ZILA Zila (MM)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

Form 10-K

 

 

Commission file number 0-17521

 

 

Registrant’s telephone number, including area code

(602) 266-6700

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No  þ

 

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

 

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

 

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

 

Large Accelerated Filer  o      Accelerated Filer  þ      Non-Accelerated Filer  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

 

At January 31, 2007, the end of our second fiscal quarter, the aggregate market value of common stock held by non-affiliates of the registrant was approximately $139.1 million based on the closing price of $2.26 as reported on the Nasdaq Global Market. Shares of common stock known to be owned by directors and executive officers of the registrant subject to Section 16 of the Securities Exchange Act of 1934 are not included in the computation. No determination has been made that such persons are “affiliates” within the meaning of Rule 12b-2 under the Exchange Act. At September 30, 2007, the number of shares of common stock outstanding was 62,508,711.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information contained in the registrant’s definitive proxy statement for the annual meeting of shareholders to be held on December 13, 2007 has been incorporated by reference into Part III, Items 10, 11, 12, 13 and 14.

 

 

TABLE OF CONTENTS

 

 

PART I

 

cash contingent upon the performance of the divested division during the one-year period after the closing. The sale resulted in a pre-tax gain of $11.0 million. Under the stock purchase agreement, we agreed to indemnify NBTY, Inc. for a number of matters, including the breach of our representations, warranties and covenants contained in the stock purchase agreement, in some cases until the expiration of the statute of limitations applicable to claims related to such breaches.

 

Private Placements

 

During November 2006, we completed private placements of our securities for gross proceeds of $40.0 million, consisting of $15.9 million of common stock, convertible debt instruments including $12.1 million of Unsecured Notes and $12.0 million of Secured Notes, and warrants, to selected accredited investors (collectively, the “Private Placements”). The proceeds of the Private Placements were used to complete the Pro-Dentec acquisition and to augment existing working capital. We granted registration rights for the common shares and common shares issuable upon conversion of the debt instruments and exercise of the warrants.

 

As more fully described elsewhere in this filing, a dispute arose with certain investors regarding the extent of the registration rights. Separately, the Secured Notes contained financial and non-financial covenants from which Zila desired relief. On August 13, 2007, subsequent to our fiscal year-end, we entered into an Amendment Agreement with certain of these investors to restructure their holdings, modify the registration rights granted to these investors and, with respect to the investors in the secured notes, provide relief from certain financial and non-financial covenants. We believe that the restructuring strengthens our financial position by reducing the minimum cash and EBITDA covenants and allowing future interest to be paid in kind with common stock.

 

The Amended and Restated Secured Notes are in the same aggregate principal amount as the original Secured Notes, but are now 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 10 trading days immediately prior to the relevant interest payment date. The required cash balance was reduced from $10.5 million to $2.0 million commencing July 31, 2007 and EBITDA of at least $1.00 is required for each of the fiscal quarters ending July 31, 2008 and October 31, 2008. As part of this agreement, we also (i) repurchased 932,832 common shares from the investors for $1.25 million in cash, (ii) repurchased 227,270 warrants from the investors for $0.15 million in cash and (iii) paid the investors a $0.6 million fee.

 

Additional information concerning the Private Placements and the subsequent restructuring can be found elsewhere in this filing and also in our Definitive Proxy Statement on Schedule 14A, which was filed with the Securities and Exchange Commission (“SEC”) on November 24, 2006.

 

OraTest ^® Strategic Direction

 

In December 2005, we reached an agreement with the Food and Drug Administration (“FDA”) on the design and size of a phase III clinical trial for OraTest ^® under the FDA’s special protocol assessment process and commenced patient enrollment. The agreement was limited to the ZIL-401 clinical trial and did not include non-clinical and Chemistry, Manufacturing and Control (“CMC”) issues.

 

Enrollment in ZIL-401 was open for approximately 22 months, through October 5, 2007. The clinical trial was designed to provide support for safety and efficacy in the OraTest ^® new drug application (“NDA”) and to assess the efficacy of OraTest ^® in staining cancerous and pre-cancerous oral lesions in a population of tobacco users and/or alcohol drinkers, ages 45 and older. The demonstration of efficacy in the clinical trial is based upon the achievement of a predetermined number of differences in diagnoses between the standard visual exam and the OraTest ^® exam.

 

Patient data for the ZIL-401 trial continues to be monitored by an independent organization to determine if the number of differences required to trigger analysis has been achieved. The results will be available to us in the coming months, but at this time there can be no assurance that the endpoint requirement necessary for trial completion has been, or will be, achieved.

 

As with any drug development program, the length of the FDA regulatory process and review period varies considerably, as does the amount of data required to demonstrate the safety and efficacy of a specific product. In

addition, delays or rejections may be encountered based upon changes in FDA policy, personnel or prior understandings during the period of product development and FDA regulatory review or each new drug application. Even if FDA approval of a drug application is received, such approval may entail limitations on the indicated uses for which the product may be marketed and there is no assurance that the product would be successful in gaining market acceptance.

 

As previously reported, we recently conducted a comprehensive review of all aspects of the OraTest ^® program. The review included its history, present status and future prospects, including the regulatory path to approval of OraTest ^® with the FDA and its post-approval commercial potential and challenges. We also considered the growing market acceptance for its adjunctive oral cancer screening product, ViziLite Plus with T-Blue ^{630 tm} , and the fact that we currently have toluidine blue on the market today in the T-Blue ^{630 tm} marker. Finally, we considered the fact that we have regulatory approval to sell OraTest ^® in a number of international markets today including the United Kingdom, Australia, Belgium, Holland, Luxembourg, Finland, Greece, Portugal, Bermuda and the Bahamas, none of which require FDA approval.

 

Following completion of the review and analysis described above, we determined that successfully resolving the outstanding CMC and non-clinical issues will require substantial additional time and funding, both of which exceed our previous estimates. Further, we believe that at least one additional clinical trial will be required, and even if the endpoint is met on the ZIL-401 study, no assurance can be made that the FDA would view the study data and other additional submissions as sufficient to support the approval of the NDA.

 

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. Our analysis concluded that the incremental market potential of OraTest ^® , considering the availability of ViziLite ^® Plus, does not justify the cost, time and uncertain study outcomes associated with continuing the program in its current form.

 

Also as previously reported, we have initiated the process of seeking a partner in an effort to realize the value of the ZTC ^tm platform. ZTC ^tm , the active staining component in OraTest ^® , may have additional applications, including the detection of high-risk lesions of the cervix, esophagus and skin. We believe that the potential of these additional therapeutic applications could appeal to a partner.

 

Finally , we are taking the steps necessary to capture, secure and analyze the clinical and program data obtained to date, which we intend to use to support the growth of the ViziLite ^® Plus program. We conducted an “impairment” analysis regarding the OraTest ^® asset and concluded that based upon future sales of toluidine blue in connection with ViziLite ^® Plus and OraTest ^® international sales, no impairment of the OraTest ^® asset is required by generally accepted accounting principles.

 

Our Products

 

Currently, our product portfolio is centered primarily on two key oral disease therapeutic areas: oral cancer and periodontal disease. With the ongoing aging of the population, we believe that we are well-positioned to take advantage of the growing need for screening and treatment of an increased risk population for these diseases, which tend to be associated with patients who are above the age of 40 years old.

 

ViziLite ^® Plus

 

ViziLite ^® Plus with TBlue ^{630 tm} is a patented, FDA-cleared oral lesion identification and marking system that is used as an adjunct to the conventional head and neck examination. It consists of a chemiluminescent light source (ViziLite ^® ) to improve the identification of lesions and TBlue ^{630 tm} , the oral lesion marking system, to mark those lesions differentially identified by ViziLite ^® . ViziLite ^® Plus with TBlue ^{630 tm} is designed to be used in a patient population at increased risk for oral cancer.

 

In clinical trials involving more than 13,000 female patients, abnormal squamous epithelium in the cervical complex appears acetowhite after washing the cervix with a dilute acetic acid solution. Similarly in the oral cavity, after rinsing with a dilute acetic acid solution, abnormal squamous epithelium tissue appears acetowhite when viewed under the diffuse low-energy wavelength light of ViziLite ^® due to reflectance. Normal epithelium absorbs the light. ViziLite ^® can assist a dentist or hygienist in identifying an abnormality in the oral cavity for further

evaluation and follow-up. The efficacy of ViziLite ^® has been proven in four (4) Zila-sponsored clinical trials in the United States and numerous studies independently performed at academic institutions throughout the world. ViziLite consistently demonstrates a high degree of sensitivity in the identification of pathological lesions in both high risk and general screening populations. These studies demonstrate that ViziLite ^® can assist a dentist or hygienist in identifying an abnormality in the oral cavity for further evaluation and follow-up.

 

TBlue ^{630 tm} is a patented, pharmaceutical-grade toluidine blue-based metachromatic dye used to further evaluate and closely monitor changes in ViziLite ^® -identified lesions. TBlue ^{630 tm} , packaged in an easy to use 3-swab system, provides a deep blue staining that allows ViziLite ^® -identified lesions to be seen clearly under normal patient lighting. ViziLite ^® Plus is recommended for use annually for all new and re-care adult dental patients following the standard head and neck exam. We believe that patients with a history of oral cancer should receive at least semi-annual ViziLite ^® Plus exams. We developed and use the term Lumenoscopy ^tm to describe the examination conducted with ViziLite ^® Plus.

 

Rota-dent One Step ^® With MicroAccess Flossing Action ^tm

 

The Rota-dent One Step ^® With MicroAccess Flossing Action ^tm (“Rota-dent ^® ”) is a proprietary, patented, rotary-action, plaque removal and teeth cleaning device dispensed by dental professionals to patients for use at home between dental office visits. The Rota-dent ^® is a rechargeable, power assisted instrument that is designed using a Lexan ^tm (by General Electric) water-resistant power handle that accepts interchangeable heads and uniquely designed patented brush tips. The product utilizes a cleaning action similar to that of the rotary instruments used by dentists and hygienists to professionally clean teeth in the dental office. Each Rota-dent ^® has two interchangeable heads so that different persons can economically and hygienically use the same power handle. Replacement interchangeable heads and brush tips are available through dental offices and from our customer service department by telephone. Each of the patented interchangeable brush tips is comprised of a bundle of microfilaments that create more than 90,000 cleaning sweeps per second and, when compared to conventional toothbrush bristles, are less abrasive to tooth enamel and gingival tissue (gums). The tips are soft, safe and durable. The small size of the filaments and brush tips enables the user to reach areas of the mouth that conventional toothbrushes generally cannot reach effectively. The Rota-dent ^® has been demonstrated to reduce plaque by 92% in just one minute, which is twice as fast as a manual brush.

 

The effectiveness of the Rota-dent ^® results from its ability to remove dental plaque. Plaque is a thin filmy substance that continually forms in the mouth due to bacterial activity and, if allowed to remain, hardens on teeth as calculus or tartar. Unless removed daily, plaque deposits can cause inflammation and gingivitis and can ultimately lead to more severe periodontal disease, which is now a leading cause of tooth loss in the United States. Numerous clinical trials conducted at major university dental schools have shown the Rota-dent ^® to be more effective than manual tooth brushing for removing plaque and controlling gingivitis. Two one-year clinical trials published in a leading refereed periodontal research journal have shown that the Rota-dent ^® is as effective in removing plaque, controlling gingivitis and reducing the bacteria that cause periodontal disease as using a combination of dental floss, an interspace brush, toothpicks and a conventional toothbrush.

 

The Rota-dent ^® is engineered to be especially effective for plaque removal from the area at or just below the gumline and between the teeth, the most critical areas for cleaning to prevent periodontal disease. Many dentists and hygienists recommend the use of the Rota-dent ^® for applying antimicrobials and other medications to tooth surfaces and gums. A study at the Harvard School of Dental Medicine, jointly sponsored with Procter & Gamble, concluded that the effect of the leading antimicrobial, chlorahexidine gluconate, is significantly enhanced when applied with the Rota-dent ^® .

 

Pro-Select ^® Platinum ^tm Piezo-Ultrasonic Scaler System

 

Pro-Select ^® Platinum ^tm Piezo-Ultrasonic Scaler System (“Pro-Select ^® ”) with Advanced Comfort Technology ^tm is an ultrasonic instrument used by dentists and dental hygienists for the therapeutic removal of hardened deposits from both the anatomic crown and root surfaces of the tooth. The Pro-Select ^® is a scaler that combines computerized piezo-ultrasonic technology with a closed, multi-fluid, heated irrigation system that effectively delivers purified water, antimicrobials, disinfectants and desensitizing solutions to the teeth and gums during and

after scaling or root planning procedures. Our proprietary piezo-ultrasonic technology provides faster, linear tip movement, which adjusts to deliver optimal speed for the clinical condition and we believe results in maximum patient and operator comfort and may eliminate the need for anesthesia for most patients.

 

Dental Fluoride Products

 

We manufacture and market a full line of topically applied dental fluoride products, including rinses and gels. The line consists of products applied in the office by dental professionals as well as products utilized at home by patients between office visits. The effectiveness of fluoride for fighting tooth decay is widely recognized. Fluoride is also extensively used by dental professionals to destroy the bacteria associated with periodontal disease, as well as to reduce the sensitivity of exposed roots due to soft tissue loss from periodontal disease and/or periodontal surgery. We believe that our fluoride product line is now the broadest-based and most complete product line available in dentistry.

 

Other Oral Pharmaceutical Products

 

In addition to the above products, we manufacture and market a full line of oral rinse, gels, dentifrice and oral care accessories for use in the office by dental professionals as well as products used at home by patients between office visits.

 

OraTest ^®

 

ZTC ^tm , a patented form of pharmaceutical grade toluidine blue, is the active staining component in OraTest ^® . In clinical studies, ZTC ^tm has demonstrated preferential staining of oral cancers and lesions with a high risk of progressing to cancer. The potential applications for ZTC ^tm may include detecting high-risk lesions of the cervix, esophagus and skin as well as oral cancer, for which OraTest ^® is currently designed. The product is approved for distribution in the United Kingdom, Australia, Belgium, Holland, Luxembourg, Finland, Greece, Portugal, Bermuda and the Bahamas.

 

The OraTest ^® product is a patented system designed to be an aid in the early detection of oral squamous cell carcinoma and high-risk premalignancies. It is to be used as a diagnostic adjunct for oral cancer and may be used as a general rinse for detecting oral cancer and high-grade pre-malignancies in patients at elevated risk for oral cancer and as an aid to establish borders for biopsy and surgical site selection. OraTest ^® contains the active ingredient ZTC ^tm , a staining agent reported in medical literature to stain cells within the mouth that are cancer and pre-cancer and that may not be otherwise visible to physicians or dentists. The OraTest ^® kit consists of a ZTC ^tm aqueous solution with acetic acid and alcohol, and acetic acid pre- and post-rinse solutions. The OraTest ^® kit is applied as a chair-side oral rinse and swab and administered by either a medical practitioner or dentist. Clinical research has shown that OraTest ^® may detect lesions on the progression pathway to oral cancer, which are diagnosed as non-serious pathology under the microscope.

 

Sales and Marketing

 

During fiscal 2007, with the acquisition of Pro-Dentec and the disposition of non-core lines of business, we completed our transition to a company focused on the prevention, early detection and treatment of oral disease, with a principal emphasis in oral cancer. We sell our products directly to dental offices through our national sales force. Our national marketing programs reach most of the nation’s dental offices and include continuing education seminars that dentists and their staffs pay to attend. Pro-Dentec is certified by the American Dental Association and the Academy of General Dentistry to provide continuing education seminars. We believe that these seminars are ideally suited to educate a large number of dental professionals on the importance of oral cancer screening and periodontal health.

 

In order to achieve the vision of establishing ViziLite ^® Plus with TBlue ^{630 tm} as the key to an enhanced standard of care for oral abnormality screening, our overall strategy is to educate the dental professional and widen distribution among practicing dentists. Through our national sales force and the selective use of national and

regional distributors, we have focused on geographical markets that have demonstrated early acceptance. Market expansion is primarily generated by the following drivers:

 

 

We also believe that the market for our entire line of products is expanding, attributable in part to a shift in focus by the general dentist from the treatment of tooth decay to greater emphasis on the prevention, early detection and treatment of oral disease. The expanding market is also attributable to the aging population, which puts these consumers at increased risk for both oral cancer and periodontitis. Our products specifically address the need for early diagnosis of oral abnormalities and the diagnosis, treatment and prevention of periodontal disease.

 

These trends, coupled with the increasing awareness of the importance of oral health and the need for improved technology for the prevention, early detection and treatment of oral disease among consumers and dental professionals alike, should lead to an expanding marketplace for our products. With this increased professional and consumer awareness, we believe that we are positioned to benefit from both demographic trends and the overall shift in the healthcare focus towards prevention and wellness.

 

We expect continued expansion of our professional field sales force during the coming fiscal year. The focus of this expansion is to provide greater territorial coverage, which management believes is the most effective way to increase the awareness and penetration of our products in dental offices across the nation. Customers in geographic areas not covered by a field sales representative are served by a network of experienced call-center account executives.

 

We currently sell the OraTest ^® product through our wholly-owned subsidiary, Zila Limited, in the United Kingdom. During fiscal 2003, we suspended promotion of the product in Europe in favor of funding the FDA clinical trial. On July 1, 2004, we entered into an agreement with Scope Advertising and Marketing Services, Ltd. for limited European marketing and sales support of the OraTest ^® product and development and implementation of marketing plans for ViziLite ^® . During fiscal 2007 and 2006, OraTest ^® sales in the United Kingdom were nominal.

 

Manufacturing and Supply

 

The ViziLite ^® Plus product consists of a number of components produced and assembled by our manufacturing facility in Phoenix, Arizona and by different contract manufacturers under our direction and control. For some components, we currently rely on a single source of supply.

 

A contract manufacturing facility in the United Kingdom produces and packages the OraTest ^® product in conformance with applicable quality standards for sale in the United Kingdom and other European countries. In order to ensure an available and stable supply of ZTC ^tm , the active pharmaceutical ingredient in the OraTest ^® product, we established our own manufacturing facility in Phoenix, Arizona. This facility manufactures ZTC ^tm under our quality standards and the FDA’s current Good Manufacturing Practices (“cGMP”) standards, providing the pharmaceutical-grade quality required. Conversion of ZTC ^tm into finished product for use in our clinical trials is accomplished at a contract manufacturing facility in the United States under Zila’s specifications and cGMP standards, as outlined in the “Code of Federal Regulations”, and FDA requirements for production of finished, pharmaceutical, clinical trial materials (“CTM”).

 

At our facilities in Batesville, Arkansas, we develop and manufacture our Rota-dent ^® , Pro-Select ^® , dental fluoride and other oral pharmaceutical products. At these facilities, we engineer and own computer-driven, automated, and patented brush machines, tooling and equipment for manufacturing high precision metal parts,

injection molding machines and multi-cavity injection molds for precision plastic parts, equipment for compounding mixing and filling liquids pastes and gels, as well as other manufacturing and assembly equipment.

 

There are generally alternate sources of supply for key components and materials used in the manufacturing process. We are not dependent upon a single supplier for these components or types of materials for our products, with the exception of our chlorhexidine gluconate periodontal rinse, which has a single source of supply. A local vendor in Batesville, Arkansas molds certain of our probe products using tooling that we designed and own. These probes are made from materials readily available from multiple sources.

 

Competition

 

All of the industries in which we sell our products are highly competitive. A number of companies, many of which have greater financial resources, marketing capabilities and research and development capacities than we have, are actively engaged in the development of products that may compete with our products. The pharmaceutical industry is characterized by extensive and ongoing research efforts that may result in development by other companies of products comparable or superior to any that are now on the market, including those that we sell.

 

ViziLite ^® Plus

 

ViziLite ^® Plus oral lesion identification and marking system with TBlue ^{630 tm} is a patented, FDA-cleared device used to detect oral mucosal abnormalities. ViziLite ^® Plus competes with the conventional method of simple visual and tactile testing for abnormalities that has previously been the only available methodology for identifying lesions. While there are other technologies that claim utility as general screening tools, ViziLite ^® Plus is still the only technology that has been validated in numerous single-center and multi-center studies evaluating general screening populations.

 

Rota-dent ^®

 

The marketplace for home use oral hygiene devices is highly competitive. We compete with many different manufacturers of manual and electrically powered tooth cleaning devices, including electric toothbrushes such as the Interplak (by Conair), the Braun Oral-B (by Gillette) and the Sonicare (by Optiva Corporation). These competitors are larger and use a wider variety of distribution methods than we do. We successfully compete with these companies using a niche market strategy and based on favorable long-term clinical studies, product design, product quality and responsive service to both professionals and consumers. We primarily focus on a professional distribution system. Thus, we have invested in clinical trials and in efforts to demonstrate to dentists and hygienists the advantages of dispensing the Rota-dent ^® product from their dental offices as part of their plaque control programs and the other professional services they offer, including implant maintenance, orthodontic appliances, the maintenance of cosmetic restorations, post-surgical maintenance of periodontal cases and general preventive oral hygiene.

 

Pro-Select ^®

 

The Pro-Select ^® competes with products of several other companies that manufacture, market and sell electronically powered dental scaling equipment. We seek to compete with other manufacturers based on direct distribution to an established network of dental practitioners, and through the effectiveness and comfort of the Pro-Select ^® for both the patient and clinician.

 

Dental Fluorides and Other Oral Pharmaceutical Products

 

Our fluoride dental products, periodontal probes and our oral rinses, gels, dentifrices and oral care accessories, compete with products of several other companies that manufacture, market, and distribute these types of products to dentists. The market for dental pharmaceuticals is fragmented, with no one company controlling or dominating. We compete in this market by selling directly through our professional representatives, based on quality, breadth of offering and the price of our products. We believe dental offices recognize the ability to purchase fluorides, prophylaxis paste, manual and powered toothbrushes and other dental products from a single supplier as a

convenience. We believe we have an advantage over other companies to the extent we offer a complete line of such products that reduces the number of suppliers with which each dental office must deal.

 

Licensing

 

OraTest ^®

 

We have entered into agreements for the manufacture, marketing and distribution of our OraTest ^® products in several foreign countries. These arrangements are currently inactive. Royalty payments would be required should sales of the OraTest ^® product commence in the foreign countries covered by these arrangements.

 

Governmental Regulation

 

General

 

Our operations are subject to regulation by governmental authorities in the United States and other countries with respect to the testing, approval, manufacture, labeling, marketing, distribution and sale of our products. We devote significant time, effort and expense addressing the extensive government regulations applicable to our business. On an ongoing basis, the FDA reviews the safety and efficacy of marketed pharmaceutical products and monitors labeling, advertising and other matters related to the promotion of pharmaceutical products.

 

The FDA also regulates the facilities and procedures used to manufacture pharmaceutical products in the United States and the sale of such products in the United States. Such facilities must be registered with the FDA and all products made in such facilities must be manufactured in accordance with cGMP’s. Compliance with cGMP’s requires the dedication of substantial resources and requires significant costs. The FDA periodically inspects both our manufacturing facilities and our contract manufacturing plants and laboratories to review compliance with applicable regulations and procedures. The FDA may recommend a recall or withdraw product approvals if regulatory standards are not maintained. FDA approval to manufacture a drug is site specific. If an approved manufacturing facility for a particular drug becomes inoperable, obtaining the required FDA approval to manufacture such drug at a different manufacturing site could result in production delays, which could adversely affect our business and results of operations.

 

In connection with our activities outside the United States, we are also subject to regulatory requirements governing the testing, approval, manufacture, labeling, marketing, distribution and sale of our products, which requirements vary from country to country. Whether or not FDA approval has been obtained for a product, approval of the product by comparable regulatory authorities of foreign countries may need to be obtained prior to marketing the product in those respective countries. The approval process may be more or less rigorous from country to country, and the time required for approval may be longer or shorter than that required in the United States. No assurance can be given that any clinical studies conducted outside of any country will be accepted by such country and the approval of any product in one country does not assure that such product will be approved in another country.

 

We are also subject to worldwide governmental regulations and controls relating to product safety, efficacy, packaging, labeling and distribution. While not all of the products that we plan to introduce into the market are “new drugs” or “new devices,” those fitting the regulatory definitions are subject to a stringent pre-market approval process in most countries. Submission of a substantial amount of preclinical and clinical information prior to market introduction significantly increases the amount of time and related costs incurred for preparing such products for market.

 

Several of our dental products, such as ViziLite ^® Plus, the Rota-dent ^® , the Pro-Select ^® , and fluoride products are subject to regulation by the FDA and, in some instances, by foreign governments. Under the 1976 Amendments to the Federal Food, Drug and Cosmetic Act, as amended (the “Act”), and the regulations promulgated thereunder, the manufacturers of “devices,” as such term is defined in Section 201(h) of the Act, must comply with certain controls that regulate the testing, manufacturing, packaging and marketing of devices. Under the Act, devices are subject to different levels of approval requirements, the most comprehensive of which requires that a clinical evaluation program be conducted before a device receives pre-market approval by the FDA for commercial distribution. Our products are “Class II” products under this classification system and did not require such clinical

evaluation. We have complied with the FDA’s applicable qualification procedures for all such products. The Rota-dent ^® also bears the CE Mark, permitting it to be sold within the European Union. We anticipate that other products will be certified for the CE Mark in the future. Device manufacturing facilities in Batesville, Arkansas are ISO 13485:2003 certified.

 

Manufacturing companies, especially those engaged in healthcare related fields, are subject to a wide range of laws and regulations. Concern for maintaining compliance with federal, state, local and foreign laws and regulations on environmental protection, hazardous waste management, occupational safety and industrial hygiene has also increased substantially. We cannot predict what additional legislation or governmental action, if any, will be enacted or taken with respect to the above matters and what its effect, if any, will be on our consolidated financial position, results of operations or cash flows.

 

ViziLite ^® Plus

 

In January 2005, the Food and Drug Administration cleared the product, ViziLite ^® Blue Oral Exam Kit (ViziLite ^® Plus), that contains the ViziLite ^® chemiluminescent device to identify abnormalities in the oral mucosa and the TBlue ^{630 tm} marking device, an adjunct to ViziLite ^® . TBlue ^{630 tm} is used to further evaluate and monitor lesions by providing physical marking of the lesions already differentially identified by ViziLite ^® for patients at increased risk for oral cancer. We introduced our ViziLite ^® Plus product at the October 2005 annual meeting of the American Dental Association and commenced sales of ViziLite ^® Plus in our second fiscal quarter 2006.

 

OraTest ^®

 

We have received regulatory approval to market the OraTest ^® product in various European countries. We currently sell the OraTest ^® product through our wholly-owned subsidiary, Zila Limited, in the United Kingdom.

 

Patents and Trademarks

 

ViziLite ^® Plus with TBlue ^{630 tm}

 

In February 2006, we acquired from Shared Medical Resources, LLC all of the rights, titles and interests in the ViziLite ^® technology including patent number 6,496,718 issued December 17, 2002 for “Body Cavity Light using Diffuse Light Source.” We previously had a license agreement for the exclusive and perpetual rights to the ViziLite ^® technology covered by United States patent numbers 8,179,938 and 5,329,938 issued January 19, 1993 and July 19, 1994, respectively. Together, the patents cover the apparatus and method for endoscopic examination of certain body cavities using a chemiluminescent light source.

 

The ViziLite ^® trademark was granted registration by the USPTO in December 2002 and by the European Union in June 2003, and by five Asian countries. Applications for this and related marks, including TBlue ^tm and TBlue ^{630 tm} , are pending in the United States and 11 additional countries. We coined the term Lumenoscopy ^tm to describe examination of the oral cavity using ViziLite ^® Plus and filed a United States application for its registration.

 

On September 30, 2004, we filed an International application for a technology covering the use of the ViziLite ^® Plus chemiluminescent technology entitled “Light-Directed Method for Detecting and Aiding Further Evaluation of Abnormal Mucosal Tissue”. We also filed National applications in 13 countries, including the United States, Canada and several European countries.

 

On September 28, 2004, we filed an International application covering the use of a wavelength specific lens with the ViziLite ^® chemiluminescent technology entitled “Methods for Detecting Abnormal Epithelial Tissue.” We also filed National applications in 15 countries, including the United States, Canada and several European countries.

 

In 2006, we filed a U.S. patent application entitled “Method And Apparatus For Detecting Abnormal Epithelial Tissue” directed to an improved retractor. An international application is pending, along with three additional foreign applications for this technology.

 

We are developing improvements to our ViziLite ^® technology and expect to seek patent protection for such improvements as is appropriate for our business goals. In addition, we are prepared to assert our trademark, trade

dress and copyright rights to the ViziLite ^® products and packaging, as is necessary, to protect the ViziLite ^® brand. With respect to our ViziLite ^® related patents, to the extent any infringement of the patents began before they expired, we intend to aggressively protect our patent rights.

 

Rota-dent ^® Professional Powered Brush

 

In November 2006, we acquired Pro-Dentec, whose products include the Rota-Dent ^® powered toothbrush. Pro-Dentec owns fifteen issued United States patents covering the Rota-dent ^® design and technology with expiration dates ranging from 2008 to 2019. Twelve foreign patents have also been issued in Canada, several European countries and Hong Kong related to this technology.

 

The Rota-Dent ^® trademark and related trademarks are registered in the United States and 23 foreign countries, including Canada and several European countries.

 

Pro-Select ^® Dental Scaler and Other Dental Products

 

Pro-Dentec also holds one United States patent covering the Pro-Select ^® dental scaler technology expiring in 2017 and six United States patents covering other assorted dental products (i.e. toothpick, dental probes, etc). Twenty-three foreign patents have also been issued in Canada and several European countries related to these products.

 

The Pro-Select ^® trademark and related trademarks are registered in the United States, Canada and several European countries.

 

OraTest ^®

 

When we purchased the shares of CTM Associates, Inc. (“CTM”) in June 1996, we acquired certain technology rights and United States and foreign patent rights related to the OraTest ^® product. On November 18, 2003, we were granted a patent in the United States covering the method by which our ZTC ^tm has been shown to detect pre-cancer and cancer cells. The patent is based upon in-vitro studies of the ZTC ^tm mechanism of action. In December 2004, we were granted a patent in the United States covering all related substances/“impurities” present in ZTC ^tm at levels equal to or greater than 0.1%. We now have 10 issued United States patents related to ZTC ^tm and/or the OraTest ^® product with expiration dates ranging from 2011 to 2020. An additional 113 corresponding foreign patents have been issued, and there are pending United States and international applications that could result in coverage of ZTC ^tm and/or OraTest ^® related technology by approximately 280 United States and foreign patents. These patents and pending applications cover: (i) the composition of matter for ZTC ^tm ; (ii) the process for manufacturing ZTC ^tm ; (iii) the mechanism of action, methods and products for using ZTC ^tm to detect epithelial cancer; and (iv) other compounds that are chemically related to Tolonium Chloride for use in detecting epithelial cancer.

 

In 2007, we filed a U.S. patent application entitled “Oral Cancer Markers and Their Detection.”

 

The OraTest ^® trademark is registered in the United States, Canada, Israel, Japan, Norway, Switzerland, South Africa, Taiwan and 15 European countries that have signed the European Community Trademark treaty. Applications are pending in five additional countries. The trademark OraScreen ^® is registered in Australia, Canada, Ireland, Japan and New Zealand for the same product.

 

Employees

 

As of July 31, 2007, we had a total of 416 employees located in the United States (411) and Canada (5). No employees are represented by a labor union. We believe our relationship with our employees is good.

 

Available Information

 

We file annual, quarterly and current reports, proxy statements and other documents with the SEC under the Securities Exchange Act of 1934, as amended. The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may

obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet web site that contains reports, proxy and information statements, and other information regarding issuers, including Zila, Inc., that file electronically with the SEC. The public can obtain any documents that we file with the SEC at www.sec.gov.

 

We make available free of charge through our internet web-site, www.zila.com, our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act as well as Section 16 reports on Forms 3, 4 and 5, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

 

Forward-looking Statements

 

This annual report on Form 10-K contains forward-looking statements (including financial projections) regarding future events and our future results that are within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which we believe are subject to the safe harbors created under the Securities Act and the Exchange Act. Forward-looking statements are often identified by words such as “believe,” “anticipate,” “expect,” “estimate,” “intend,” “plan,” “project,” “will,” “may” and variations of such words and similar expressions. In addition, any statements that refer to expectations, projections, plans, objectives, goals, strategies or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements speak only as of the date of this filing and we do not undertake any obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise, even if experience or future events make it clear that any expected results expressed or implied by these forward-looking statements will not be realized. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we caution you that these expectations or predictions may not prove to be correct or we may not achieve the financial results, savings or other benefits anticipated in the forward-looking statements. These forward-looking statements are necessarily estimates reflecting the best judgment of our senior management and involve a number of risks and uncertainties, some of which may be beyond our control that could cause actual results to differ materially from those suggested by the forward-looking statements. Many of the factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements are set forth below under “Part I, Item 1A. Risk Factors.” Our business, financial condition or results of operations could also be materially and adversely affected by other factors besides those listed here. However, these are the risks our management currently believes are material.

 

 

The statements in this section describe the major risks to our business and should be considered carefully. If any of the following risks actually occur, they may materially harm our business, financial condition, operating results or cash flow. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. 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.

 

Trends, Risks and Uncertainties Related to Our Business

 

We may be unable to obtain FDA or other regulatory approval for new drugs, devices or products or to establish markets in the United States and obtaining regulatory approval is costly and uncertain.

 

The rigorous clinical testing and extensive regulatory approval process mandated by the FDA and equivalent foreign authorities before any new drug, device or product can be marketed can take a number of years, require the expenditure of substantial resources, and approval may not ultimately be obtained.

 

If FDA approval of a new product is received, such approval may entail limitations on the indicated uses for which the product may be marketed and there is no assurance that we will be successful in gaining market acceptance of that product. Moreover, a marketed product, its manufacturer, its manufacturing facilities, and its

suppliers are also subject to continual review and periodic inspections, and later discovery of previously unknown problems, or the exacerbation of problems previously deemed acceptable, with a product, manufacturer, or facility may result in restrictions on such product or manufacturer, potentially including withdrawal of the product from the market, which would adversely affect our operations and financial condition. The length of the FDA regulatory process and review period varies considerably, as does the amount of data required to demonstrate the safety and efficacy of a specific product. If the compounds in testing are modified or optimized or if certain results are obtained, it may extend the testing process. Additional testing, delays or rejections may be encountered based upon changes in FDA policy, personal or prior understandings during the period of product development and FDA regulatory review of each investigational new drug application, new drug application, or product license application. Similar delays may also be encountered in other countries. There can be no assurance that even after such time and expenditures we will obtain regulatory approval for any products we develop.

 

In its regulation of advertising, the FDA from time to time issues correspondence to pharmaceutical companies alleging that some advertising or promotional practices are false, misleading or deceptive. The FDA has the power to impose a wide array of sanctions on companies for such advertising practices, and the receipt of correspondence from the FDA alleging these practices can result in the following:

 

 

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.

 

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 future strategic initiatives. In the past, we have met these cash requirements through our cash and cash equivalents, borrowings under our credit facility, cash from operations and working capital management, the sale of non-core assets, proceeds from the issuance of common stock under our employee stock option and stock purchase programs, and, recently, proceeds from the Private Placements.

 

The development of products, such as OraTest ^® , 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 the 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.

 

After an evaluation of our strategic direction, including an assessment of the OraTest ^® regulatory program, 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 ability to develop and commercialize our oral cancer screening product, ViziLite ^® Plus. Our analysis concluded that the incremental market potential of OraTest ^® , considering the availability of ViziLite ^® Plus, does not justify the cost, time and uncertain study outcomes associated with continuing the program in its current form. We believe that the ZTC ^® platform may have additional therapeutic applications and that these therapeutic applications could appeal to a partner. We have therefore initiated the process of seeking a partner in an effort to realize the value of the ZTC ^® platform. (For further discussion, see Item 1. Business — Recent Developments.)

We anticipate that we will be able to pursue our strategy with our currently available funds through (i) the anticipated growth in our commercial business; (ii) cost reductions in research and development expenditures on the OraTest ^® regulatory program; and (iii) reduced overhead from our actions to reorganize and streamline our operations. We, therefore, believe that our cash and cash equivalents along with cash flows generated from operations and working capital management will allow us to fund our planned operations over the next 12 months. However, there can be no assurance that we will be successful in executing these strategies. If we are unable to execute these strategies, we may break the financial covenants of our senior secured debt and be unable to repay the outstanding balance of such debt.

 

In addition, our lack of earnings history and our level of debt could have important consequences, such as:

 

 

Our debt instruments contain restrictive covenants that could adversely affect our business by limiting our flexibility.

 

Our Amended and Restated Secured 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 Amended and Restated Secured Notes also require us to maintain defined levels of cash and EBITDA, defined as earnings (loss) before interest, taxes (benefit), depreciation and amortization. Our ability to comply with these covenants and restrictions may be affected by events beyond our control. If we are unable to comply with the terms of our Secured Notes, or if we fail to generate sufficient cash flow from operations to service our debt, we may be required to refinance all or a portion of our indebtedness or to obtain additional financing. If cash flow is insufficient and refinancing or additional financing is unavailable because of our high levels of debt and the debt incurrence restrictions under our debt instruments, 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.

 

We may fail to realize the anticipated cost savings, revenue enhancements, product focus, or other benefits expected from our recent acquisition of Pro-Dentec.

 

Our future growth will depend on our ability to implement our business strategy. We believe that our recent acquisition of Pro-Dentec, a privately-held dental products company, will strengthen our business, including the development and commercialization of our oral cancer screening products. Further, we believe that this acquisition could increase our ability to deliver our products into the dental marketplace and could result in synergies that enhance our sales capability, potentially reduce our costs and increase our profits. However, successful acquisitions in our industry are difficult to accomplish because they require, among other things, efficient integration and aligning of product offerings and manufacturing operations and coordination of sales and marketing and research and development efforts. The difficulties of integration and alignment may be increased by the necessity of

coordinating geographically separated organizations, the complexity of the technologies being integrated and aligned and the necessity of integrating personnel with disparate business backgrounds and combining different corporate cultures. The integration and alignment of operations following an acquisition or alliance requires the dedication of management resources that may distract attention from the day-to-day operations of the business, and may disrupt key research and development, marketing or sales efforts. In addition, there is no guarantee that such acquisition will result in the synergies we anticipate. Furthermore, uncertainties associated with such acquisition combined with the recent disposition of our Nutraceuticals Business Unit may cause loss of employees. Ultimately, the success of such acquisition depends in part on the retention of key personnel. There can be no assurance that we will be able to retain the acquired company’s key management, technical, sales and customer support personnel. If we fail to retain such key employees, we may not realize the anticipated benefits of such acquisition.

 

Historically we have been dependent on a few key products and our future growth is dependent 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 nationally 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 cGMP’s 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 development and/or acquisition. 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 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 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 (OSHA) 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.

 

Following the August 13, 2007 restructuring to the securities issued under the November 2007 Private Placements, an additional approximately 16.9 million shares of our common stock would be issued should investors convert all Amended and Restated Secured notes and exercise all warrants issued in connection with the Private Placements, which would dilute existing shareholders current ownership percentages and voting power. If we choose to raise additional funds through the issuance of shares of our common 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. We believe that announcements of new products, quarterly fluctuations in the results of operations and other factors, including changes in conditions in general in the industries in which we operate and developments in regulatory arenas may have caused such fluctuations. Stock markets have experienced extreme price volatility in recent years. 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.

 

In December 2006, our Board of Directors and stockholders approved an increase in our authorized capital stock from 67.5 million to 150.0 million and an increase in authorized common stock from 65.0 million to 147.5 million. Some of these newly authorized shares are reserved for issuance upon the exercise of the Initial Warrants, Additional Warrants, Secured Note Warrants and Roth Warrants, as well as the conversion of the Secured Notes, that were issued in the Private Placements. 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 2.5 million 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 July 31, 2007 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.

 

 

Not applicable.

 

Manufacturing Facilities

 

We lease 15,500 square feet for a manufacturing facility and laboratory in Phoenix, Arizona. This facility produces ZTC ^tm , which is the active ingredient in the OraTest ^® product as well as a component of the ViziLite ^® Plus marker system. This facility also provides technical support and testing for our other pharmaceutical products. The lease expires December 31, 2010. Monthly lease payments are: $12,300 through August 31, 2007; $13,000 through April 30, 2009; and $13,800 through December 31, 2010.

 

We own four buildings in Batesville, Arkansas containing a total of approximately 90,000 square feet of administration, warehouse and production space. One building houses the production facilities for the Rota-dent ^® and Pro-Select ^® Platinum and other products. Another building houses the engineering and product development staff. A third building houses the marketing, information technology, accounting and administrative staffs. The fourth building houses the pharmaceutical manufacturing facilities, and has approximately 20 acres of Company owned land adjacent to it.

 

We lease two other business related buildings in Batesville, Arkansas, for a monthly rental of $20,200. One building houses the Company’s warehouse and its shipping and receiving facilities. This building is on the last year of a lease that expires January 31, 2009, with one renewal term remaining. Another building is used for our maintenance facility, with a lease expiring October 31, 2009. Separately, we lease one business related office building in Ontario, Canada for a monthly rental of $2,200. This lease expires on February 28, 2009.

 

Together with our laboratory facilities, we believe that our current facilities are adequate for our current production needs and that additional space, if needed, can be leased, constructed or purchased without materially affecting operations. See “Item 1. Business — Manufacturing and Supply.”

 

to assist the competitor in creating an effervescent vitamin C product similar to Alacer’s Emergen-C product line. ZNI and Landes denied Alacer’s claims. In particular, ZNI and Landes denied that the information contained in the documents at issue here constituted trade secrets. A non-binding mediation was held on March 29, 2007. The parties settled this matter, and we paid $100,000 to Alacer, the cost of which was recorded in discontinued operations for the quarter ended April 30, 2007.

 

An antitrust case was filed in 2000 in the U.S. District Court in Delaware by several dental laboratories as class representatives for all dental labs that had purchased Dentsply artificial teeth. The suit alleges that Dentsply, the major supplier of artificial teeth, required each of its distributors to agree not to supply the teeth of its competitors as a condition of Dentsply’s supplying its artificial teeth to a distributor. According to the complaint this requirement resulted in a lack of choices for the laboratories and increased costs for the Dentsply teeth because it permitted Dentsply to limit the supply of its competitors’ teeth so as to give it a monopoly and the power to set prices. Plaintiffs also alleged that each of the distributors agreed with Dentsply to this condition in violation of Sections 1 and 2 of the Sherman Act and Section 6 of the Clayton Act. At the same time the U.S. Department of Justice was criminally prosecuting Dentsply for the same activities. Ultimately Dentsply was found guilty of the charges.

 

The civil lawsuit, in which Ryker Dental of Kentucky, Inc. (“Ryker”), our inactive wholly-owned subsidiary, is one of about 15 defendants, was stayed for years because of appeals taken by the plaintiffs from orders by the trial court that since the plaintiffs had not purchased artificial teeth directly from Dentsply, it could not, as a matter of law, have any liability to the plaintiffs or class members. The 3rd Circuit Court of Appeals largely agreed with Dentsply, except that it permitted a claim to proceed that Dentsply and the distributors had conspired to monopolize the artificial teeth market. The case is now in the trial court and discovery against the largest distributors has been permitted by the trial judge. On September 26, 2007, the Court dismissed the case against Ryker for lack of personal jurisdiction and improper venue.

 

 

We have not paid dividends on our common stock and we do not presently intend to do so. The policy of our Board of Directors has been to retain earnings to finance the growth and development of our business. Furthermore, the payment of cash dividends is restricted by the terms of our Amended and Restated Secured Notes, as more fully described in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation — Liquidity and Capital Resources and our Consolidated Financial Statements included elsewhere herein.

 

Preferred Stock

 

On February 1, 2001, as part of the IST acquisition, we issued 100,000 shares of Series B Convertible Preferred Stock (“Preferred Stock”) to National Healthcare Manufacturing Corporation for the patent rights and the Antioch, Illinois manufacturing operations for swab products. The Preferred Stock is convertible into shares of our common stock at any time at a conversion ratio of one to one. 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. Holders of the Preferred Stock have no voting rights except as required by applicable law. Preferred Stock dividends were $39,000 in each of the fiscal years ending July 31, 2007, 2006 and 2005. Accumulated accrued dividends are $9,750 as of July 31, 2007. The shares of Preferred Stock were issued pursuant to the exemption set forth in Section 4(2) of the Securities Act. There is no established public trading market for the Preferred Stock. As of July 31, 2007, there are 100,000 shares of our Preferred Stock outstanding.

 

2006 Private Placements

 

On November 13, 2006, we entered into two separate purchase agreements that, in the aggregate, provided for the sale of common stock, warrants and convertible notes for an aggregate gross purchase price of approximately $40.0 million (collectively, the “Private Placements”). The Private Placements closed and funded on November 28 and 29, 2006. We used the net proceeds of the Private Placements to fund the Pro-Dentec ^® acquisition described in Note 3 to the Consolidated Financial Statements included elsewhere herein, and for working capital and general corporate purposes.

 

Pursuant to the first purchase agreement, we issued and sold:

 

(i) 9.1 million shares of common stock for $1.75 per share (the “Shares”);

 

(ii) Approximately $12.1 million in aggregate principal amount of 12.0% Unsecured Convertible Notes (the “Unsecured Notes”), which converted into 6.9 million shares (the “Unsecured Note Shares”) of Zila’s common stock at a conversion price of $1.75 per share on December 14, 2006, the date on which our stockholders approved, among other things, the Private Placements;

 

(iii) Warrants to purchase approximately 5.4 million shares of Zila’s common stock, which became exercisable starting in May 2007 for five years at an exercise price of $2.21 per share (the “Initial Warrants”);

 

(iv) Warrants to purchase approximately 3.1 million shares of Zila’s common stock, which became exercisable for five years at an exercise price of $2.21 per share following approval by our stockholders on December 14, 2006 (the “Additional Warrants”);

 

Pursuant to the second purchase agreement, we issued and sold:

 

(i) Approximately $12.0 million in aggregate principal amount of 6.0% Senior Secured Convertible Notes (the “Secured Notes”), which are due in November 2009 and became convertible into approximately 5.5 million shares of Zila’s common stock at a conversion price of $2.20 following approval by our stockholders on December 14, 2006; and

 

(ii) Warrants to purchase approximately 1.9 million shares of our common stock, which became exercisable for five years at an exercise price of $2.21 per share following approval by our stockholders on December 14, 2006 (the “Secured Note Warrants”).

 

Roth Capital Partners, LLC (“Roth”) served as placement agent in the transaction and received warrants to purchase 1,218,701 shares of common stock at an exercise price of $2.21 per share (the “Roth Warrants”). Additionally, we paid Roth cash fees of $1.7 million at the closing of the Private Placements and on

February 20, 2007, after negotiation, we issued 289,728 shares of our common stock to Roth as well as the Roth Warrants in final settlement of the fees.

 

The conversion price of the Secured Notes of $2.20 per common share at its commitment date, the date of shareholder approval on December 14, 2006, was below the market price of $2.58 per common share.

 

As disclosed by the Company in its Current Report on Form 8-K that was filed with the SEC on August 14, 2007 (the “Restructuring Form 8-K”), the Company reached an agreement on August 13, 2007 with certain investors (the “Investors”) in the Private Placements to restructure the Investors’ holdings and provide the Company with relief from certain financial and non-financial covenants contained in the Secured Notes. As amended and restated, the “Amended and Restated Secured Notes” are in the same aggregate principal amount as the Secured Notes, or approximately $12.0 million, but are due July 31, 2010.

 

The Amended and Restated Secured Notes bear interest, payable quarterly, at 7.0% per annum, but at the Company’s option, interest payments can be made at an 8.0% annual rate in shares of the Company’s 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 Amended and Restated Secured Notes remain convertible into shares of common stock at a conversion price of $2.20 per share at the option of the holders of such notes.

 

In addition, the Amended and Restated Secured Notes contain comprehensive covenants that restrict the way in which the Company can operate, and contain covenants that require the Company to:

 

(i) Maintain, at the end of each fiscal quarter commencing with the fiscal quarter ending July 31, 2007, free cash in an amount not less than $2.0 million; and

 

(ii) Maintain, at the end of each of the fiscal quarters ending July 31, 2008 and October 31, 2008, EBITDA of at least $1.00.

 

As disclosed in the Restructuring Form 8-K, on August 13, 2007, the Company also:

 

(i) Repurchased 932,832 Unsecured Note Shares from the Investors for approximately $1.25 million in cash, at a price based on the average closing bid price of our common stock for the ten trading days prior to August 13, 2007, or $1.34 per Unsecured Note Share;

 

(ii) Repurchased 227,270 Secured Note Warrants from the Investors for approximately $150,000 in cash, at a price based on a Black — Scholes valuation, or $0.66 per Secured Note Warrant; and

 

(iii) Paid the Investors a $0.6 million fee.

 

The Private Placements were made only to accredited investors in transactions that are exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”) pursuant to Regulation D promulgated thereunder. The following investors made purchases in the Private Placements:

 

 

 

Warrants

 

In addition to the warrants issued in connection with the 2006 Private Placements described above, the Company had the following activity related to its stock purchase warrants:

 

 

Issuer Purchase of Equity Securities

 

We did not purchase any of our equity securities pursuant to our Stock Repurchase Program during fiscal 2007.

Comparative Stock Performance

 

The graph below compares the cumulative total stockholder return on Zila’s common stock for the five years ended July 31, 2007, with the cumulative total return on the NASDAQ Composite Index and the RDG MicroCap Pharmaceutical Index over the same period (assuming an investment of $100 in Zila’s Common Stock, the NASDAQ Composite Index and the RDG MicroCap Pharmaceutical Index on July 31, 2002, and reinvestment of all dividends).

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among ZILA, Inc., The NASDAQ Composite Index
And The RDG MicroCap Pharmaceutical Index

 

 

 

 

 

 

 

As is described more fully in Notes 2 and 3 to the Consolidated Financial Statements and in Management’s Discussion and Analysis of Financial Condition and Results of Operation included elsewhere herein, during fiscal 2007, we acquired Pro-Dentec, and during fiscal 2007, 2006 and 2005 we divested (i) our former Nutraceuticals Business Unit and (ii) several operations that were previously part of our former Pharmaceuticals Business Unit including: (i) inventory and technology related to our Peridex ^® brand of products, (ii) substantially all of the assets and certain defined liabilities of our IST swab operations and (iii) substantially all of the assets of our Zilactin ^® brand of over-the-counter lip and oral care products.

 

We manufacture and market ViziLite ^® Plus with TBlue ^{630 tm} (“ViziLite ^® Plus”), our flagship product, which is rapidly enhancing the standard of care for the early detection of oral abnormalities that could lead to cancer. ViziLite ^® Plus is the chemiluminescent disposable light product with our patented pharmaceutical-grade toluidine blue, used for the illumination and marking of oral mucosal abnormalities in patients at increased risk for oral cancer. In addition, Zila designs, manufactures and markets a suite of periodontal products sold directly and exclusively to dental professionals, including the Rota-dent ^® 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 research and development division holds expertise in pre-cancer/cancer detection through our patented ZTC ^tm and OraTest ^® technologies and is developing a pipeline of products focused on oral disease detection and treatment.

 

In December 2005, we reached an agreement with the Food and Drug Administration (“FDA”) on the design and size of a phase III clinical trial for OraTest ^® under the FDA’s special protocol assessment process and commenced patient enrollment. The agreement was limited to the ZIL-401 clinical trial and did not include non-clinical and Chemistry, Manufacturing and Control (“CMC”) issues.

 

Enrollment in ZIL-401 was open for approximately 22 months, through October 5, 2007. The clinical trial was designed to provide support for safety and efficacy in the OraTest ^® new drug application (“NDA”) and to assess the efficacy of OraTest ^® in staining cancerous and pre-cancerous oral lesions in a population of tobacco users and/or alcohol drinkers, ages 45 and older. The demonstration of efficacy in the clinical trial is based upon the achievement of a predetermined number of differences in diagnoses between the standard visual exam and the OraTest ^® exam.

 

Patient data for the ZIL-401 trial continues to be monitored by an independent organization to determine if the number of differences required to trigger analysis has been achieved. The results will be available to us in the coming months, but at this time there can be no assurance that the endpoint requirement necessary for trial completion has been, or will be, achieved.

 

As with any drug development program, the length of the FDA regulatory process and review period varies considerably, as does the amount of data required to demonstrate the safety and efficacy of a specific product. In addition, delays or rejections may be encountered based upon changes in FDA policy, personnel or prior understandings during the period of product development and FDA regulatory review or each new drug application. Even if FDA approval of a drug application is received, such approval may entail limitations on the indicated uses for which the product may be marketed and there is no assurance that the product would be successful in gaining market acceptance.

 

As previously reported, we recently conducted a comprehensive review of all aspects of the OraTest ^® program. The review included its history, present status and future prospects, including the regulatory path to approval of OraTest ^® with the FDA and its post-approval commercial potential and challenges. We also considered the growing market acceptance for its adjunctive oral cancer screening product, ViziLite ^® Plus with T-Blue ^{630 tm} , and the fact that we currently have toluidine blue on the market today in the T-Blue ^{630 tm} marker. Finally, we considered the fact that we have regulatory approval to sell OraTest ^® in a number of international markets today including the United Kingdom, Australia, Belgium, Holland, Luxembourg, Finland, Greece, Portugal, Bermuda and the Bahamas, none of which require FDA approval.

 

Following completion of the review and analysis described above, we determined that successfully resolving the outstanding CMC and non-clinical issues will require substantial additional time and funding, both of which exceed our previous estimates. Further, we believe that at least one additional clinical trial will be required, and even if the endpoint is met on the ZIL-401 study, no assurance can be made that the FDA would view the study data and other additional submissions as sufficient to support the approval of the NDA.

 

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. Our analysis concluded that the incremental market potential of OraTest ^® , considering the availability of ViziLite ^® Plus, does not justify the cost, time and uncertain study outcomes associated with continuing the program in its current form.

 

Also as previously reported, we have initiated the process of seeking a partner in an effort to realize the value of the ZTC ^tm platform. ZTC ^tm , the active staining component in OraTest ^® , may have additional applications, including

the detection of high-risk lesions of the cervix, esophagus and skin. We believe that the potential of these additional therapeutic applications could appeal to a partner.

 

Finally , we are taking the steps necessary to capture, secure and analyze the clinical and program data obtained to date, which we intend to use to support the growth of the ViziLite ^® Plus program. We conducted an “impairment” analysis regarding the OraTest ^® asset and concluded that based upon future sales of toluidine blue in connection with ViziLite ^® Plus and OraTest ^® international sales, no impairment of the OraTest ^® asset is required by generally accepted accounting principles.

 

net revenues increased 143% to $6.6 million in fiscal 2007 from fiscal 2006, primarily as a result of selling direct to dental offices through Pro-Dentec’s national sales organization beginning in December 2006. ViziLite ^® Plus net revenues were affected by our deliberate reductions in sales to our existing distribution channel in the first quarter of fiscal 2007 as we prepared to modify our means of distribution upon the completion of the Pro-Dentec acquisition.

 

Gross profit as a percentage of net revenues was 58.8% for fiscal 2007 compared to 31.8% for fiscal 2006. Prior year’s gross profit reflects our distributor-only business model and the impact of discounts and incentives offered in support of the launch of ViziLite ^® Plus.

 

Marketing and selling expenses as a percentage of net revenues were 50.0% and 198.3%, for fiscal 2007 and 2006, respectively. Marketing and selling expenses as a percentage of net revenues decreased for fiscal 2007 as a result of the increased revenue base from the Pro-Dentec acquisition. Marketing and selling expenses for fiscal 2007 and 2006 were $14.4 million and $5.6 million, which represents an increase of 157.6%. Pro-Dentec represented the majority of these increases as we integrated its dedicated national sales force that sells directly to dental offices. Increased expenditures for ViziLite ^® Plus represent the balance of the increase as we continue our efforts to establish ViziLite ^® Plus as the standard of care for dental offices in the detection of oral abnormalities.

 

General and administrative expenses were $15.1 million, or 52.6% of net revenues, for fiscal 2007, compared to $10.5 million, or 371.0% of net revenue, for fiscal 2006. The increased expense for fiscal 2007 is primarily related to the acquisition and integration of Pro-Dentec, stock-based compensation costs and additional support costs for ViziLite ^® Plus and our OraTest ^® regulatory program, severance, professional fees for the special corporate governance review, and settlement costs for the modification of the Private Placements. For fiscal 2007 and 2006, the reclassification of revenues for discontinued operations significantly impacted general and administrative expenses expressed as a percent of net revenues. General and administrative expenses for continuing operations include significant public-company related costs, which do not vary in relation to net revenues. As noted above, in the fourth quarter of fiscal 2007, we streamlined our operations and reduced overhead costs with an estimated annual savings of approximately $3.0 million dollars.

 

Research and development expenses increased 4.5% to $7.5 million for fiscal 2007 from $7.2 million in fiscal 2006. Research and development expenses are comprised primarily of costs for the OraTest ^® regulatory program. We incurred higher expense levels in fiscal 2007 with the continued efforts of our OraTest ^® regulatory program. As more fully described above, we conducted an extensive review and analysis of our strategic direction, including the OraTest ^® regulatory program, and in the first quarter of fiscal 2008, we curtailed enrollment in the OraTest ^® clinical trial and ceased expenditures for CMC and non-clinical aspects of the OraTest ^® regulatory program. While activities continue to preserve the value of the OraTest ^® asset, we believe that our level of expenditures for research and development in the coming fiscal year will be substantially reduced over historical levels.

 

Depreciation and amortization expenses increased 106.4%, to $2.9 million for fiscal 2007 from $1.4 million for fiscal 2006. The increased level of depreciation and amortization expense in fiscal 2007 is primarily related to the acquisition of Pro-Dentec and its related property, plant, equipment and amortizable intangible assets, as more fully described in Note 2 of the accompanying Consolidated Financial Statements.

 

Other expense was $5.8 million for fiscal 2007, compared to other expense of $2.3 million for fiscal 2006, an increase of 149.9%. The increase relates to increased interest expense arising from the retirement of the credit facility (“Credit Facility”) with Black Diamond Commercial Finance (“BDCF”) in fiscal 2007 and the associated non-cash expense associated with this retirement. During fiscal 2007, an aggregate of approximately $3.8 million of non-cash charges were incurred in relation to the write-off of unamortized debt financing costs and debt discounts upon the repayments of the BDCF Credit Facility and the Industrial Revenue Bonds. These costs were offset by derivative income recognized on the Black Diamond warrant liability in the first quarter.

 

Income tax benefit of $5.8 million for fiscal 2007 resulted primarily from the utilization of net operating loss carryforwards to offset the income tax expense on the taxable gains on the dispositions of the Nutraceuticals Business Unit and the Peridex ^® product line, which are presented in discontinued operations.

Fiscal Year Ended July 31, 2006 Compared to Fiscal Year Ended July 31, 2005

 

The key factors influencing Zila’s financial performance and operations during fiscal 2006 include:

 

(i) Introduced ViziLite ^® Plus at the October 2005 annual meeting of the American Dental Association and commenced sales in our second fiscal quarter. ViziLite ^® Plus consists of a chemiluminescent light source (ViziLite ^® ) to improve the identification of lesions and TBlue ^{630 tm} , the oral lesion marking system, to mark those lesions differentially identified by ViziLite ^® . ViziLite ^® Plus with TBlue ^{630 tm} is designed to be used in a patient population at increased risk for oral cancer.

 

(ii) Targeted key geographical markets that demonstrated early acceptance of ViziLite ^® and placed Specialists into 11 key markets as part of our strategy to establish ViziLite ^® as the standard of care for dental offices in the detection of oral abnormalities;

 

(iii) Increased dental professional awareness of ViziLite ^® Plus to greater than 50% of dentists nationally;

 

(iv) Expanded ViziLite ^® distribution into 500 of the nation’s group dental practices;

 

(v) Expanded insurance reimbursement for ViziLite ^® Plus regionally and nationally;

 

(vi) Divested IST in July 2006 as part of our ongoing strategy to focus on our core products with the greatest growth potential. (IST is presented as discontinued operations in the accompanying financial statements and no longer part of the Pharmaceuticals Business Unit.)

 

(vii) Reached agreement in our second fiscal quarter with the FDA on the design and size of a phase III clinical trial under the FDA’s special protocol assessment process and commenced patient enrollment. The clinical trial was designed to provide the support for safety and efficacy of the OraTest ^® NDA and to assess the efficacy of OraTest ^® in staining cancerous and pre-cancerous oral lesions in a population of tobacco users and alcohol drinkers, ages 45 and older;

 

(viii) Continued efforts to re-commission our manufacturing facility as we prepared to commercialize OraTest ^® ; and

 

(ix) Continued efforts to determine and address the remaining clinical, non-clinical and CMC requirements for the NDA.

 

The following table summarizes our results of operations and related statistical information for the fiscal years ended July 31, 2006 and 2005 (dollars in thousands):

 

Net revenues increased 135.4% to approximately $2.8 million for fiscal 2006, compared to net revenues of approximately $1.2 million for fiscal 2006. The growth in net revenues for fiscal 2006 was driven by the launch of ViziLite ^® Plus with TBlue ^{630 tm} and our strategy of educating the dental professional and broadening distribution channels. In the fourth quarter of fiscal 2006, we began to prepare for the acquisition of Pro-Dentec and the transition to a national sales force that would provide us with the opportunity to sell ViziLite ^® Plus directly to dentists. We focused our fourth quarter sales and marketing efforts toward ViziLite ^® Plus adoption and integration within dental practices resulting in continued increased in acceptance, growth and repeat orders by dental offices from dental distributors. However, we made deliberate reductions in sales to our existing distribution channel as we prepared for modifying our means of distribution. The upward trend of quarterly ViziLite ^® /ViziLite ^® Plus revenues generated during the preceding seven quarters was disrupted by these strategic measures.

 

Gross profit as a percentage of net revenues was 31.8% for fiscal 2006 compared to 58.4% for fiscal 2005 primarily as a result of incentives offered to dentists in support of ViziLite ^® Plus as well as one time costs of certain TBlue ^{630 tm} swabs provided to existing ViziLite ^® users upon the launch of ViziLite ^® Plus.

 

Marketing and selling expenses as a percentage of net revenues were 198.3% and 177.1%, for fiscal 2006 and 2005, respectively. Marketing and selling expenses for fiscal 2006 and 2005 were $5.6 million and $2.1 million, which represent an increase of 163.4%. Marketing and selling expenses increased for fiscal 2006 as we introduced ViziLite ^® Plus with TBlue ^{630 tm} in the second quarter and as we executed our strategy to establish ViziLite ^® Plus as the standard of care for oral abnormality screening.

 

General and administrative expenses were $10.5 million, or 371.0% of net revenues, for fiscal 2006, compared to $8.3 million, or 693.8% of net revenue, for fiscal 2005. Cost reduction measures undertaken during the year were offset by increased expenses related primarily to (i) additional professional, business development and consulting fees, (ii) the addition of senior leadership personnel, (iii) growth in support functions for our regulatory program and for our ViziLite ^® product line and stock compensation expense recognized under SFAS No. 123R.

 

Research and development expenses increased 6.9%, to $7.2 million for fiscal 2006 from $6.7 million in fiscal 2005. Research and development expenses are comprised primarily of costs for the OraTest ^® regulatory program. We incurred higher expense levels in fiscal 2006 with the commencement of a new phase III clinical trial in the second fiscal quarter, with the continued efforts of our OraTest ^® regulatory program, and with the re-commissioning of our manufacturing facility.

 

Depreciation and amortization expenses increased 15.9%, to $1.4 million for fiscal 2006 from $1.2 million for fiscal 2005. The increased level of depreciation and amortization expense in fiscal 2006 is primarily related to depreciation and amortization relative to additions of property and equipment and patents and trademarks.

 

Other expense was $2.3 million for fiscal 2006 compared to less than $0.1 million of other income for fiscal 2005. The increase in other expense relates to new borrowings in fiscal 2006 resulting in a significant increase in interest expense. In addition to the stated interest due on the secured term loan facility, interest expense included the amortization of debt issue costs and debt discount that resulted from the issuance of a stock purchase warrant in connection with that facility.

 

Inflation and Seasonality

 

Inflation has had no unique or material effect on the operations or financial condition of our businesses. Historically, our consolidated operations are not considered seasonal in nature.

 

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.

 

As more fully described above, we evaluated the strategic direction of the company, including an assessment of the OraTest ^® regulatory program, and 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. Further, we believe that our greatest potential lies within the synergies created with the acquisition of Pro-Dentec, which increases our ability to develop and commercialize our already existing oral cancer screening product, ViziLite ^® Plus. Our analysis concluded that the incremental market potential of OraTest ^® , considering the availability of ViziLite ^® Plus, does 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, we believe that it is necessary to reduce future research and development expenditures on the OraTest ^® regulatory program. Additionally, in the fourth quarter of fiscal 2007, we took actions to streamline our operations and reduce overhead expenditures by approximately $3.0 million annually. With our cost reduction measures and with the anticipated growth in ViziLite ^® Plus and our other core products, we believe that our cash and cash equivalents along with cash flows generated from operations and working capital management will allow us to fund our planned operations over the next 12 months.

 

Selected cash flow and working capital information is set forth in the table below (dollars in thousands):

 

 

At July 31, 2007, our primary sources of liquidity included cash and cash equivalents of $14.9 million compared to $4.0 million as of July 31, 2006. Our working capital was $14.3 million as of July 31, 2007 compared to negative $6.9 million as of July 31, 2006. The improvement in cash and cash equivalents and in working capital at the end of fiscal 2007 resulted primarily from the net proceeds received from the Private Placements of debt and equity and the dispositions of the Nutraceuticals Business Unit and our Peridex product line. Also, at July 31, 2006, working capital was negatively affected by the classification of debt of $18.0 million (net of discount) as a current obligation. Our current ratio has improved to 2.4 as of July 31, 2007 compared to 0.8 as of July 31, 2006, primarily as a result of the working capital improvements outlined above.

 

Operating Activities

 

Net cash used in operating activities was $15.0 million for fiscal 2007 compared to $20.8 million for fiscal 2006. The decrease for fiscal 2007 resulted from the reduced cash loss from continuing operations as a result of the Pro-Dentec acquisition and a reduced cash loss from discontinued operations as a result of the disposition of the Nutraceuticals Business Unit and Peridex product line. Additionally, reduced levels of inventory and accounts receivable through the disposition of the Nutraceuticals Business Unit and increased accounts payable and accrued liabilities resulting from the Pro-Dentec acquisition provided working capital improvements of approximately $0.6 million over the prior year period.

 

Net cash used in operating activities was $20.8 million for fiscal 2006 compared to $7.4 million for fiscal 2005. The increase for fiscal 2006 resulted primarily from the funding of our operating loss, the increase in inventory arising from lower than anticipated sales levels, a decrease in our accounts payable and accrued liabilities and

business development costs related to the disposition of the Nutraceuticals Business Unit and acquisition of Pro-Dentec. These uses were offset primarily by (i) non-cash items related primarily to depreciation and amortization, stock based compensation and financing costs and discounts related to our Credit Facility; and (ii) a decrease in accounts receivable of $7.5 million.

 

Investing Activities

 

Net cash provided by investing activities was $12.4 million for fiscal 2007 compared to net cash used in investing activities of $5.3 million for fiscal 2006. Significant components of cash provided by investing activities during fiscal 2007 included net proceeds of $34.9 million and $9.4 million for the dispositions of the Nutraceuticals Business Unit and Peridex product line, respectively. Collateral returned upon the retirement of the Industrial Revenue Bonds also provided $3.6 million. Separately, we used $34.1 million to acquire Pro-Dentec. For fiscal 2006, we used $5.2 million to increase the restricted cash collateral for the letter of credit supporting the Industrial Revenue Bonds and for capital asset purchases and expenditures for patents and trademarks.

 

Net cash used in investing activities was $5.3 million for fiscal 2006 compared to net cash provided by investing activities of $16.6 million for fiscal 2005. For fiscal 2006, we used $5.2 million to increase the restricted cash collateral for the letter of credit supporting the Industrial Revenue Bonds and for capital asset purchases and expenditures for patents and trademarks. Capital expenditures for property and equipment were $1.0 million for fiscal 2006 compared to $1.9 million for fiscal 2005. Our capital expenditures were directed toward investments in (i) an improved Ester-C ^® production and development capability at our former Nutraceuticals Business Unit and (ii) preparations for commercialization of TBlue ^{630 tm} and OraTest ^® in the Biotechnology Business Unit. Separately, the fiscal 2005 results include $11.0 million of net proceeds associated with the Zilactin disposition and $8.0 million for proceeds from the sale of short-term investments.

 

Financing Activities

 

Net cash provided by financing activities was $13.5 million for fiscal 2007 compared to $17.1 million for fiscal 2006. The decrease in cash provided by financing activities in fiscal 2007 relates to the repayment of the Credit Facility, the Industrial Development Revenue Bonds and equipment and mortgage notes of Pro-Dentec. Offsetting these payments are gross proceeds from the Private Placements of $40.0 million.

 

Net cash provided by financing activities was $17.1 million for fiscal 2006 compared to $0.1 million for fiscal 2005. Proceeds from the term loan under our Credit Facility were the primary source of funds in fiscal 2006, while the issuance of common stock under our employee stock purchase plan and exercised stock options provided funds in both years. Short-term borrowings under our previous line of credit with Wells Fargo Bank provided funding during fiscal 2005. On March 24, 2006, we repaid $3.5 million outstanding under the Wells Fargo line of credit with proceeds from the new term loan.

 

Private Placements

 

On November 13, 2006, we entered into two separate purchase agreements that, in the aggregate, provided for the sale of common stock, warrants and convertible notes for an aggregate gross purchase price of approximately $40.0 million (collectively, the “Private Placements”). The Private Placements closed and funded on November 28 and 29, 2006. We used the net proceeds of the Private Placements to fund the Pro-Dentec acquisition and for working capital and general corporate purposes.

 

Pursuant to the first purchase agreement, we issued and sold:

 

(i) 9.1 million shares of common stock for $1.75 per share (the “Shares”);

 

(ii) Approximately $12.1 million in aggregate principal amount of 12.0% Unsecured Convertible Notes (the “Unsecured Notes”), which converted into 6.9 million shares (the “Unsecured Note Shares”) of Zila’s common stock at a conversion price of $1.75 per share on December 14, 2006, the date on which our stockholders approved, among other things, the Private Placements;

(iii) Warrants to purchase approximately 5.4 million shares of Zila’s common stock, which became exercisable in May 2007 for five years at an exercise price of $2.21 per share (the “Initial Warrants”);

 

(iv) Warrants to purchase approximately 3.1 million shares of Zila’s common stock, which became exercisable for five years at an exercise price of $2.21 per share following approval by our stockholders on December 14, 2006 (the “Additional Warrants”);

 

Pursuant to the second purchase agreement, we issued and sold:

 

(i) Approximately $12.0 million in aggregate principal amount of 6.0% Senior Secured Convertible Notes (the “Secured Notes”), which are due in November 2009 and became convertible into approximately 5.5 million shares of Zila’s common stock at a conversion price of $2.20 following approval by our stockholders on December 14, 2006; and

 

(ii) Warrants to purchase approximately 1.9 million shares of our common stock, which became exercisable for five years at an exercise price of $2.21 per share following approval by our stockholders on December 14, 2006 (the “Secured Note Warrants”).

 

Roth Capital Partners, LLC (“Roth”) served as placement agent in the transaction and received warrants to purchase 1,218,701 shares of common stock at an exercise price of $2.21 per share (the “Roth Warrants”). Additionally, we paid Roth cash fees of $1.7 million at the closing of the Private Placements and on February 20, 2007, after negotiation, we issued 289,728 shares of our common stock to Roth as well as the Roth Warrants in final settlement of the fees.

 

As more fully described in Notes 8 and 15 to our consolidated financial statements, on August 13, 2007, subsequent to our fiscal year-end, we reached an agreement with certain investors in the Private Placements to restructure their holdings and provide relief from certain financial and non-financial covenants contained in the Secured Notes. As more fully described elsewhere in this filing, these investors, and one other, had also previously disputed the extent of certain registration rights granted in connection with the securities issued in the Private Placements.

 

In an effort to resolve the aforementioned dispute and to obtain covenant relief, Zila and certain of the investors with whom we had the dispute, agreed to take certain actions and restructure the investors’ holdings (the “Restructuring”). As part of the Restructuring, on August 13, 2007, Zila entered into an Amendment Agreement (the “Amendment Agreement”) with Visium Balanced Offshore Fund, Ltd., Visium Balanced Fund, LP, Visium Long Bias Offshore Fund, Ltd., Visium Long Bias Fund, LP, and Atlas Master Fund, Ltd. (collectively, the “Investors”), which provides for, among other things, the following:

 

(i) Zila repurchased 932,832 Unsecured Note Shares from the Investors for approximately $1.25 million in cash, at a price based on the average closing bid price of our common stock for the ten trading days prior to August 13, 2007, or $1.34 per Unsecured Note Share;

 

(ii) Zila repurchased 227,270 Secured Note Warrants from the Investors for approximately $0.15 million in cash, at a price based on a Black — Scholes valuation or $0.66 per Secured Note Warrant;

 

(iii) Zila and the Investors agreed to amend and restate the Secured Notes (the “Amended and Restated Secured Notes”) on the terms set forth below and in Notes 8 and 15; and

 

(iv) Zila paid the Investors a $0.6 million fee.

 

We believe that the Restructuring strengthens our cash position by relaxing the minimum cash and EBITDA covenants and allows future interest to be paid in kind with common stock. The Amended and Restated Secured Notes are in the same aggregate principal amount as the Secured Notes, or $12.0 million, but are now due July 31, 2010. They bear interest, payable quarterly, at 7% per annum, but at our option, interest payments can be made at an 8% annual rate in shares of our common stock at a price equal to 90% of the average closing bid price of such common stock for the 10 trading days immediately prior to the relevant interest payment date. The required cash balance was reduced from $10.5 million to $2.0 million commencing July 31, 2007 and defined EBITDA of at least $1.00 is required for each of the fiscal quarters ending July 31, 2008 and October 31, 2008.

Failure to satisfy the financial covenants, or to maintain compliance with the negative covenants described in our definitive proxy statement filed with the SEC on November 24, 2006, could, at the option of the Amended and Restated Secured Note holders, result in an event of default under the Amended and Restated Secured Notes. Upon the occurrence of the first specified event of default, the holders of the Amended and Restated Secured Notes could accelerate and demand repayment of one-third of the outstanding principal balance and all accrued but unpaid interest on the Amended and Restated Secured Notes. Upon the occurrence of the second specified event of default, the holders of the Amended and Restated Secured Notes could accelerate and demand repayment of one-half of the outstanding principal balance and all accrued but unpaid interest on the Secured 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.

 

In connection with the Restructuring and the issuance of the Amended and Restated Secured Notes, Zila also received waivers from the required majority of the holders of the Initial Warrants, Additional Warrants and Secured Note Warrants waiving any antidilution rights to which any holder of such warrants would otherwise be entitled in connection with the issuance of any shares as payment for interest on the Amended and Restated Secured Notes. Also, on August 13, 2007, Zila and the Investors entered into a Registration Rights Agreement (the “Registration Rights Agreement”), which is described further in Note 15; however, a registration rights dispute remains with one investor. Separately, a side letter that imposed certain corporate governance obligations on the Company, the most notable of which that had not yet been fulfilled was to appoint two additional directors to the Company’s Board of Directors, was terminated.

 

Credit Facility

 

On March 24, 2006, we, certain of our domestic subsidiaries and BDCF, as the initial lender and administrative agent, entered into the Credit Facility. On October 2, 2006, debt outstanding under the Credit Facility in the amount of approximately $20.0 million plus accrued interest was repaid from the proceeds of the disposition of the Nutraceuticals Business Unit and the Credit Facility was terminated. Upon termination of the Credit Facility, we recognized a non-cash loss of approximately $3.6 million for the write-off of unamortized debt financing costs and debt discount. These costs were recorded as interest expense.

 

Industrial Development Revenue Bonds

 

On September 28, 2006, as a requirement of the nutraceuticals disposition, we redeemed Industrial Development Revenue Bonds in the amount of $2.8 million plus accrued interest. Funds in a restricted cash collateral account were utilized for this repayment. The balance of the restricted cash collateral was returned to Zila. Upon the retirement of the bonds, we recognized a loss of approximately $0.2 million for the write-off of the unamortized deferred financing costs. These bonds were included in long-term assets of discontinued operations at July 31, 2006.

 

PharmaBio Investment

 

In December 2002, we entered into an agreement with PharmaBio Development, Inc. (“PharmaBio”), the strategic investment group of Quintiles Transnational Corp., our 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 the OraTest ^® product in the European Union and the United States. The aggregate amount of the royalty payments 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.

 

Preferred Stock

 

On February 5, 2001, we issued 100,000 shares of Series B Convertible Preferred Stock (“Preferred Stock”) as part of the IST acquisition. 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. The Preferred Stock dividends were $39,000 each year during fiscal 2007, 2006 and 2005. At July 31, 2007, accumulated accrued dividends are $9,750. 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 on our common stock for the five trading days immediately proceeding the date we give notice. The Preferred Stock shall be 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 then remaining Preferred Stock will be converted into our common stock at a ratio of one-to-one.

 

EBITDA

 

We utilize EBITDA (defined as earnings (loss) before interest, taxes, depreciation, and amortization) to monitor compliance with the covenants contained in our Amended and Restated Secured Notes, some of which are based on EBITDA. Although we use EBITDA as a financial measure to monitor compliance with debt covenants, it does not include certain material costs, expenses, and other items necessary to operate our business. Because EBITDA does not include these items, a stockholder, potential investor or other user of our financial information should not consider this non-GAAP financial measure as a substitute for Net Cash Used in Operating Activities or as the sole indicator of our financial performance since Net Cash Used in Operating Activities provides a more complete measure of our performance.

 

The following is a reconciliation of EBITDA to GAAP measures (unaudited) (in thousands):

 

Off-Balance Sheet Financing Arrangements

 

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

 

Contractual Obligations

 

The table below summarizes our future cash contractual obligations as of July 31, 2007, and the effect that such obligations are expected to have on our liquidity and cash flows for fiscal years presented (in thousands):

 

 

 

 

Purchase obligations include contractual arrangements that are legally binding and enforceable. These contractual arrangements specify all significant terms, including fixed or minimum quantities to be purchased, pricing provisions and the approximate timing of the transaction. The timing of payments for our purchase obligations is estimated based upon current information. The actual timing and amount of payment may differ from this estimate.

 

Purchase orders for raw materials and other goods and services are not included in the above table. Our purchase orders may represent authorizations to purchase rather than definitive binding contractual obligations. Contractual arrangements for goods and services that contain clauses allowing for cancellation without significant penalty are not included in the above table.

 

Critical Accounting Policies and Estimates

 

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of the consolidated financial statements requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates related to sales allowances, chargebacks, rebates, returns and other pricing adjustments, depreciation and amortization and other contingencies and litigation. We base our estimates on historical 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 sell our products. There are several accounting policies that we believe are significant to the presentation of our consolidated financial statements and require management’s most difficult, complex or subjective judgments about matters that are inherently uncertain. Note 1 to our Consolidated Financial Statements “Nature of Business Activities, Basis of Presentation and Summary of Significant Accounting Policies” summarizes each of our significant accounting policies. We believe our most critical accounting policies are as follows:

 

Revenue Recognition — Revenue from sales of products is recognized when earned; that is, when the risks and rewards of ownership have transferred to the customer, upon delivery to the designated carrier. Cash discounts, sales incentives, and returns are estimated and recognized as a reduction of revenue at the time of sale based upon historical experience and current customer commitments. We evaluate these estimates on a quarterly basis and revise them as necessary.

 

We provide for allowances for doubtful accounts and sales returns based on historical experience and a review of our receivables. Receivables are presented net of allowances for doubtful accounts and for sales

returns of $173,000 and $9,000 as of July 31, 2007 and 2006, respectively. We evaluate these estimates on a quarterly basis and revise them as necessary.

 

Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America necessarily requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as 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. The accounting estimates used in the preparation of our consolidated financial statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. 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.

 

We make changes in estimates as appropriate, and as we become aware of circumstances surrounding those estimates. Such changes and refinements in estimation methodologies are reflected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to Consolidated Financial Statements.

 

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 assess the impairment of goodwill annually, and for 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. In evaluating the recoverability of goodwill, intangibles and other long-lived assets, our policy is to compare the carrying amounts of such assets with the estimated undiscounted future operating cash flows. If we have 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 impaired which would result in a charge to earnings.

 

Recent Accounting Pronouncements

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (Topic 1N), “Quantifying Misstatements in Current Year Financial Statements,” (“SAB No. 108”). SAB No. 108 addresses how the effect of prior-year uncorrected misstatements should be considered when quantifying misstatements in current-year financial statements. SAB No. 108 requires SEC registrants (i) to quantify misstatements using a combined approach which considers both the balance-sheet and income-statement approaches, (ii) to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors, and (iii) to adjust their financial statements if the new combined approach results in a conclusion that an error is material. SAB No. 108 addresses the mechanics of correcting misstatements that include effects from prior years. It indicates that the current-year correction of a material error that includes prior-year effects may result in the need to correct prior-year financial statements even if the misstatement in the prior year or years is considered immaterial. Any prior-year financial statements found to be materially misstated in years originating subsequent to the issuance of SAB No. 108, the prior year financial statements requiring restatement would be restated in accordance with SFAS No. 154, “Accounting Changes and Error Corrections.” Because the combined approach represents a change in practice, the SEC staff will not require registrants that followed an acceptable approach in the past to restate prior years’ historical financial statements. Rather, these registrants can report the cumulative effect of adopting the new approach as an adjustment to the current year’s beginning balance of retained earnings. If the new approach is adopted in a quarter other than the first quarter, financial statements for prior interim periods within the year of adoption may need to be restated. SAB 108 is effective for any report for an interim period of the first fiscal period

ending after November 15, 2006. The adoption of SAB 108 did not have a material effect on our financial position or results of operations.

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measures” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP, expands disclosures about fair value measurements, and applies under other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 does not require any new fair value measurements. However, the FASB anticipates that for some entities, the application of SFAS No. 157 will change current practice. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, which for us will be our fiscal year beginning August 1, 2008. We are currently evaluating the impact of SFAS No. 157 to determine whether its adoption will have a material effect on our consolidated financial statements.

 

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006 and the provisions of FIN 48 will be applied to all tax positions upon initial adoption of the Interpretation, which for us will be our fiscal year beginning August 1, 2007. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We are currently evaluating the impact of FIN 48 to determine whether its adoption will have a material effect on our consolidated financial statements.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments — An Amendment of FASB Statements No. 133 and 140” (“SFAS No. 155”). This standard amends the guidance in SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Specifically, SFAS No. 155 amends SFAS No. 133 to permit fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided the whole instrument is accounted for on a fair value basis. Additionally, SFAS No. 155 amends SFAS No. 140 to allow a qualifying special purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006, which for us will be our fiscal year beginning August 1, 2007, with early application allowed. The adoption of SFAS No. 155 is not expected to have a material impact to our results of operations or financial position.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 159”). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain items at fair value. The objective of this standard is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reporting earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. Entities will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (i) may be applied instrument by instrument, with a few exceptions, such as investments accounted for by the equity method; (ii) is irrevocable (unless a new election date occurs); and (iii) is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, which for us would be our fiscal year beginning August 1, 2008. We are currently evaluating whether to adopt SFAS No. 159.

 

In December 2006, the FASB issued FSP EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“FSP EITF 00-19-2”), which addresses accounting for registration payment arrangements. FSP EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as

a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “Accounting for Contingencies.” FSP EITF 00-19-2 further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable generally accepted accounting principles without regard to the contingent obligation to transfer consideration pursuant to the registration payment. FSP EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to December 21, 2006. For registration payment arrangements and related financial instruments entered into prior to December 21, 2006, FSP EITF 00-19-2 is effective for financial statements issued for fiscal years beginning after December 15, 2006 and interim periods within those financial years. Companies are required to report transition through a cumulative-effect adjustment to the opening balance of retained earnings as of the first interim period for the fiscal year in which FSP EITF 00-19-2 is adopted.

 

As described more fully in Notes 8 and 15, in March 2006, we entered into a debt agreement that required issuance of a warrant to purchase 1.2 million shares of our common stock. As required under the debt agreement, we registered the common shares underlying the warrant with the Securities and Exchange Commission (“SEC”) and must maintain such registration over the term of the warrant. At the time of issuance, the obligation created by our agreement to register and maintain registration of the underlying common shares was recorded as a warrant liability measured at fair value. We determined the fair value of the warrant based on available market data using a Black-Scholes valuation model. The fair value of the warrant was recorded as a debt discount amortizable as interest expense over the life of the debt using the effective interest method. Any gains or losses resulting from the changes in fair value of the warrant liability from period to period are included as non-cash credits or charges to earnings.

 

As permitted under FSP EITF 00-19-2, we elected early adoption as of the beginning of our fiscal quarter beginning November 1, 2006. At such time, we recorded the effect of applying FSP EITF 00-19-2 to our derivative liability for the BCDF warrant using the cumulative-effect transition method, which resulted in a decrease in derivative liability of approximately $1.5 million and an increase to the carrying amount of additional paid-in capital of approximately $2.5 million, representing the original value assigned to the warrants with an offsetting cumulative-effect entry to accumulated deficit of approximately $0.9 million, as set forth in our Consolidated Statements of Shareholders’ Equity. The cumulative adjustment is not recorded in the consolidated statements of operations and prior periods are not adjusted.

 

 

 

 

 

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 Securities Exchange Act of 1934, as amended (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 Chief Executive Officer and Chief 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) and 15d-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.

 

Management’s Annual Report on Internal Control Over Financial Reporting.

 

Management of Zila, Inc (“Zila” or the “Company”) is responsible for establishing and maintaining effective internal controls over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act, as amended.

 

Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.

 

Management, with the participation of the Company’s principal executive and principal financial officers, assessed the effectiveness of the Company’s internal control over financial reporting as of July 31, 2007. This assessment was performed using the criteria established under the Internal Control-Integrated Framework established by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

On November 28, 2006, Zila acquired Professional Dental Technologies, Inc. (“Pro-Dentec”). The Company has excluded Pro-Dentec from its assessment of internal control over financial reporting as of July 31, 2007 because Pro-Dentec was acquired during fiscal 2007. Pro-Dentec constituted 61% and 80% of total assets and net assets, respectively, as of July 31, 2007, and 96% and 4% of revenues and loss from continuing operations, respectively, for the fiscal year then ended.

 

Based on the assessment performed using the criteria established by COSO, management has concluded that the Company maintained effective internal control over financial reporting as of July 31, 2007.

 

BDO Seidman, LLP, the independent registered public accounting firm that audited the financial statements included in this Annual Report on Form 10-K for the fiscal year ended July 31, 2007, has issued an audit report on the effectiveness of the Company’s internal control over financial reporting. Such report appears in Item 8 of this filing.

 

 

 

 

 

 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, this 15th day of October, 2007.

 

ZILA, INC., a Delaware corporation

 

Frank J. Bellizzi

Executive Vice President

(Principal Executive Officer)

 

POWER OF ATTORNEY

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Frank J. Bellizzi his or her attorney-in-fact, with the full power of substitution, for such person, in any and all capacities, to sign the Zila, Inc. Annual Report on Form 10-K and all amendments thereto, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he or she might do or could do in person hereby ratifying and confirming all that each of said attorneys-in-fact and agents, or his substitute, may do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report on Form 10-K has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated.

 

APPENDIX F

 

ZILA, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULE

 

Report of Independent Registered Public Accounting Firm On Internal Control Over Financial Reporting

 

Board of Directors and Shareholders

Zila, Inc.

Phoenix, Arizona

 

We have audited Zila, Inc.’s internal control over financial reporting as of July 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Zila, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

As indicated in the accompanying Management’s Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Professional Dental Technologies, Inc. (“Pro-Dentec”), which was acquired on November 28, 2006, and which is included in the consolidated balance sheets of Zila, Inc. as of July 31, 2007, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for the year then ended. Pro-Dentec constituted 61% and 80% of total assets and net assets, respectively, as of July 31, 2007, and 96% and 4% of revenues and loss from continuing operations, respectively, for the year then ended. Management did not assess the effectiveness of internal control over financial reporting of Pro-Dentec because of the timing of the acquisition which was completed on November 28, 2006. Our audit of internal control over financial reporting of Zila, Inc. also did not include an evaluation of the internal control over financial reporting of Pro-Dentec.

In our opinion, Zila, Inc. maintained, in all material respects, effective internal control over financial reporting as of July 31, 2007, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Zila, Inc. as of July 31, 2007 and 2006, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended July 31, 2007 and our report dated October 12, 2007 expressed an unqualified opinion thereon.

 

 

Phoenix, Arizona

October 12, 2007

 

Report of Independent Registered Public Accounting Firm

 

Board of Directors and Shareholders

Zila, Inc.

Phoenix, Arizona

 

We have audited the accompanying consolidated balance sheets of Zila, Inc. and subsidiaries as of July 31, 2007 and 2006 and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended July 31, 2007. We have also audited the schedule listed in the accompanying index. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

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

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Zila, Inc. and subsidiaries at July 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended July 31, 2007, in conformity with accounting principles generally accepted in the United States of America.

 

Also, in our opinion, the schedule presents fairly, in all material respects, the information set forth therein.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Zila Inc.’s internal control over financial reporting as of July 31, 2007, based on criteria established in Internal Control —  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated October 12, 2007 expressed an unqualified opinion thereon.

 

 

Phoenix, Arizona

October 12, 2007