with whom we have had discussions required, as a condition of their investment, that the Senior Secured Convertible Notes be repaid from the funds provided by the investor(s) and that this repayment be at a substantial discount from the $12.0 million principal outstanding to reflect the current market value of those notes. We are also engaged in discussions and negotiations with other parties regarding a variety of possible strategic transactions, including the possible sale of the Company or substantially all of its assets. One of those parties and the holders of the Senior Secured Convertible Notes have entered into an agreement (a “Note Purchase Agreement”) whereby such party has the right, subject to certain conditions and for a limited period of time, to acquire all of the Senior Secured Convertible Notes from the current holders at a significant discount from the $12.0 million principal balance of these notes. The Company is not a party to the Note Purchase Agreement.

We are in compliance with the terms of the Senior Secured Convertible Notes, except for the quarterly interest payments due April 30, 2009 and January 31, 2009, which have not been made as of the date of this filing. The failures to make these payments are events of default under our Senior Secured Convertible Notes. Upon an event of default, the Senior Secured Convertible Notes bear interest at a default rate of 15.0% per annum. Although we have not received a notice of default or acceleration from the note holders as of the date of this filing, which is required prior to any of the principal amount becoming due and payable as a result of such default, we have reclassified the Senior Secured Convertible Notes to current liabilities. Pursuant to the Note Purchase Agreement, the holders of the Senior Secured Convertible Notes have agreed not to exercise their remedies under such notes unless and until the Note Purchase Agreement is terminated. However, there can be no assurance that the current or future note holders will not accelerate amounts due under the Senior Secured Convertible Notes and proceed against their collateral. In the event of acceleration, we would likely be forced to file for protection under Chapter 11 of the Federal Bankruptcy Code or liquidate the Company under Chapter 7 of the Federal Bankruptcy Code, which would likely result in our common stock becoming worthless.

We were unable to issue shares for the April 30, 2009 and January 31, 2009 interest payments because, due to our share price at such time, the number of shares to be issued would have required shareholder approval under applicable NASDAQ rules. Accordingly, as of April 30, 2009, there was approximately $0.7 million of unpaid accrued interest due the holders of the Senior Secured Convertible Notes. In addition, given our current level of cash and cash equivalents, the impact of the global economic downturn on our business and customer concern about our viability as an ongoing business, it is uncertain whether we will have sufficient cash available to pay our future quarterly interest payments due under the Senior Secured Convertible Notes.

2. Recently Issued Accounting Pronouncements and Adopted Accounting

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “ Fair Value Measurements ” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information for those instruments measured at fair value. The fair value hierarchy distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs).

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The hierarchy consists of three levels:

	Level one —		Quoted market prices in active markets for identical assets or liabilities;

	Level two —		Inputs other than Level one inputs that are either directly or indirectly observable; and

	Level three —		Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use.

Determining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.

SFAS 157 is effective for financial instruments issued for years beginning after November 15, 2007, with the exception of certain nonfinancial assets and liabilities, for which the effective date has been deferred by one year. On August 1, 2008, we adopted the provisions of SFAS 157, except as it applies to those nonfinancial assets and nonfinancial liabilities for which the effective date has been delayed by one year. The adoption of SFAS 157 did not have a material effect on our financial position or results of operations.

Other than our notes payable, the fair value of financial instruments approximates their carrying value at April 30, 2009. These financial instruments consist of cash and cash equivalents, receivables, accounts payable and accrued expenses. We do not believe it is currently practicable to estimate the fair value of the Senior Secured Convertible Notes as there is no active market for such notes and there are a limited number of investors in the notes. The carrying amount of other borrowings is estimated to approximate fair value as the actual interest rate is consistent with the rate estimated to be currently available for borrowings of similar term and remaining maturity.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS 160”). SFAS 160 establishes accounting and reporting standards that require (i) noncontrolling interests to be reported as a component of equity; (ii) changes in a parent’s ownership interest while the parent retains its controlling interest to be accounted for as equity transactions; and (iii) any retained noncontrolling equity investment upon the deconsolidation of a subsidiary to be initially measured at fair value. SFAS 160 is effective for fiscal years and interim periods within those fiscal years, beginning on or after December 15, 2008, which for us was the fiscal quarter beginning February 1, 2009. The adoption of SFAS 160 did not have a material effect on our financial position or results of operations.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R establishes the principles and requirements for how an acquirer: (i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree; (ii) recognizes and measures goodwill acquired in a business combination or a gain from a bargain purchase; and (iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of a business combination. Additionally, under SFAS 141R transaction related costs must be expensed as incurred, rather than accounted for as part of the purchase price of an acquisition. SFAS 141R is to be applied prospectively to business combinations consummated on or after the beginning of the first annual reporting period on or after December 15, 2008, which for us would be our fiscal year beginning August 1, 2009. Early adoption is prohibited. Following its effective date, we will apply the provisions of SFAS 141R to future acquisitions, if any.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133” (“SFAS 161”), which establishes, among other things, the disclosure requirements for derivative instruments and hedging activities. SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of, and gains and losses on, derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements. SFAS 161 is effective for fiscal periods and interim periods beginning after November 15, 2008, which for us was our third quarter of our fiscal year 2009 ending April 30, 2009. The adoption of SFAS 161 did not have a material effect on our financial position or results of operations.

In April 2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). The intent of FSP SFAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R and other applicable accounting literature. FSP SFAS 142-3 is effective for financial statements issued for fiscal years beginning on or after December 15, 2008, which for us will be our fiscal year beginning August 1, 2009, and must be applied prospectively to intangible assets acquired after the effective date. We are currently evaluating the impact FSP SFAS 142-3 will have on our financial position or results of operations.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In May 2008, the FASB issued FSP Accounting Principles Board No. 14-1 “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). FSP APB 14-1 requires the issuer of certain convertible debt instruments that may be settled in cash (or other assets) on conversion (including partial cash settlement) to separately account for the liability and equity components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning on or after December 15, 2008, which for us will be our fiscal year beginning August 1, 2009, and interim periods within those fiscal years. Early adoption is prohibited. We are currently evaluating the impact FSP APB 14-1 will have on our financial position or results of operations.

In June 2008, the FASB ratified Emerging Issued Task Force (“EITF”) Issue No. 07-5 “Determining Whether an Instrument (or Embedded Feature) is Indexed to an Entity’s Own Stock ” (“EITF 07-5”). Equity-linked instruments (or embedded features) that otherwise meet the definition of a derivative as outlined in SFAS No. 133, “ Accounting for Derivative Instruments and Hedging Activities ,” are not accounted for as derivatives if certain criteria are met, one of which being the instrument (or embedded feature) must be indexed to the entity’s stock. EITF 07-5 provides guidance on determining if equity-linked instruments (or embedded features), such as warrants to purchase our stock, are considered indexed to our stock. EITF 07-5 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, which for us will be our fiscal year beginning August 1, 2009. Upon adoption, a cumulative effect adjustment may be recorded based on amounts that would have been recognized if this guidance had been applied from the issuance date of the affected instruments. Early adoption is not permitted for reporting entities that have previously established a different accounting policy (prior to the adoption of EITF 07-5) for determining whether an instrument is indexed to an entity’s own stock.

As of April 30, 2009, we have 1,212,995 warrants outstanding that may no longer be afforded equity treatment upon our adoption of EITF 07-5 on August 1, 2009. These warrants have an exercise price of $14.63, expire in November and December 2011 and have exercise price reset features. The aggregate fair value of these warrants, based on the Black-Scholes option pricing model, was less than $0.1 million as of April 30, 2009. We are currently evaluating the impact EITF 07-5 will have on our financial position or results of operations.

3. Inventories

Inventories consist of the following (in thousands):


	April 30,			July 31,
	2009			2008
	(Unaudited)

Finished goods	$	613		$	675
Work-in-process		135			396
Raw materials		2,247			2,470
Inventory reserves		(443	)		(434	)

Total inventories	$	2,552		$	3,107

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

4. Property and Equipment

Property and equipment consist of the following (in thousands):


	April 30,			July 31,
	2009			2008
	(Unaudited)

Land	$	529		$	529
Building and improvements		2,185			2,132
Furniture and equipment		2,709			3,408
Leasehold improvements and other assets		803			823
Production, laboratory and warehouse equipment		4,514			4,582

Total property and equipment		10,740			11,474
Less: Accumulated depreciation and amortization		(6,282	)		(6,157	)

Property and equipment — net	$	4,458		$	5,317

For the three months ended April 30, 2009 and 2008, approximately $0.1 million of depreciation expense was included in cost of products sold. For the nine months ended April 30, 2009 and 2008, approximately $0.3 million of depreciation expense was included in cost of products sold.

5. Goodwill and Other Intangible Assets

Goodwill and other intangible assets consist of the following (in thousands):


	April 30, 2009 (Unaudited)							July 31, 2008
	Gross					Net		Gross					Net
	Carrying		Accumulated			Carrying		Carrying		Accumulated			Carrying
	Amount		Amortization			Amount		Amount		Amortization			Amount

Amortizable intangible assets:
Purchased technology	$	9,518	$	(7,242	)	$	2,276	$	15,592	$	(6,732	)	$	8,860
Trademarks		174		(29	)		145		168		(18	)		150
Patents		805		(381	)		424		2,019		(385	)		1,634
Licensing costs		2,028		(1,902	)		126		2,674		(1,777	)		897
Customer relationships, covenants not to compete and other		2,591		(2,585	)		6		3,556		(2,153	)		1,403

Total amortizable intangible assets		15,116		(12,139	)		2,977		24,009		(11,065	)		12,944
Unamortizable trademarks		1,519		—			1,519		5,449		—			5,449

Total other intangible assets		16,635		(12,139	)		4,496		29,458		(11,065	)		18,393
Goodwill		—		—			—		10,171		—			10,171

Total intangible assets	$	16,635	$	(12,139	)	$	4,496	$	39,629	$	(11,065	)	$	28,564

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Amortization of amortizable intangible assets is calculated using the following useful lives (in years):


			Weighted Average
	Range of		Remaining Useful Lives
	Useful Lives		April 30, 2009		July 31, 2008
			(Unaudited)

Purchased technology		15		11.6		11.5
Trademarks		7-10		5.9		6.6
Patents		4-17		8.2		7.4
Licensing costs		7-10		2.7		3.4
Customer relationships, covenants not to compete and other		2-15		2.7		6.0

We have historically assessed the impairment of goodwill annually in our fourth fiscal quarter, or whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable. During fiscal 2009, our revenues have been negatively impacted as a result of the severity of the global economic downturn and its impact on discretionary spending on our products. Our revenues have also been affected as a result of customer concern about our viability as an ongoing business. We would expect these factors to cause near term future operating results to be less favorable than previously anticipated for fiscal 2009. We also experienced a decline in our stock price and a corresponding decline in our market capitalization and enterprise value throughout fiscal 2009. Finally, as of December 2008, we anticipated we would fail to make the interest payment due January 31, 2009 on our Senior Secured Convertible Notes, which is an event of default under such notes. As of the date of this filing, we have not made the quarterly interest payments due April 30, 2009 and January 31, 2009 on these notes. Although we have not received a notice of default or acceleration from the note holders as of the date of this filing, which is required prior to any of the principal amount becoming due and payable as a result of such defaults, the note holders may, at any time, demand $8.0 million of note principal as a result of our defaults under these notes. In order to continue as a going concern and fund our current level of operations over the next twelve months, we will be required to seek additional funding and restructure or retire our Senior Secured Convertible Notes. If we are unable to do so, we will likely be forced to sell all or a portion of the Company or file for protection under Chapter 11 of the Federal Bankruptcy Code, which may lead to a liquidation of our business under Chapter 7 of the Federal Bankruptcy Code. Primarily as a result of these factors, we assessed goodwill for impairment on an interim basis during December of 2008. The assessment is performed using the two-step process prescribed by SFAS 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. The first step of the goodwill impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of the reporting unit’s net assets, including goodwill, exceeds the fair value of the reporting unit, then we determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment of goodwill has occurred and we recognize an impairment loss for the difference between the carrying amount and the implied fair value of goodwill as a component of operating income. The implied fair value of goodwill is calculated by subtracting the fair value of tangible and intangible assets associated with the reporting unit from the fair value of the unit. For fiscal 2008, the first step of our annual goodwill impairment test reflected fair value that was in excess of the carrying value. Accordingly, we did not perform the second step of this test during fiscal 2008. The December 2008 impairment test resulted in an impairment of the entire balance of goodwill, or $10.2 million.

A summary of changes in our goodwill for the first nine months of fiscal 2009, and the impairment charge recognized during December 2008, is as follows (in thousands):


Balance — beginning of period	$	10,171
Impairment of goodwill		(10,171	)

Balance — end of period	$	—

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

For fiscal 2009 and 2008, our business has been managed and operated as one operating segment and one reporting unit, and accordingly, our goodwill impairment tests conducted during these years were based on one reporting unit. We relied upon the discounted cash flow method under the income approach, and the orderly and forced liquidation method, as the primary means to calculate fair value. Significant estimates used in the fair value calculation include, but are not limited to: (i) estimates of future revenue and expense growth; (ii) future estimated effective tax rates, which we estimate to be approximately 40%; (iii) future estimated capital expenditures and future required investments in working capital; (iv) average cost of capital, which we base on expectations for market participants and estimate to be approximately 43% for fiscal 2009 and 25% for fiscal 2008; (v) the ability to utilize certain tax attributes and (vi) the future terminal value of the reporting unit. The primary factors leading to impairment for the December 2008 interim impairment test were (i) lower levels of projected cash flows, which were affected by the recent declines in our revenues, (ii) an increase in the average cost of capital, which is primarily attributable to general increases in the cost of capital relative to the recent global economic downturn and increased risks associated with the cash flows from our business and (iii) an increased likelihood of a liquidation of our business. There have been no substantial changes in the methodologies employed, significant assumptions used, or calculations applied in the first step of the SFAS 142 impairment test over the past several years; however, due to the factors discussed above, for the December 2008 interim impairment test we placed more emphasis on liquidation scenarios. Prior to fiscal 2008 we divested and acquired certain businesses, and accordingly, the number of business units identified in prior periods was different than those identified for the fiscal 2009 and 2008 impairment tests.

We assess impairment of other intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value of any of these assets may not be recoverable. Such events or circumstances might include a significant decline in market share and/or significant negative industry or economic trends, a significant decline in profits and/or significant underperformance relative to expected historical or projected operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business, rapid changes in technology, significant litigation or other items. As a result of the factors discussed above, we assessed our other intangible assets for impairment during December 2008. In evaluating the recoverability of intangibles and other long-lived assets, our policy is to first compare the carrying amounts of such assets with the estimated undiscounted future operating cash flows. If the carrying amount exceeds the undiscounted future operating cash flows, an impairment charge is recognized for the excess of the carrying amount of the asset over its fair value. We calculate fair value of trademark and know-how intangible assets by using a relief from royalty method. The relief from royalty method is based on the assumption that, in lieu of ownership of an intangible asset, a company would be willing to pay a royalty in order to enjoy the benefits of the asset. Under this method, value is estimated by discounting the hypothetical royalty payments to their present value over the economic life of the asset. We calculate fair value of our customer relationships by using the excess earnings method. The excess earnings method estimates the value of an intangible asset by quantifying the amount of residual (or excess) cash flows generated by the asset, and discounting those cash flows to the present. Growth rates of net sales and average cost of capital used for discounting cash flows are consistent with those utilized in the December 2008 interim goodwill test. We recognized an impairment charge of approximately $13.0 million relative to these intangible assets, which was primary driven by lower levels of projected cash flows, an increase in the average cost of capital and lower estimated royalty rates of our products relative to other products in the market. This impairment charge consists of $6.1 million for purchased technology, $3.9 million for trademarks, $1.4 million for patents, $0.6 million for licensing costs and $1.0 million for customer relationships and other intangible assets. If we have future changes in events or circumstances, including reductions in anticipated cash flows generated by our operations or determinations to divest of certain assets, certain assets could be further impaired, which would result in additional charges to earnings.

The impairment charge discussed above for goodwill and other intangible assets was recognized as of December 31, 2008 and is stated separately on the accompanying Unaudited Condensed Consolidated Statements of Operations under the caption “Impairment of goodwill and other intangible assets.” Estimated future amortization expense for fiscal 2010 through fiscal 2014, based on balances existing at April 30, 2009, approximates $0.2 million to $0.3 million per year.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

6. Accrued Liabilities

Accrued liabilities consist of the following (in thousands):


	April 30,		July 31,
	2009		2008
	(Unaudited)

Accrued research and development	$	1,152	$	1,154
Accrued employee compensation and related taxes		593		1,000
Accrued professional and consulting fees		248		795
Accrued interest payable		660		—
Other accrued expenses		1,011		1,110


Total accrued expenses	$	3,664	$	4,059

7. Debt

Debt consists of the following (in thousands):


	April 30,			July 31,
	2009			2008
	(Unaudited)

Short-term borrowings and current portion of long-term debt:
Senior Secured Convertible Notes	$	12,000		$	—
Unamortized discount — Senior Secured Convertible Notes		(2,229	)		—


Senior Secured Convertible Notes — net		9,771			—
Short-term borrowings		28			—
Current portion of capital lease obligations		51			71


Total short-term borrowings and current portion of long-term debt	$	9,850		$	71


Long-term debt:
Senior Secured Convertible Notes	$	—		$	12,000
Unamortized discount — Senior Secured Convertible Notes		—			(3,560	)


Senior Secured Convertible Notes — net		—			8,440
PharmaBio		500			500
Capital lease obligations		51			105


Total long-term debt		551			9,045
Less: Current portion		(51	)		(71	)


Long-term debt — net of current portion	$	500		$	8,974

Short-term Borrowings

As of April 30, 2009, we had short-term borrowings for installments due on an insurance policy, with an interest rate of 6.6%.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Senior Secured Convertible Notes

Our Senior Secured Convertible Notes were originally entered into in November 2006 as part of a private placement offering. The Senior Secured Convertible Notes are in the aggregate principal amount of $12.0 million, are due July 31, 2010 and bear interest, payable quarterly, at 7.0% per annum, but at our option, interest payments can be made at an 8.0% annual rate in shares of our common stock at a price equal to 90.0% of the average closing bid price of such common stock for the ten trading days immediately prior to the relevant interest payment date. The Senior Secured Convertible Notes are convertible into shares of our common stock at a conversion price of $15.40 per share at the option of the holders of such notes. In addition, the Senior Secured Convertible Notes contain comprehensive covenants that restrict the way in which we can operate, and contain financial covenants that require us to: (i) maintain a minimum cash and cash equivalents balance of $1.0 million at the end of each fiscal quarter and (ii) achieve a required EBITDA level, as defined in the Senior Secured Convertible Notes (“Defined EBITDA”), of at least $1.00 for any one fiscal quarter on or prior to our quarter ending July 31, 2009. The Defined EBITDA covenant was satisfied during the fourth quarter of fiscal 2008. The Senior Secured Convertible Notes are secured by certain of our existing and future property.

Failure to satisfy the financial covenants, or to maintain compliance with other covenants, could, at the option of the Senior Secured Convertible Note holders, result in an acceleration of some or all of the amounts outstanding thereunder. Upon the occurrence of the first specified event of default, the holders of the Senior Secured Convertible Notes could accelerate and demand repayment of one-third of the outstanding principal balance and all accrued but unpaid interest on the Senior Secured Convertible Notes. Upon the occurrence of the second specified event of default, the holders of the Senior Secured Convertible Notes could accelerate and demand repayment of one-half of the outstanding principal balance and all accrued but unpaid interest on these notes. Upon the occurrence of the third specified event of default, the entire principal balance and all accrued but unpaid interest may become due and payable. Additionally, upon the occurrence and during the continuation of any event of default, all amounts outstanding under the Senior Secured Convertible Notes shall bear interest at a rate of 15.0% per annum.

PharmaBio Development, Inc.

In December 2002, we entered into an agreement with PharmaBio Development, Inc. (“PharmaBio”), the strategic investment group of Quintiles Transnational Corp., our then contract research organization. Under this agreement, PharmaBio invested $0.5 million in us. In return for the investment, we agreed to pay PharmaBio an amount equal to 5.0% of all net sales of an oral cancer diagnostic drug product in the European Union and the United States. The aggregate amount of the royalty cannot exceed $1.25 million and the royalty is payable quarterly. The investment was recorded as long-term debt and will be amortized using the effective interest method.

8. Share-Based Payments

We have one active share-based stock award plan that provides for the grant of stock options and stock awards, such as restricted stock and restricted stock units, to our employees, members of our Board of Directors and non-employee consultants, as approved by our Board of Directors. We typically grant stock option awards to our employees and to members of our Board of Directors at prices equal to the market value of our stock on the date of grant. These awards vest over a period determined at the time of the grant and generally range from one to three years of continuous service, with maximum terms ranging from five to ten years. Certain awards granted to our employees provide for accelerated vesting if there is a “change in control” of Zila (as defined in the plan). As of April 30, 2009, there were 436,258 shares available for grant under the plan.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

During the nine months ended April 30, 2009, we granted options to purchase 50,000 shares of our common stock. During the nine months ended April 30, 2008, we granted options to purchase 446,881 shares of our common stock. The fair value of options granted for the nine months ended April 30, 2009 and 2008 is estimated using the Black-Scholes option pricing model using the following assumptions:


	Nine Months Ended April 30,
	2009			2008
Risk-free interest rate		1.1	%		3.5	%
Expected volatility		98.0	%		59.6	%
Expected term (in years)		3.3			5.2
Dividend yield		0.0	%		0.0	%

The risk free interest rate is based on U.S. Treasury rates with maturity dates approximating the expected term of the grant. The historic volatility of our stock is used as the primary basis for the expected volatility assumption. Expected term is based on evaluations of historic and expected future employee exercise behavior. Our ability to pay dividends is restricted and therefore we have assumed no dividend yield.

SFAS No. 123 (revised 2004), “Share-Based Payment” requires the estimation of forfeitures when recognizing compensation expense and that this estimate of forfeitures be adjusted over the requisite service period should actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through an adjustment, which is recognized in the period of change and which impacts the amount of unamortized compensation expense to be recognized in future periods.

A summary of stock option activity for our stock award plan for the nine months ended April 30, 2009 is as follows (in thousands except exercise price per share and option term amounts) (unaudited):


						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
	Number			Exercise		Contractual		Intrinsic
	of Options			Price		Term (Years)		Value
Options outstanding — beginning of period		515		$	11.55		6.7	$	—
Granted		50
Exercised		—
Expired		(54	)
Forfeited		(78	)


Options outstanding — end of period		433			10.23		5.3		—


Options vested or expected to vest — end of period		417			10.37		5.2		—


Options exercisable — end of period		292			12.07		4.2		—

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

A summary of unvested common stock award activity within our share-based compensation plan for the nine months ended April 30, 2009 is as follows (in thousands except grant value and recognition period amounts) (unaudited):


						Weighted
				Weighted		Average
				Average		Remaining
	Number			Grant		Recognition
	of Shares			Value		Period (Years)
Unvested balance — beginning of period		56		$	7.00		1.1
Granted		21			2.10
Vested		(54	)		5.12
Forfeited		(7	)		7.98


Unvested balance — end of period		16			5.61		0.5

Stock-based compensation costs are reflected in the following financial statement captions (in thousands) (unaudited):


	Three Months Ended April 30,				Nine Months Ended April 30,
	2009		2008		2009		2008
Marketing and selling expense	$	29	$	48	$	124	$	158
General and administrative expense		65		344		246		1,200
Research and development expense		—		1		1		3
Inventory		29		12		73		20

Total stock-based compensation	$	123	$	405	$	444	$	1,381

As of April 30, 2009, total unrecognized compensation cost related to unvested stock options and unvested common stock awards was approximately $1.0 million and $0.1 million, respectively, with a weighted average period over which these costs are expected to be recognized of approximately 1.3 years and less than one year, respectively.

9. Warrants

As of April 30, 2009 and July 31, 2008, we have warrants outstanding for the purchase of 1,384,424 shares of our common stock, all of which are exercisable. As of April 30, 2009, these warrants have a weighted average exercise price of $14.76 and a weighted average remaining contractual term of approximately 2.5 years.

10. Convertible Preferred Stock

During February 2001, we issued 100,000 shares of Series B Convertible Preferred Stock (“Preferred Stock”) as part of an acquisition, all of which were outstanding as of April 30, 2009 and July 31, 2008. The holders of the Preferred Stock are entitled to receive cumulative quarterly dividends at a rate of $0.0975 per share per fiscal quarter, payable in arrears, which represents an aggregate annual dividend of $39,000. As of April 30, 2009 and July 31, 2008, accumulated accrued dividends were less than $0.1 million. The Preferred Stock can be redeemed at our option if our common stock maintains a closing price on each trading day equal to or greater than $9.00 per share for any ten trading day period. The redemption price shall be the average bid closing price of our common stock for the five trading days immediately proceeding the date we give notice. The Preferred Stock is convertible at the option of the holder at any time on or before December 31, 2010 into our common stock at the ratio of one-to-one. On December 31, 2010, all of the remaining Preferred Stock will be converted into our common stock at a ratio of one-to-one. Holders of the Preferred Stock have no voting rights except as required by applicable law and have a liquidation preference of $0.65 million. The shares of Preferred Stock were issued pursuant to the exemption set forth in Section 4(2) of the Securities Act of 1933. There is no established public trading market for the Preferred Stock.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

11. Treasury Stock

During fiscal 2001, we began acquiring shares of our common stock under a stock repurchase program announced in November 1999. The program authorized the repurchase of up to 142,857 shares of Zila common stock from time to time on the open market depending on market conditions and other factors. Under this repurchase program, we purchased 32,157 shares of common stock at an aggregate cost of approximately $0.6 million, and made the last purchases under this program in fiscal 2003, after which we suspended purchases under the program. In fiscal 2005, we reissued 955 shares of treasury stock for a stock award.

12. Supplemental Cash Flow Information

Supplemental cash flow information is as follows (unaudited) (in thousands):


	Nine Months Ended April 30,
	2009		2008
Interest paid	$	11	$	246
Income taxes paid		9		45
Insurance policy financed with short-term borrowings		193		275

13. Comprehensive Loss

Comprehensive loss includes the effects of foreign currency translation and does not reflect an income tax effect due to the recording of valuation allowances. Comprehensive loss is as follows (unaudited) (in thousands):


	Three Months Ended April 30,						Nine Months Ended April 30,
	2009			2008			2009			2008
Net loss	$	(1,485	)	$	(4,445	)	$	(29,540	)	$	(14,036	)
Foreign currency translation adjustment		—			1			1			12

Comprehensive loss	$	(1,485	)	$	(4,444	)	$	(29,539	)	$	(14,024	)

14. Commitments and Contingencies

Legal Proceedings

Except as described below, as of April 30, 2009, we were not a party to any pending legal proceedings other than claims that arise in the conduct of our business. While we currently believe that the ultimate outcome of these proceedings will not have a material adverse effect on our consolidated financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our net income in the period in which a ruling occurs. Our estimate of the potential impact of the following legal proceedings on our financial position and our results of operation could change in the future.

In connection with the acquisition of patent rights in 1980, we agreed to pay to Dr. James E. Tinnell (“Tinnell”), the inventor of one of our former treatment compositions, a royalty of 5.0% of gross sales of the invention disclosed in Tinnell’s then pending patent application. In September 2000, we notified Tinnell that we would no longer pay such royalties because the obligations ceased in August 1998 when the related product patents expired and we requested reimbursement of royalties paid since August 1998. We then filed suit on November 8, 2000, in the United States District Court for the District of Nevada (the “Court”) requesting a declaratory judgment that we had no royalty obligations to Tinnell and judgment for the overpaid royalties. On April 22, 2004, the Court, in part, ruled in our favor, stating that our royalty obligations to Tinnell ceased in August 1998, however, our request for reimbursement of overpaid royalties was dismissed. Tinnell filed a notice of appeal and we filed a notice of cross-appeal. On September 5, 2007, the Ninth Circuit Court of Appeals reversed the decision of the lower court and remanded the case for a determination of whether or not Tinnell should be credited with inventing the improvement embodied in a 1992 patent. Both parties filed motions for summary judgment and on September 30, 2008, the Court denied both motions and the parties met and conferred on pre-trial matters in January 2009. No trial date has been set.

ZILA, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

For the three months ended April 30, 2009 and 2008 and nine months ended April 30, 2009, we incurred expense of less than $0.1 million relative to the pending litigation with Tinnell. For the nine months ended April 30, 2008, we incurred expense of approximately $0.3 million for this pending litigation. This expense is reflected in our loss from discontinued operations on the accompanying Unaudited Condensed Consolidated Statements of Operations since this litigation relates to our previously disposed Zilactin ^® brand of over-the-counter lip and oral care products. The disposal of the Zilactin ^® brand of over-the-counter lip and oral care products was completed during June 2005.

Indemnifications

During the normal course of business, we make certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These include: (i) intellectual property indemnities to customers in connection with the use, sales and/or license of products and services; (ii) indemnities to customers in connection with losses incurred while performing services on their premises; (iii) indemnities to vendors and service providers pertaining to claims based on negligence or willful misconduct; and (iv) indemnities involving the representations and warranties in certain contracts. In addition, under our by-laws we are committed to our directors and officers for providing for payments upon the occurrence of certain prescribed events. The majority of these indemnities, commitments and guarantees do not provide for any limitation on the maximum potential for future payments that we could be obligated to make. To help address these risks, we maintain general business liability insurance coverage, including product, commercial, general, fiduciary, employment practices and directors’ and officers’ liability coverages. We have not recorded a liability for these indemnities, commitments and other guarantees.

Registration Payment Arrangements

We have entered into various registration rights agreements in connection with financing transactions. In some instances, these registration rights agreements contain provisions that may call for us to pay penalties in certain circumstances. These registration payment arrangements primarily relate to our ability to either file a registration statement within a particular time period, have a registration statement declared effective within a particular time period or to maintain the effectiveness of a registration statement for a particular time period. As of April 30, 2009, all registration statements related to registration rights agreements containing penalty provisions have been filed and declared effective, or the securities covered by such registration rights agreements have been sold or can be sold under Rule 144 of the Securities Act of 1933 by the investors who purchased such securities, and accordingly, we are in compliance with such registration payment arrangements. We will be required to file registration statements in the future for shares that may be issued as payment of interest on our Senior Secured Convertible Notes. If we do not file such registration statements, we would be subject to cash penalties equal to 1.0% of the Market Price (as defined in the Senior Secured Convertible Notes) of the registrable securities for each 30-day period or pro rata for any portion thereof following the filing deadline. We do not believe it is probable that penalty payments will be made for the registration rights agreements discussed above, and accordingly we have not accrued for such potential penalties as of April 30, 2009.

FDA Observation Letter

During September 2008, after completion of a Current Good Manufacturing Practice audit of our fluoride manufacturing facility, we received notice from the FDA regarding certain deficiencies in our documentation, processes and procedures relative to certain of our fluoride products. We have halted production of these products while an action plan was developed to address these deficiencies. The resulting action plan included the voluntary recall of a select group of lots of certain fluoride products. During October 2008, we resumed distribution of fluoride products purchased from third party vendors. As of April 30, 2009 and July 31, 2008, we have provided an estimated reserve of approximately $0.3 million and $0.2 million related to these products and this issue, respectively.

Corporate Office Lease

During October 2008, we entered into a lease agreement for new corporate office facilities, which we have relocated to in the second quarter of fiscal 2009. The lease agreement is for a term of approximately two years and calls for monthly rental payments of approximately $26,000.

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

The following management’s discussion and analysis of financial condition and results of operations (“MD&A”) should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included elsewhere herein as well as our annual report on Form 10-K for the year ended July 31, 2008, as filed with the Securities and Exchange Commission (“SEC”), including the factors set forth in the section titled “Forward-looking Statements,” as well as our other filings made with the SEC. In this MD&A, “Zila,” “we,” “us,” or “our” refer to Zila, Inc. and its wholly-owned subsidiaries.

Forward-Looking Statements

This Quarterly Report on Form 10-Q, including this MD&A, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). These statements are based on current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “may,” “could,” “foresees,” “should,” “likely,” and variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified in our Form 10-K for the year ended July 31, 2008 under Item 1A “Risk Factors,” and in Item 1A, “Risk Factors” under Part II hereof. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.

Overview

Business

Zila is a diagnostic company dedicated to the prevention, detection and treatment of oral cancer and periodontal disease. We manufacture and market ViziLite ^® Plus with TBlue ^® (“ViziLite ^® Plus”), our flagship product for the early detection of oral abnormalities that could lead to cancer. ViziLite ^® Plus is an adjunctive medical device cleared by the FDA for use in a population at increased risk for oral cancer. In addition, Zila designs, manufactures and markets a suite of proprietary products sold exclusively and directly to dental professionals for periodontal disease, including the Rotadent ^® Professional Powered Brush, the Pro-Select Platinum ^® ultrasonic scaler and a portfolio of oral pharmaceutical products for both in-office and home-care use. Our products are marketed and sold in the United States and Canada primarily through our direct field sales force and telemarketing organization. Our products are marketed and sold in other international markets through the sales forces of third party distributors. Historically, our marketing programs have reached most U.S. dental offices by direct marketing efforts and various media outlets. However, because of cost control and cash preservation initiatives, during fiscal 2009 we have significantly reduced our marketing efforts, which has impacted our reach to new and existing customers. We are an approved American Dental Association continuing education provider and recently submitted our renewal application to the Academy of General Dentistry to continue as an approved continuing education provider.

Recent Developments and Continuance of Operations

Our business is sensitive to general economic conditions since our products are somewhat discretionary in nature. Accordingly, the recent global economic downturn has had a negative impact on our revenues. We implemented profit enhancement initiatives in the second half of fiscal 2008 that resulted in satisfying the Defined EBITDA covenant contained in our Third Amended and Restated Secured Notes (the “Senior Secured Convertible Notes”), which are discussed in more detail elsewhere herein, including: (i) completing the hiring of the targeted level of sales representatives and completing their training across the full portfolio of our products; (ii) improving revenues and gross profit through the implementation of selective price increases and implementing initiatives to reduce our cost of goods; (iii) reducing personnel in our non-selling workforce, temporarily reducing the salaries of our management employees and reducing certain other employee benefits; and (iv) reducing, deferring or eliminating non-critical programs across the organization while maintaining key selling initiatives. Although these initiatives proved to be effective in satisfying the Defined EBITDA covenant contained in our Senior Secured Convertible Notes during the fourth quarter of fiscal 2008, some of these initiatives, such as reducing or deferring salaries, benefits and other operating costs, are not sustainable into future periods.

Other Key Operating Initiatives

During May 2009, Zila and other experts on oral oncology and oral cancer diagnostics testified at a congressional hearing on innovative technology for Veterans. Legislators were urged to press the U.S. Department of Veterans Affairs to expand the use of ViziLite ^{^®} Plus for Veterans, who are at a dramatically higher risk of oral cancer. In December 2007, the U.S. Department of Veterans Affairs awarded Zila a five-year contract to market ViziLite ^{^®} Plus to 58 Veterans Administration dental clinics and 154 Department of Defense dental clinics; however, screens performed using our ViziLite ^{^®} Plus product by these clinics have not been as numerous as expected since the time this contract was entered into. We believe ViziLite ^{^®} Plus provides a significant opportunity for Veterans and the early detection of oral abnormalities that could lead to cancer. We believe there is also a significant opportunity for Zila should the clinics covered by the contract with the Department of Defense realize the benefits of ViziLite ^{^®} Plus for Veterans who utilize these clinics and expand their screening with ViziLite ^{^®} Plus.

During the second quarter of fiscal 2009, we completed the first phase of the global rollout of our proprietary oral cancer screening product, ViziLite ^{^®} Plus. Beginning in North America and through our direct sales force, we now market ViziLite ^® Plus in all 50 states of the U.S., as well as Canada. Since May 2008, we have expanded to Western Europe by forming strategic alliances to distribute ViziLite ^® Plus in a number of European markets. ViziLite ^{^®} Plus is now available in the United Kingdom, Ireland, Germany, Spain, Portugal, France and Greece. For the next phase of our expansion, we have formed distribution agreements in other international markets, including Russia and Belarus, where product registration is in process. During February 2009, we furthered this expansion initiative with the selection of Getwell Life Sciences to distribute ViziLite ^{^®} Plus throughout India. We expect these markets and others in the Pacific Rim region, especially China and India, will form the bulk of our continued global expansion for ViziLite ^® Plus.

During October 2008, the U.K. Medicines and Healthcare products Regulatory Agency issued an indefinite renewal of the marketing authorization for OraTest ^® , our proprietary oral cancer diagnostic kit. Under the European Union’s (“EU”) mutual recognition process, we expect to receive renewal licenses for member states including Finland, Greece, Luxembourg, The Netherlands, Belgium, the U.K. and Portugal. We are seeking marketing partners in the seven EU countries. Adding OraTest ^® to our international product portfolio provides the opportunity to expand the potential market for our oral cancer screening and testing product franchise. The OraTest ^® diagnostic kit and ViziLite ^® Plus are complementary products with distinct indications, which will allow us to market to a more diverse group of healthcare professionals within the EU.

During November 2008, Essex Dental Benefits began offering coverage for ViziLite ^® Plus examinations. Essex Dental Benefits joins the growing list of premiere and national insurance plans that provide coverage for ViziLite ^® Plus, which also includes Humana, United Healthcare, Cigna, Guardian, SafeGuard, Northeast Delta Dental and a number of regional plans and self-insured employers. With the addition of Essex Dental Benefits, approximately 25 million lives are part of dental plans that cover oral cancer screening; however, not all dental professionals in these plans have made ViziLite ^® Plus available to their patients. We are actively working with several large dental plans to co-promote ViziLite ^® Plus to their national contracted dentist networks. Additionally, there has been an increased focus by Zila sales staff on dentists contracted with dental plans that offer coverage for ViziLite ^® Plus.

Results of Operations

The following table summarizes our results of operations and related statistical information for the three and nine months ended April 30, 2009 and 2008 (dollars in thousands):


	For the Three Months Ended April 30,
				% of						% of			%
	2009			Revenue			2008			Revenue			Change

Net revenues	$	8,467			100.0	%	$	11,245			100.0	%		(24.7)	%
Cost of products sold		3,459			40.9			4,438			39.5			(22.1	)


Gross profit		5,008			59.1			6,807			60.5			(26.4	)

Operating costs and expenses:
Marketing and selling		3,165			37.4			6,046			53.8			(47.7	)
General and administrative		1,773			20.9			3,281			29.1			(46.0	)
Research and development		90			1.1			247			2.2			(63.6	)
Depreciation and amortization		308			3.6			952			8.5			(67.6	)


Total operating costs and expenses		5,336			63.0			10,526			93.6			(49.3	)


Loss from operations		(328	)		(3.9	)		(3,719	)		(33.1	)		(91.2	)
Other expense — net		(1,121	)		(13.2	)		(758	)		(6.7	)		47.9


Loss from continuing operations before income taxes		(1,449	)		(17.1	)		(4,477	)		(39.8	)		(67.6	)
Income tax benefit (expense)		(32	)		(0.4	)		34			0.3			(194.1	)


Loss from continuing operations	$	(1,481	)		(17.5)	%	$	(4,443	)		(39.5)	%		(66.7	)


	For the Nine Months Ended April 30,
				% of						% of			%
	2009			Revenue			2008			Revenue			Change

Net revenues	$	26,620			100.0	%	$	33,176			100.0	%		(19.8)	%
Cost of products sold		11,006			41.3			13,264			40.0			(17.0	)


Gross profit		15,614			58.7			19,912			60.0			(21.6	)

Operating costs and expenses:
Marketing and selling		10,884			40.9			16,564			49.9			(34.3	)
General and administrative		5,810			21.9			9,883			29.8			(41.2	)
Impairment of goodwill and other intangible assets		23,193			87.1			—			—
Research and development		335			1.3			2,237			6.7			(85.0	)
Depreciation and amortization		1,843			6.9			2,811			8.5			(34.4	)


Total operating costs and expenses		42,065			158.0			31,495			94.9			33.6


Loss from operations		(26,451	)		(99.4	)		(11,583	)		(34.9	)		128.4
Other expense — net		(3,012	)		(11.3	)		(2,155	)		(6.5	)		39.8


Loss from continuing operations before income taxes		(29,463	)		(110.7	)		(13,738	)		(41.4	)		114.5
Income tax benefit (expense)		(45	)		(0.1	)		23			0.1			(295.7	)


Loss from continuing operations	$	(29,508	)		(110.8)	%	$	(13,715	)		(41.3)	%		115.2

Net Revenues

Net revenues were $8.5 million and $11.2 million for the three months ended April 30, 2009 and 2008, respectively, a decrease of $2.7 million or 24.7%. Net revenues were $26.6 million and $33.2 million for the nine months ended April 30, 2009 and 2008, respectively, a decrease of $6.6 million or 19.8%. ViziLite ^® Plus net revenues decreased to $2.7 million and $8.5 million for the three and nine months ended April 30, 2009, a decrease of 25.5% and 13.1% from the same periods in the previous year, respectively. Also contributing to the decrease in net revenues were lower sales of our Rotadent ^® Professional Powered Brush and Pro-Select Platinum ^® ultrasonic scalers. Although we have recently been successful in increasing the utilization of ViziLite ^® Plus, expanding our international programs and driving increases in the number of insurance companies reimbursing for the ViziLite ^® Plus examination, the deepening of the global economic downturn and customer concern about our viability as an ongoing business have had a significant negative impact on our business. As discussed above, our business is sensitive to general economic conditions since our products are somewhat discretionary in nature.

Gross Profit

Gross profit was $5.0 million and $6.8 million for the three months ended April 30, 2009 and 2008, respectively, a decrease of $1.8 million or 26.4%. Gross profit was $15.6 million and $19.9 million for the nine months ended April 30, 2009 and 2008, respectively, a decrease of $4.3 million or 21.6%. Gross profit as a percentage of net revenues was 59.1% and 60.5% for the three months ended April 30, 2009 and 2008, respectively, and 58.7% and 60.0% for the nine months ended April 30, 2009 and 2008, respectively. Our gross profit margin for the three and nine months ended April 30, 2009 was negatively impacted by selective discounting programs that were implemented in the first half of fiscal 2009 in an effort to stimulate sales and counteract the revenue declines discussed above. At times in fiscal 2009, we have also experienced product cost increases as a result of decreased purchasing volumes and the resulting impact on discounts for products purchased.

Marketing and Selling Expense

Marketing and selling expense was $3.2 million and $6.0 million for the three months ended April 30, 2009 and 2008, respectively, a decrease of $2.8 million or 47.7%. Marketing and selling expense was $10.9 million and $16.6 million for the nine months ended April 30, 2009 and 2008, respectively, a decrease of $5.7 million or 34.3%. The decline in marketing and selling expense for the three and nine months ended April 30, 2009 resulted from the reduction in the level of commissions and bonuses paid to the sales force as a result of reduced sales levels, reduced sales force personnel as a result of a realignment of our sales territories to gain efficiencies and reductions in expenditures in non-direct selling related expenses. Additionally, we have continued the temporary reduction of our marketing expenditures in connection with our profit enhancement initiatives, which include reductions in expenditure levels for tradeshows, seminars and other marketing activities. Concerns about our financial viability have also contributed to increased turnover in our field sales force and other key staff areas and have led to a reduction in our marketing effectiveness and our reach to new and existing customers.

General and Administrative Expense

General and administrative expense was $1.8 million and $3.3 million for the three months ended April 30, 2009 and 2008, respectively, a decrease of $1.5 million or 46.0%. General and administrative expense was $5.8 million and $9.9 million for the nine months ended April 30, 2009 and 2008, respectively, a decrease of $4.1 million or 41.2%. The decrease in general and administrative expense primarily relates to profitability initiatives that were implemented during the second half of fiscal 2008 and the first part of fiscal 2009. These profitability initiatives included reducing personnel in our non-selling workforce by approximately 35% through the third quarter of fiscal 2009, the temporary reduction of the salaries of certain management employees, reducing certain other employee benefits and reducing, deferring or eliminating non-critical programs across the organization. Professional fees declined for the three and nine months ended April 30, 2009 as fees incurred in the prior-year for investment banking expenses to explore financing alternatives and Sarbanes Oxley compliance costs were lower in fiscal 2009, but were offset to some extent by increased professional fees associated with analysis of our impairment charge relative to goodwill and other intangible assets, which is described more fully below.

General and administrative expense consists of the following for the three and nine months ended April 30, 2009 and 2008 (in thousands):


	Three Months Ended April 30,				Nine Months Ended April 30,
	2009		2008		2009		2008

Cash basis salaries and benefits	$	696	$	1,300	$	2,176	$	3,572
Audit, accounting and other professional fees		425		718		1,302		1,994
Investment banking fees and shareholder related expense		86		55		433		373
Legal and intellectual property related fees		147		253		477		905
Insurance		113		135		338		384
Non-cash stock-based compensation expense		65		344		246		1,200
Other general and administrative expense		241		476		838		1,455


Total general and administrative expense	$	1,773	$	3,281	$	5,810	$	9,883

Impairment of Goodwill and Other Intangible Assets

We recognized an impairment charge of $23.2 million during December 2008 as a result of these impairment assessments. This impairment charge consists of $10.2 million for goodwill and $13.0 million for other intangible assets. The impairment charge is more fully described in Note 5 to the accompanying unaudited condensed consolidated financial statements, Goodwill and Other Intangible Assets, and in the Summary of Critical Accounting Policies and Estimates section of this MD&A.

Research and Development Expense

Research and development expense was $0.1 million and $0.2 million for the three months ended April 30, 2009 and 2008, respectively, a decrease of $0.1 million or 63.6%. Research and development expense was $0.3 million and $2.2 million for the nine months ended April 30, 2009 and 2008, respectively, a decrease of $1.9 million or 85.0%. In the first quarter of fiscal 2008, we closed enrollment in a clinical trial related to an oral cancer diagnostic drug and ceased expenditures for CMC and non-clinical aspects of the regulatory program. The curtailment of the regulatory program is the primary driver of the overall decrease in research and development expense.

Depreciation and Amortization Expense

Depreciation and amortization expense was $0.3 million and $1.0 million for the three months ended April 30, 2009 and 2008, respectively, a decrease of $0.7 million or 67.6%. Depreciation and amortization expense was $1.8 million and $2.8 million for the nine months ended April 30, 2009 and 2008, respectively, a decrease of $1.0 million or 34.4%. Depreciation and amortization decreased in the three and nine months ended April 30, 2009 compared to the same period in prior years primarily as a result of the impairment charge for intangible assets recognized in December 2008, which is discussed elsewhere herein.

Other Expense — Net

Other expense, net was $1.1 million and $0.8 million for the three months ended April 30, 2009 and 2008, respectively, and $3.0 million and $2.2 million for the nine months ended April 30, 2009 and 2008. Other expense primarily consists of interest expense, which is summarized as follows:


	Three Months Ended April 30,				Nine Months Ended April 30,
	2009		2008		2009		2008

Senior secured convertible notes	$	445	$	240	$	905	$	701
Amortization of financing costs		218		97		670		293
Amortization of debt discounts		434		438		1,331		1,336
Capital leases and other		3		11		11		24


Total interest expense	$	1,100	$	786	$	2,917	$	2,354

The increase in interest expense primarily relates to interest being accrued for the Senior Secured Convertible Notes at default rates following the quarterly interest payment due January 31, 2009, which along with the quarterly interest payment due April 30, 2009, have not been made as of the date of this filing. Also contributing to the increase in interest expense is increased amortization of financing costs, which relates to costs incurred in connection with amendments to our Senior Secured Convertible Notes during fiscal 2008.

Income Taxes

Income tax expense or benefit for the three and nine months ended April 30, 2009 and 2008 was less than $0.1 million and primarily relates to state income taxes.

Inflation and Seasonality

We do not believe that inflation has a unique or material effect on the operations or financial condition of our businesses. However, we are sensitive to general economic conditions since our products are somewhat discretionary in nature. Sales for the dental industry are generally affected by holiday and vacation related seasonality, which impacts the number of available selling days in each fiscal quarter. We sell directly to dental professionals in the United States and Canada, and accordingly, our sales are subject to these seasonal trends.

Liquidity and Capital Resources

Overview

We have historically sustained recurring losses and negative cash flows from operations as we changed our strategic direction to focus on the growth and development of ViziLite ^® Plus and our periodontal product lines. Our liquidity needs have typically arisen from the funding of our research and development program and the launch of our new products, such as ViziLite ^® Plus, working capital and debt service requirements, and strategic initiatives. In the past, we have met these cash requirements through our cash and cash equivalents, working capital management, the sale of non-core assets and proceeds from certain private placements of our securities.

Previously, our research and development program for our oral cancer diagnostic drug required the commitment of substantial resources to conduct the time-consuming research and development, clinical studies and regulatory activities necessary to bring any potential product to market and to establish production, marketing and sales capabilities. We believe that in order to maximize shareholder value our resources must be directed to those products and programs with the greatest probability of financial return. We believe that our greatest potential lies with our continued development and commercialization of our already existing oral cancer screening product, ViziLite ^® Plus. The incremental market potential of the oral cancer diagnostic drug, considering the availability of ViziLite ^® Plus, did not justify the cost, time and uncertain study outcomes associated with continuing the program in its current form. In order to pursue our strategy with our currently available funds, during fiscal 2008 we curtailed activity and spending related to the oral cancer diagnostic drug program. We have continued this strategy into fiscal 2009. As a result of this curtailment, research and development expenditures decreased during fiscal 2008 compared to historic levels, and have continued to decrease into fiscal 2009. We believe that our level of expenditures for research and development in fiscal 2009 will be reduced further from our historic levels.

During fiscal 2009, our revenues have been negatively impacted as a result of the severity of the global economic downturn and its impact on discretionary spending on our products. Our revenues have also been affected as a result of customer concern about our viability as an ongoing business. Concerns about our financial viability have also contributed to increased turnover in our field sales force and other key staff areas and have led to a reduction in our marketing effectiveness and our reach to new and existing customers. We would expect these factors to cause near term future operating results to be less favorable than our financial results for the fourth quarter of fiscal 2008 and those previously anticipated for fiscal 2009. To address the impact of this revenue decline, during fiscal 2009 we have (i) continued salary reductions for a number of management personnel; (ii) eliminated additional personnel, including an approximately 15% reduction of our field sales force as a result of the realignment of our sales territories; (iii) eliminated the employee stock purchase plan and its associated costs; (iv) furloughed certain manufacturing production personnel; (v) reduced the number of seminar programs and streamlined the cost structure of these programs; and (vi) reduced tradeshow expenditures. Excluding the effect of the $23.2 million non-cash impairment charge for goodwill and other intangible assets recognized during December 2008, these actions significantly narrowed our operating loss over the same periods in the prior year. The impairment loss is more fully described in Note 5 to the accompanying unaudited condensed consolidated financial statements, Goodwill and Other Intangible Assets. To address the impact of the economic downturn on our revenues, we continue to identify cost-reduction and working capital initiatives to reduce the impact on future cash flows from operations and results of operations.

Our efforts to seek additional funding have included discussions with numerous potential financial and strategic investors as well as with the holders of the Senior Secured Convertible Notes. All potential investors with whom we have had discussions required, as a condition of their investment, that the Senior Secured Convertible Notes be repaid from the funds provided by the investor(s) and that this repayment be at a substantial discount from the $12.0 million principal outstanding to reflect the current market value of those notes. We are also engaged in discussions and negotiations with other parties regarding a variety of possible strategic transactions, including the possible sale of the Company or substantially all of its assets. One of those parties and the holders of the Senior Secured Convertible Notes have entered into a Note Purchase Agreement whereby such party has the right, subject to certain conditions and for a limited period of time, to acquire all of the Senior Secured Convertible Notes from the current holders at a significant discount from the $12.0 million principal balance of these notes. The Company is not a party to the Note Purchase Agreement.

Selected Cash Flow and Working Capital Information

Selected cash flow and working capital information is summarized as follows (dollars in thousands):


	Nine Months Ended April 30,
	2009			2008

Net cash used in operating activities	$	(640	)	$	(8,762	)
Net cash used in investing activities		(511	)		(930	)
Net cash used in financing activities		(247	)		(1,627	)


	April 30,			July 31,
	2009			2008

Cash and cash equivalents	$	3,064		$	4,462
Working capital		(5,254	)		6,558
Current ratio		0.7			1.8

As of April 30, 2009, our primary sources of liquidity included cash and cash equivalents of $3.1 million compared to $4.5 million as of July 31, 2008. Our working capital was negative $5.3 million as of April 30, 2009 compared to $6.6 million as of July 31, 2008. The decrease in working capital primarily relates to our decreased cash and receivable balances and the reclassification of our Senior Secured Convertible Notes to current liabilities, offset by a decline in accounts payable and other accrued expenses. Our current ratio declined to 0.7 as of April 30, 2009 from 1.8 as of July 31, 2008 due primarily to the reclassification of our Senior Secured Convertible Notes and the decline in cash and cash equivalents.

Cash Flows from Operating Activities

Cash used in operating activities was $0.6 million and $8.8 million for the nine months ended April 30, 2009 and 2008, respectively. The improvement in cash used in operating activities relates to the recent profit enhancement initiatives undertaken and the curtailment of activity and spending related to the oral cancer diagnostic drug program. Also contributing to the lower amount of cash used in operating activities was an increase in cash provided by changes in working capital, which was $0.9 million for the nine months ended April 30, 2009 compared to cash used of $1.4 million for the nine months ended April 30, 2008. Working capital changes for the nine months ended April 30, 2009 primarily relate to a decline in accounts receivable balances of $1.1 million, which in part relates to our decline in revenue from the levels experienced in the fourth quarter of fiscal 2008 compared to the first half of fiscal 2009, offset by a decline in accounts payable and accrued liabilities of $1.4 million for payments made on these balances. During the first nine months of fiscal 2009, our accounts payable and accrued liabilities have declined as a result of lower expense levels coupled with the tightening of payment terms from our vendors. Our inventories have also decreased during the first nine months of fiscal 2009 as a result of strategic initiatives to reduce and better manage our inventory levels.

Cash Flows from Investing Activities

Cash used in investing activities was $0.5 million and $0.9 million for the nine months ended April 30, 2009 and 2008, respectively, and consists primarily of disbursements for additional property and equipment and development of intangible assets.

Cash Flows from Financing Activities

Cash used in financing activities was $0.2 million and $1.6 million for the nine months ended April 30, 2009 and 2008, respectively. During the first nine months of fiscal 2008, we paid $1.4 million for the repurchase of common stock and warrants in connection with an amendment to our Senior Secured Convertible Notes.

Senior Secured Convertible Notes

PharmaBio Development, Inc.

Convertible Preferred Stock

Off-Balance Sheet Financing Arrangements

We do not have any off-balance sheet financing arrangements.

Summary of Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared pursuant to the rules and regulations of the SEC. Certain information related to our organization, significant accounting policies and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted. The preparation of the financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates related to (i) useful lives of intangibles; (ii) impairment analyses; (iii) depreciable lives of assets; (iv) income tax valuation allowances; (v) contingency and litigation reserves; (vi) inventory valuation; (vii) allowances for accounts receivable, cash discounts, sales incentives and sales returns; and (viii) valuation assumptions for share-based payments. We base our estimates on historic experience and various other factors related to each circumstance. Actual results could differ from those estimates based upon future events, which could include, among other risks, changes in the business environment in which we operate and changes in the regulations governing the manner in which we manufacture and/or sell our products.

There are several accounting policies that we believe are significant to the presentation of our financial statements and require management’s most difficult, complex or subjective judgments about matters that are inherently uncertain. We believe our most critical accounting policies include (i) revenue recognition; (ii) use of estimates, which is described more fully above; and (iii) the carrying values of goodwill and other long-lived assets. Our significant accounting policies and critical accounting estimates are disclosed more fully in our Annual Report on Form 10-K for the year ended July 31, 2008. With the exception of our goodwill and other intangible assets disclosure below, we do not believe there have been significant changes to our critical accounting policies and estimates subsequent to July 31, 2008.

Goodwill, Intangibles and Other Long-Lived Assets

We have made acquisitions of products and businesses that include goodwill, license agreements, patents and trademarks, product rights and other intangible and long-lived assets. We have historically assessed the impairment of goodwill annually in our fourth fiscal quarter, or whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable. During fiscal 2009, our revenues have been negatively impacted as a result of the severity of the global economic downturn and its impact on discretionary spending on our products. Our revenues have also been affected as a result of customer concern about our viability as an ongoing business. We would expect these factors to cause near term future operating results to be less favorable than previously anticipated for fiscal 2009. We also experienced a decline in our stock price and a corresponding decline in our market capitalization and enterprise value throughout fiscal 2009. Finally, as of December 2008, we anticipated we would fail to make the interest payment due January 31, 2009 on our Senior Secured Convertible Notes, which is an event of default under such notes. As of the date of this filing, we have not made the quarterly interest payments due April 30, 2009 and January 31, 2009 on these notes. Although we have not received a notice of default or acceleration from the note holders as of the date of this filing, which is required prior to any of the principal amount becoming due and payable as a result of such defaults, the note holders may, at any time, demand $8.0 million of note principal as a result of our defaults under these notes. In order to continue as a going concern and fund our current level of operations over the next twelve months, we will be required to seek additional funding and restructure or retire our Senior Secured Convertible Notes. If we are unable to do so, we will likely be forced to sell all or a portion of the Company or file for protection under Chapter 11 of the Federal Bankruptcy Code, which may lead to a liquidation of our business under Chapter 7 of the Federal Bankruptcy Code. Primarily as a result of these factors, we assessed goodwill for impairment on an interim basis during December of 2008. The assessment is performed using the two-step process prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 142, “ Goodwill and Other Intangible Assets ” (“SFAS 142”). The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. The first step of the goodwill impairment test compares the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying value, goodwill is not impaired. If the carrying value of the reporting unit’s net assets, including goodwill, exceeds the fair value of the reporting unit, then we determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment of goodwill has occurred and we recognize an impairment loss for the difference between the carrying amount and the implied fair value of goodwill as a component of operating income. The implied fair value of goodwill is calculated by subtracting the fair value of tangible and intangible assets associated with the reporting unit from the fair value of the unit. For fiscal 2008, the first step of our annual goodwill impairment test reflected fair value that was in excess of the carrying value. Accordingly, we did not perform the second step of this test during fiscal 2008. The December 2008 impairment test resulted in an impairment of the entire balance of goodwill, or $10.2 million.

For our annual fiscal 2008 goodwill impairment test, we performed a sensitivity analysis considering a decline in revenues in all years of 12.5%, and variable expenses of 10.8% of revenues. Fixed expenses were grown at a 3.0% annual inflation rate over the projection period. Although we considered this projection set to be much less risky than our base case used for SFAS 142 step one conclusion purposes, we kept the average cost of capital constant at approximately 25%. This analysis did not indicate impairment of goodwill. We also performed an internal rate of return analysis that indicated an average cost of capital of 51.0% is required to tie our projections to the market value of total invested capital for Zila.

There have been no substantial changes in the methodologies employed, significant assumptions used, or calculations applied in the first step of the SFAS 142 impairment test over the past several years; however, due to the factors discussed above, for the December 2008 interim impairment test we placed more emphasis on liquidation scenarios. Prior to fiscal 2008 we divested and acquired certain businesses, and accordingly, the number of business units identified in prior periods was different than those identified for the fiscal 2009 and 2008 impairment tests.

The impairment charge for goodwill and other intangible assets was recognized as of December 31, 2008 and is stated separately on the accompanying Unaudited Condensed Consolidated Statements of Operations under the caption “Impairment of goodwill and other intangible assets.”

Recently Issued Accounting Pronouncements and Adopted Accounting

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “ Fair Value Measurements ” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information for those instruments measured at fair value. The fair value hierarchy distinguishes between assumptions based on market data (observable inputs) and an entity’s own assumptions (unobservable inputs). The hierarchy consists of three levels:


Level one	—	Quoted market prices in active markets for identical assets or liabilities;

Level two	—	Inputs other than Level one inputs that are either directly or indirectly observable; and

Level three	—	Unobservable inputs developed using estimates and assumptions, which are developed by the reporting entity and reflect those assumptions that a market participant would use.

Determining which category an asset or liability falls within the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter.

In April 2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142. The intent of FSP SFAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R and other applicable accounting literature. FSP SFAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. We are currently evaluating the impact FSP SFAS 142-3 will have on our financial position or results of operations.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Our exposure to market risk for a change in interest rates relates primarily to our investments, which consists of cash and cash equivalents. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. We maintain our portfolio in high credit quality cash deposits and money market funds with carrying values that approximate market value. Because our investments consist of cash and cash equivalents, a hypothetical 100 basis point change in interest rates is not likely to have a material effect on our consolidated financial statements.

We also have market risk arising from changes in foreign currency exchange rates through our subsidiaries that conduct business in Canada and Europe and have functional currencies denominated in Canadian dollars and British pounds. We believe that such exposure does not present a significant risk due to the limited number of transactions and/or accounts denominated in foreign currency.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures.

We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) that are designed: (i) to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) to ensure that such information is accumulated and communicated to management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. Our management, with the participation of our Principal Executive Officer and Principal Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report, and, based on that evaluation, our Principal Executive Officer and Principal Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) are effective.

Changes in Internal Control over Financial Reporting .

There were no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) of the Exchange Act) during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings.

Information regarding our legal proceedings may be found under the “Legal Proceedings” section of the footnote titled “Commitments and Contingencies” to our unaudited condensed consolidated financial statements contained elsewhere herein.

Item 1A. Risk Factors.

You should consider carefully the risk factors described below, and all other information contained in this filing and our other filings made with the SEC, before deciding to invest in our common stock. If any of the following risks actually occur, they may materially harm our business, financial condition, operating results or cash flow. As a result, the market price of our common stock could decline, and you could lose all or part of your investment. Additional risks and uncertainties that are not yet identified or that we think are immaterial may also materially harm our business, operating results or financial condition and could result in a complete loss of your investment.

Trends, Risks and Uncertainties Related to Our Business

We are in default with respect to our Senior Secured Convertible Notes.

The quarterly interest payments due January 31, 2009 and April 30, 2009 on the Senior Secured Convertible Notes have not been made as of the date of this filing. The failures to make these payments are events of default under our Senior Secured Convertible Notes. Upon an event of default, the Senior Secured Convertible Notes bear interest at a default rate of 15.0% per annum. Although we have not received a notice of default or acceleration from the note holders as of the date of this filing, which is required prior to any of the principal amount becoming due and payable as a result of such default, we have reclassified the Senior Secured Convertible Notes to current liabilities. Pursuant to the Note Purchase Agreement, the holders of the Senior Secured Convertible Notes have agreed not to exercise their remedies under such notes unless and until the Note Purchase Agreement is terminated. However, there can be no assurance that the current or future note holders will not accelerate amounts due under the Senior Secured Convertible Notes and proceed against their collateral. In the event of acceleration, we would likely be forced to file for protection under Chapter 11 of the Federal Bankruptcy Code or liquidate the Company under Chapter 7 of the Federal Bankruptcy Code, which would likely result in our common stock becoming worthless.

Adverse economic conditions could negatively affect our business and operating results.

Our operating results may be adversely affected by market and economic challenges, including the crisis currently impacting global credit and financial markets that may result in a continued or exacerbated general economic slowdown. Such a slowdown has negatively affected sales of our products, including ViziLite ^® Plus. We have received reports that dental visits by patients for routine checkups are down as a result of the slowing economy. The length and severity of any economic slowdown or downturn cannot be predicted. If the current economic crisis is prolonged or becomes more severe, its adverse impact on our business and operating results could be significant.

Our lack of earnings history could adversely affect our financial health and prevent us from fulfilling our payment obligations, and if we are unable to generate funds or obtain funds on acceptable terms, we may not be able to develop and market our present and potential products.

During fiscal 2009, our revenues have been negatively impacted as a result of the severity of the global economic downturn and customer concern about our viability as an ongoing business. We have historically sustained recurring losses and negative cash flows from operations as we changed our strategic direction to focus on the growth and development of ViziLite ^® Plus and our periodontal product lines. Our liquidity needs have typically arisen from the funding of our research and development program and the launch of our new products, such as ViziLite ^® Plus, working capital and debt service requirements, and strategic initiatives. In the past, we have met these cash requirements through our cash and cash equivalents, working capital management, the sale of non-core assets and proceeds from certain private placements of our securities.

The development of products requires the commitment of substantial resources to conduct the time-consuming research and development, clinical studies and regulatory activities necessary to bring any potential product to market and to establish production, marketing and sales capabilities. Our ability to develop our products, to service our debt obligations, to fund working capital and capital expenditures and for other purposes that cannot at this time be quantified will depend on our future operating performance, which will be affected by factors discussed elsewhere in this filing and in the other reports we file with the SEC, including, without limitation, receipt of regulatory approvals, economic conditions and financial, business, and other factors, many of which are beyond our control.

Our efforts to seek additional funding have included discussions with numerous potential financial and strategic investors as well as with the holders of the Senior Secured Convertible Notes. All potential investors with whom we have had discussions required, as a condition of their investment, that the Senior Secured Convertible Notes be repaid from the funds provided by the investor(s) and that this repayment be at a substantial discount from the $12.0 million principal outstanding to reflect the current market value of those notes. We are also engaged in discussions and negotiations with other parties regarding a variety of possible strategic transactions, including the possible sale of the Company or substantially all of its assets. One of those parties and the holders of the Senior Secured Convertible Notes have entered into a Note Purchase Agreement whereby such party has the right, subject to certain conditions and for a limited period of time, to acquire all of the Senior Secured Convertible Notes from the current holders at a significant discount from the $12.0 million principal balance of these notes. The Company is not a party to the Note Purchase Agreement.

As a result of the foregoing, there is substantial doubt about our ability to continue as a going concern. Accordingly, realization values may be substantially different from carrying values as shown, and these financial statements do not give effect to adjustments that would be necessary to the carrying values and classification of assets and liabilities should we be unable to continue as a going concern. If we would be forced to file for protection under Chapter 11 of the Federal Bankruptcy Code or liquidate the Company under Chapter 7 of the Federal Bankruptcy Code, our common stock would likely become worthless.

Strategic business opportunities to accelerate the growth of our business may require additional funding. However, in light of recent economic conditions, there can be no assurance that we will be successful in achieving our current sales projections or in executing our strategies. Furthermore, there can be no assurance that additional funding will be obtainable on terms that are favorable to us, if at all.

Our lack of earnings history, liquidity concerns and our level of debt could have important consequences, such as:

	•		making it more difficult for us to satisfy our obligations with respect to our Senior Secured Convertible Notes;

	•		increasing our vulnerability to general adverse economic and industry conditions;

	•		limiting our flexibility in planning for, or reacting to, changes in our business and our industry;

	•		restricting us from making strategic acquisitions, introducing new products or exploiting business opportunities;

	•		requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, which will reduce the amount of our cash flow available for other purposes, including capital expenditures and other general corporate purposes;

	•		requiring us to sell debt securities or to sell some of our core assets, possibly on unfavorable terms;

	•		limiting our ability to obtain additional financing; and

	•		placing us at a possible competitive disadvantage compared to our competitors that may have greater financial resources.

We may not be able to maintain compliance with our debt covenants in the future.

Our Senior Secured Convertible Notes contain comprehensive covenants that restrict the way in which we can operate, and contain financial covenants that require us to, among other things, maintain, at the end of each fiscal quarter, cash and cash equivalents in an amount not less than $1.0 million. As of April 30, 2009, we were in compliance with this covenant and had approximately $3.1 million in cash and cash equivalents. We had cash and cash equivalents of approximately $2.5 million, $3.2 million, $4.5 million, $3.5 million, $5.9 million and $8.7 million as of January 31, 2009, October 31, 2008, July 31, 2008, April 30, 2008, January 31, 2008 and October 31, 2007, respectively. If, as a result of recent economic conditions or other reasons, we are unable to achieve our currently projected sales, we may be unable to remain in compliance with this covenant. We may also be required to use cash for working capital purposes should we experience delays in collecting receivables from our customers, which would increase the number of days our sales are outstanding. Cash flows would also be negatively affected through the tightening of payment terms from our vendors and our inability to match our inventory levels with increased or decreased sales levels. Deterioration in one or all of these factors given our current level of cash and cash equivalents could have significant adverse consequences in maintaining compliance with this covenant.

Failure to maintain compliance with this or other covenants could, at the option of the Senior Secured Convertible Note holders, result in an additional event of default under the Senior Secured Convertible Notes. Upon the occurrence of the first specified event of default, the holders of the Senior Secured Convertible Notes could accelerate and demand repayment of one-third of the outstanding principal balance and all accrued but unpaid interest on the Senior Secured Convertible Notes. Upon the occurrence of the second specified event of default, the holders of the Senior Secured Convertible Notes could accelerate and demand repayment of one-half of the outstanding principal balance and all accrued but unpaid interest on the Senior Secured Convertible Notes. Upon the occurrence of the third specified event of default, the entire principal balance and all accrued but unpaid interest may become due and payable.

The restrictive covenants contained in our senior debt could adversely affect our business by limiting our flexibility.

Our Senior Secured Convertible Notes impose restrictions that affect, among other things, our ability to incur debt, pay dividends, sell assets, create liens, make capital expenditures and investments, merge or consolidate, enter into transactions with affiliates, and otherwise enter into certain transactions outside the ordinary course of business. Our Senior Secured Convertible Notes also require us to maintain a minimum of $1.0 million of cash and cash equivalents and that we generate at least $1.00 of Defined EBITDA for one quarter ending on or before July 31, 2009. We satisfied the Defined EBITDA covenant in our fourth quarter of fiscal 2008.

Our ability to comply with the other covenants and restrictions of the Senior Secured Convertible Notes may be affected by events beyond our control. If, as a result of current economic conditions or other reasons, we are unable to achieve our currently projected sales, we may be unable to remain in compliance with these covenants. If we are unable to comply with the terms of our Senior Secured Convertible Notes, or if we fail to generate sufficient cash flow from operations to service our debt, we may default on our debt instruments. In the event of a default under the terms of any of our indebtedness, the debt holders may, under certain circumstances, accelerate the maturity of our obligations and proceed against their collateral.

Historically we have been dependent on a few key products and our future growth is dependent on the growth of ViziLite ^® Plus and on the development and/or acquisition of new products.

In the past, nearly all of our revenues were derived from the sales of Ester-C ^® , Peridex ^® and ViziLite ^® Plus products. We divested our Nutraceuticals business unit and the Ester-C ^® products in October 2006 and Peridex ^® in May 2007. With the acquisition and addition of the products of Pro-Dentec, and the change in our distribution method for ViziLite ^® Plus, we now sell direct to thousands of dental offices in the United States and Canada and we believe we have reduced our dependency on key customers.

If any of our major products were to become subject to a problem such as loss of patent protection, unexpected side effects, regulatory proceedings, publicity adversely affecting user confidence or pressure from competing products, or if a new, more effective treatment should be introduced, the impact on our revenues could be significant. Additionally, we are reliant on third party manufacturers and single suppliers for our ViziLite ^® Plus product, and any supply problems resulting from regulatory issues applicable to such parties or failures to comply with the FDA’s Current Good Manufacturing Practices standards could have a material adverse impact on our financial condition.

Our future growth is dependent on the growth of the ViziLite ^® Plus product and new product developments and/or acquisitions. New product initiatives may not be successfully implemented because of many factors, including, but not limited to, difficulty in assimilation, development costs and diversion of management time. There can be no assurance that we will successfully develop and integrate new products into our business that will result in growth and a positive impact on our business, financial condition and results of operation.

A number of factors could impact our plans to commercialize our new products, including, but not limited to:

	•		difficulties in the production process, controlling the costs to produce, market and distribute the product on a commercial scale, and our ability to do so with favorable gross margins and otherwise on a profitable basis;

	•		the inherent difficulty of gaining market acceptance for a new product;

	•		competition from larger, more established companies with greater resources;

	•		changes in raw material supplies that could result in production delays and higher raw material costs;

	•		difficulties in promoting consumer awareness for the new product;

	•		adverse publicity regarding the industries in which we market our products; and

	•		the cost, timing and ultimate results of regulatory program studies that we undertake.

Our proprietary rights may prove difficult to enforce.

Our current and future success depends on a combination of patent, trademark, and trade secret protection and nondisclosure and licensing agreements to establish and protect our proprietary rights. We own and have exclusive licenses to a number of United States and foreign patents and patent applications and intend to seek additional patent applications as we deem necessary and appropriate to operate our business. We can offer no assurances regarding the strength of the patent portfolio underlying any existing or new product and/or technology or whether patents will be issued from any pending patent applications related to a new product and/or technology, or if the patents are issued, that any claims allowed will be sufficiently broad to cover the product, technology or production process. Although we intend to defend our proprietary rights, policing unauthorized use of intellectual property is difficult or may prove materially costly and any patents that may be issued relating to new products and technology may be challenged, invalidated or circumvented.

We are dependent on our senior management and other key personnel.

Our ability to operate successfully depends in significant part upon the experience, efforts, and abilities of our senior management and other key scientific, technical, sales and managerial personnel. Competition for talented personnel is intense. The future loss of services of one or more of our key executives could adversely impact our financial performance and our ability to execute our strategies. Additionally, if we are unable to attract, train, motivate and retain key personnel, our business could be harmed.

We currently do not have a head of our sales and marketing function. Our inability to fill this position or to make adequate adjustments in our corporate organizational structure to properly delegate this role to an existing member of our management team could adversely impact our financial performance and our ability to execute our strategies.

We and our products are subject to regulatory oversight that could substantially interfere with our ability to do business.

We and our present and future products are subject to risks associated with new federal, state, local, or foreign legislation or regulation or adverse determinations by regulators under existing regulations, including the interpretation of and compliance with existing, proposed, and future regulatory requirements imposed by the FDA. We are also subject to other governmental authorities such as the Department of Health and Human Services, the Consumer Products Safety Commission, the Department of Justice and the United States Federal Trade Commission with its regulatory authority over, among other items, product safety and efficacy claims made in product labeling and advertising. Individual states, acting through their attorneys general, have become active as well, seeking to regulate the marketing of prescription drugs under state consumer protection and false advertising laws. A regulatory determination or development that affects our ability to market or produce one or more of our products could have a material adverse impact on our business, results of operation, and financial condition and may include product recalls, denial of approvals and other civil and criminal sanctions.

We are at risk with respect to product liability claims.

We could be exposed to possible claims for personal injury resulting from allegedly defective products manufactured by third parties with whom we have entered into manufacturing agreements or by us. We maintain $6.0 million in product liability insurance coverage for claims arising from the use of our products, with limits we believe are commercially reasonable under the circumstances, and, in most instances, require our manufacturers to carry product liability insurance. While we believe our insurance coverage is adequate, we could be subject to product liability claims in excess of our insurance coverage. In addition, we may be unable to retain our existing coverage in the future. Any significant product liability claims not within the scope of our insurance coverage could have a material adverse effect on us.

We face significant competition that could adversely affect our results of operation and financial condition.

The pharmaceutical, medical device and related industries are highly competitive. A number of companies, many of which have financial resources, marketing capabilities, established relationships, superior experience and operating history, and research and development capacities greater than ours, are actively engaged in the development of products similar to the products we produce and market. The pharmaceutical industry is characterized by extensive and ongoing research efforts. Other companies may succeed in developing products superior to those we market. It may be difficult for us to maintain or increase sales volume and market share due to such competition which would adversely affect our results of operations and financial condition. The loss of any of our products’ patent protection could lead to a significant loss in sales of our products in the United States market.

If the use of our technology is determined to infringe on the intellectual property rights of others, our business could be harmed.

Litigation may result from our use of registered trademarks or common law marks and, if litigation against us were successful, a resulting loss of the right to use a trademark could reduce sales of our products and could result in a significant damage award. International operations may be affected by changes in intellectual property legal protections and remedies in foreign countries in which we do business.

Furthermore, if it were ultimately determined that our intellectual property rights are unenforceable, or that our use of our technology infringes on the intellectual property rights of others, we may be required or may desire to obtain licenses to patents and other intellectual property held by third parties to develop, manufacture and market products using our technology. We may not be able to obtain these licenses on commercially reasonable terms, if at all, and any licensed patents or intellectual property that we may obtain may not be valid or enforceable. In addition, the scope of intellectual property protection is subject to scrutiny and challenge by courts and other governmental bodies. Litigation and other proceedings concerning patents and proprietary technologies can be protracted, expensive and distracting to management and companies may sue competitors as a way of delaying the introduction of competitors’ products. Any litigation, including any interference proceedings to determine priority of inventions, oppositions to patents in foreign countries or litigation against our partners, may be costly and time-consuming and could significantly harm our business.

Because of the large number of patent filings in our industry, our competitors may have filed applications or been issued patents and may obtain additional patents and proprietary intellectual property rights relating to products or processes competitive with or similar to ours. We cannot be certain that United States or foreign patents do not exist or will not be issued that would harm our ability to commercialize our products and product candidates. In addition, our exposure to risks associated with the use of intellectual property may be increased as a result of an acquisition as we have lower visibility into any potential target’s safeguards and infringement risks. In addition, third party claims may be asserted after we have acquired technology that had not been asserted prior to such acquisition.

We require certain raw materials for our manufacturing processes that may only be acquired through limited sources.

Raw materials essential to our business are generally readily available. However, certain raw materials and components used in the manufacture of pharmaceutical and medical device products are available from limited sources, and in some cases, a single source. Any curtailment in the availability of such raw materials could be accompanied by production delays, and in the case of products, for which only one raw material supplier exists, could result in a material loss of sales. In addition, because raw material sources for products must generally be approved by regulatory authorities, changes in raw material suppliers could result in production delays, higher raw material costs and loss of sales and customers. Production delays may also be caused by the lack of secondary suppliers.

We have, in the past, received minor deficiencies from regulatory agencies related to our manufacturing facilities.

The FDA, Occupational Safety and Health Administration and other regulatory agencies periodically inspect our manufacturing facilities and certain facilities of our suppliers. In the past, such inspections resulted in the identification of certain minor deficiencies in the standards we are required to maintain by such regulatory agencies. We developed and implemented action plans to remedy the deficiencies; however, there can be no assurance that such deficiencies will be remedied to the satisfaction of the applicable regulatory body. In the event that we are unable to remedy such deficiencies, our product supply could be affected as a result of plant shutdown, product recall or other similar regulatory actions, which would likely have an adverse affect on our business, financial condition, and results of operation.

Trends, Risks and Uncertainties Related to Our Capital Stock

The Private Placements and other financing arrangements or corporate events could significantly dilute existing ownership.

The Senior Secured Convertible Notes bear interest, payable quarterly, at 7.0% per annum, but at our option, interest payments can be made at an 8.0% annual rate in shares of our common stock at a price equal to 90.0% of the average closing bid price of such common stock for the ten trading days immediately prior to the relevant interest payment date. We paid interest in kind with shares of our common stock in the second, third and fourth quarters of fiscal 2008 and in the first quarter of fiscal 2009, which resulted in the issuance of an additional 788,653 shares of our common stock. As discussed above, as of the date of this filing, we have not made the quarterly interest payments due April 30, 2009 and January 31, 2009 on the Senior Secured Convertible Notes.

If we choose to pay future interest on our Senior Secured Convertible Notes in kind or to raise additional funds through the issuance of shares of our common or preferred stock, or securities convertible into our common stock, significant dilution of ownership in our company may occur, and holders of such securities may have rights senior to those of the holders of our common stock. If we obtain additional financing by issuing debt securities, the terms of these securities could restrict or prevent us from paying dividends and could limit our flexibility in making business decisions. Moreover, other corporate events such as the exercise of outstanding options would result in further dilution of ownership for existing shareholders.

In the past, we have experienced volatility in the market price of our common stock and we may experience such volatility in the future.

The market price of our common stock has fluctuated significantly in the past. Stock markets have experienced extreme price volatility in recent years, especially in connection with the crisis currently impacting global credit and financial markets. This volatility has had a substantial effect on the market prices of securities we and other pharmaceutical and health care companies have issued, often for reasons unrelated to the operating performance of the specific companies.

In the past, stockholders of other companies have initiated securities class action litigation against such companies following periods of volatility in the market price of the applicable common stock. We anticipate that the market price of our common stock may continue to be volatile. If the market price of our common stock continues to fluctuate and our stockholders initiate this type of litigation, we could incur substantial costs and expenses and such litigation could divert our management’s attention and resources, regardless of the outcome, thereby adversely affecting our business, financial condition and results of operation.

We may take actions which could dilute current equity ownership or prevent or delay a change in our control.

Subject to the rules and regulations promulgated by NASDAQ and the SEC, our Board of Directors could authorize the sale and issuance of additional shares of common stock, which would have the effect of diluting the ownership interests of our stockholders. In addition, our Board of Directors has the authority, without any further vote by our stockholders, to issue up to 2,500,000 shares of Preferred Stock in one or more series and to determine the designations, powers, preferences and relative, participating, optional or other rights thereof, including without limitation, the dividend rate (and whether dividends are cumulative), conversion rights, voting rights, rights and terms of redemption, redemption price and liquidation preference. On February 1, 2001, we issued 100,000 shares of our Series B Convertible Preferred Stock in connection with an acquisition. As of April 30, 2009 and the date of this filing, all of these shares remained outstanding. If the Board of Directors authorizes the issuance of additional shares of Preferred Stock, such an issuance could have the effect of diluting the ownership interests of our common stockholders.

Failure to maintain NASDAQ Marketplace Rules could materially and adversely affect our business.

NASDAQ Marketplace Rule 4450(a)(5) requires us to maintain a closing bid price for our common stock of at least $1.00. On April 30, 2009 and as of the date of this filing, the closing bid price was less than $1.00. NASDAQ has suspended the enforcement of this rule through July 20, 2009. If, for 30 consecutive business days beginning July 20, 2009, the bid price of our common stock closes below $1.00 per share, NASDAQ will notify us of the non-compliance. In accordance with NASDAQ Marketplace Rule 4450(e)(2), we would be provided 180 calendar days to regain compliance. If we do not regain compliance during that period our stock may be delisted. In the event that our common stock is delisted from the NASDAQ Capital Market, our common stock would become significantly less liquid, which would adversely affect its value. Although our common stock would likely be traded over-the-counter or on pink sheets, these types of listings involve more risk and trade less frequently and in smaller volumes than securities traded on the NASDAQ Capital Market.

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

None

Item 3. Defaults Upon Senior Securities.

The quarterly interest payments due April 30, 2009 and January 31, 2009 on the Senior Secured Convertible Notes have not been made as of the date of this filing. The failures to make these payments are events of default under our Senior Secured Convertible Notes. Although we have not received a notice of default or acceleration from the note holders as of the date of this filing, which is required prior to any of the principal amount becoming due and payable as a result of such default, we have reclassified the Senior Secured Convertible Notes to current liabilities. Pursuant to the Note Purchase Agreement, the holders of the Senior Secured Convertible Notes have agreed not to exercise their remedies under such notes unless and until the Note Purchase Agreement is terminated. However, there can be no assurance that the current or future note holders will not accelerate amounts due under the Senior Secured Convertible Notes and proceed against their collateral. In the event of acceleration, we would likely be forced to file for protection under Chapter 11 of the Federal Bankruptcy Code or liquidate the Company under Chapter 7 of the Federal Bankruptcy Code. Also, upon an event of default, the Senior Secured Convertible Notes begin accruing interest at the default rate of 15%. As of April 30, 2009, there was approximately $0.7 million of unpaid accrued interest due the holders of the Senior Secured Convertible Notes. As of the date of this filing, the holders of the Senior Secured Convertible Notes may, at any time, demand $8.0 million as a result of the defaults discussed above.

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

None.

Item 5. Other Information.

On April 2, 2008, the Board of Directors of the Corporation approved a salary reduction program pursuant to which certain officers’ annual base salaries were reduced by 10%. On June 16, 2008, the Corporation’s management voluntarily agreed to further reduce their annual base salaries (which reductions have since been restored). On June 5, 2009, the Corporation reinstated the officers’ salaries to the amounts in effect prior to the April 2, 2008 reduction as set forth below:


		Base Salary		Base Salary
Name	Position	(Current)		(Reinstated)

David R. Bethune	Chairman and Chief Executive Officer	$	315,000	$	350,000
Gary V. Klinefelter	Vice President, General Counsel and Secretary		216,000		240,000
Diane E. Klein	Vice President of Finance and Treasurer		166,500		185,000

The salary changes described above became effective with the pay period that ended on June 5, 2009.

The following officers of the Corporation have entered into letter agreements with the Corporation (collectively, the “Employment Letters”) setting forth certain terms and conditions of their employment:


Name		Date of Employment Letter

David R. Bethune		May 9, 2008
Gary V. Klinefelter		March 30, 2007
Diane E. Klein		March 30, 2007

The Employment Letters provide that such officers are entitled to certain severance benefits if they are terminated by the Corporation, including in connection with a change of control of the Corporation. One June 9, 2009, the Corporation and each of the above officers executed Amendment Agreements to the Employment Letters (collectively, the “Amendment Agreements”) to provide that such officers will also be entitled to the severance benefits prescribed by their respective Employment Letters if they terminate their employment with the Corporation for “Good Reason” (defined as a material diminution in base salary or job responsibilities, a breach of the Employment Letter by the Corporation or a material change in the location at which they perform services).

In addition, Mr. Bethune’s Employment Letter provided that the term of such Employment Letter will end on the earlier of his departure from the Board of Directors or October 31, 2009. The Amendment Agreement to Mr. Bethune’s Employment Letter removes the termination provision (eliminating any specified term associated with Mr. Bethune’s employment as Chairman and Chief Executive Officer of the Corporation, consistent with the terms of the other Employment Letters).

Copies of the Amendment Agreements are filed as Exhibits 10.1, 10.2 and 10.3 and their contents are incorporated herein by this reference.

Item 6. Exhibits.


Exhibit
Number		Description

10.1		Amendment Agreement with David R. Bethune dated June 8, 2009

10.2		Amendment Agreement with Gary V. Klinefelter dated June 8, 2009

10.3		Amendment Agreement with Diane E. Klein dated June 8, 2009

31.1		Section 302 Certification of the Principal Executive Officer

31.2		Section 302 Certification of the Principal Financial Officer

32.1		Section 1350 Certification of the Principal Executive Officer and Principal Financial Officer

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.


Date: June 9, 2009	Zila, Inc.
	By:	/s/ DAVID R. BETHUNE
		David R. Bethune
		Chairman and Chief Executive Officer (Principal Executive Officer)



	By:	/s/ DIANE E. KLEIN
		Diane E. Klein
		Vice President — Finance and Treasurer (Principal Financial Officer)


Exhibit
Number		Description

10.1		Amendment Agreement with David R. Bethune dated June 9, 2009

10.2		Amendment Agreement with Gary V. Klinefelter dated June 9, 2009

10.3		Amendment Agreement with Diane E. Klein dated June 9, 2009

31.1		Section 302 Certification of the Principal Executive Officer

31.2		Section 302 Certification of the Principal Financial Officer

32.1		Section 1350 Certification of the Principal Executive Officer and Principal Financial Officer

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