UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

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

Commission File Number 0-21185

AAIPHARMA INC.

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

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

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

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

The terms “we”, “us” or “our” in this Form 10-Q include aaiPharma Inc., its corporate predecessors and its subsidiaries, except where the context may indicate otherwise. Our corporation was incorporated in 1986, although its corporate predecessor was founded in 1979. Our Internet address is www.aaipharma.com. We make available through our Internet website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

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

aaiPharma Inc.
Table of Contents

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PART I. FINANCIAL INFORMATION

aaiPharma Inc.

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

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aaiPharma Inc.

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

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aaiPharma Inc.

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

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aaiPharma Inc.

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

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aaiPharma Inc.

1. Basis of presentation and other matters

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

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

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for its stock option plans; therefore, compensation expense has not been recognized for options granted at fair value. Under APB 25, if the exercise price of the Company’s stock options is not less than the estimated fair market value of the underlying stock on the date of grant, no compensation expense is recognized. If compensation cost for the Company’s plans had been determined based on the fair value at the grant dates for awards under those plans consistent with the fair value method of Statement of Financial Accounting Standards No. 123 “Accounting for Stock Based Compensation”, the Company’s net income (loss) and income (loss) per share would have been changed to the pro forma amounts indicated below:

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2. Recent developments

Special Committee

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

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

NASDAQ Listing Status

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

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

Senior Credit Agreement and Indenture Defaults

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

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

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

Royalties Receivable

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

Termination of Interest Rate Hedging Obligation

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

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

Governmental Investigations and Litigation

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

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

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

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

Generic Competition

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

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

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

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

4. Income taxes

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

5. Earnings (loss) per share

Basic earnings (loss) per share are based on the weighted average number of common shares outstanding during the year. Diluted earnings (loss) per share are computed assuming that the weighted average number of common shares was increased by the conversion of stock options issued to employees and members of the Company’s Board of Directors. The diluted per share amounts reflect a change in the number of shares outstanding (the “denominator”) to include the options as if they were converted to shares and issued, unless their inclusion would be anti-dilutive. During the six months ended June 30, 2004, approximately 360,000 options were exercised for aggregate proceeds to

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the Company of $3.6 million. In the three and six months ended June 30, 2004, 4.6 million and 3.5 million options, respectively, were excluded as they were anti-dilutive. In the three and six months ended June 30, 2003, 1.7 million and 1.6 million options, respectively, were excluded as they were anti-dilutive. In each period presented, the net income (loss) (the “numerator”) is the same for both basic and diluted per share computations.

The following table provides a reconciliation of the denominator for the basic and diluted earning per share computations (in thousands):

6. Financial information by business segment and geographic area

The Company operates in three business segments consisting of a product sales business, primarily comprised of the pharmaceuticals division, a product development business, primarily the research and development business unit, and a development services business, primarily the AAI Development Services business unit. The product sales business provides for the sales of the Company’s pharmaceutical product lines. In the product development segment, the Company internally develops drugs and technologies for future sales by the product sales business or with the objective of licensing marketing rights to third parties in exchange for license fees and royalties. The core services provided by the development services business on a fee-for-service basis to pharmaceutical and biotechnology industries worldwide include comprehensive formulation, testing and manufacturing expertise, in addition to the ability to take investigational products into and through human clinical trials. The majority of the Company’s non-U.S. operations are located in Germany.

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

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