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
For the quarterly period ended March 31, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period _______ to _______

Commission File Number 0-21185

AAIPHARMA INC.

2320 SCIENTIFIC PARK DRIVE, WILMINGTON, NC 28405
(Address of principal executive office)                       (Zip code)

(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 þ      No o

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

The number of shares of the registrant’s common stock outstanding as of April 1, 2005 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 March 31, 2005, we owned the following registered and unregistered trademarks referenced herein: Darvocet®, Darvon®, Darvon-N®, Darvocet-N®, Darvocet A500™, Brethine®, ProSorb-D™, Lynxorb™, 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 “^TM” 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
Item 1. Financial Statements.

aaiPharma Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

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

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aaiPharma Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

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

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aaiPharma Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

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

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aaiPharma Inc.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)

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

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aaiPharma Inc.
Notes to Consolidated Financial Statements
(Unaudited)

1. Basis of presentation and other matters

aaiPharma Inc. (“aaiPharma” or the “Company”) is a science-based company with corporate headquarters in Wilmington, North Carolina with over 25 years experience in drug development. The Company sells branded pharmaceutical products, including the Darvon and Darvocet product lines, primarily in the area of pain management. 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 (the “SEC”) 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, 2004 has been derived from audited financial statements; certain amounts from the three months ended March 31, 2004 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, 2004 (the “2004
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” (“SFAS 123"), 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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Going Concern

The Company incurred a substantial net loss and loss from operations for 2004 and a substantial net loss for the quarter ended March 31, 2005. The Company’s results of operations have continued to deteriorate as customer concerns regarding its financial condition have affected sales of the Company’s pharmaceutical products as well as the Company’s ability to obtain and maintain development services engagements.

As a result of the Company’s substantial and recurring net losses, the Company believes that it does not have adequate sources of liquidity to fund operations in the near term unless the Company obtains additional sources of liquidity. Because the Company did not make the $10.5 million scheduled interest payment due on April 1, 2005 on its senior subordinated notes within 30 days after April 1, holders of 25% of the notes or the trustee under the indenture governing the notes may accelerate the notes. The ability of the holders of the notes or the trustee to accelerate the notes is an event of default under the Company’s senior credit facilities, entitling the lenders to accelerate the debt thereunder. In addition, the Company was in default of certain covenants under the senior credit facilities on March 31, 2005.

In light of its current financial condition, the Company believes that its operations can no longer support its existing debt and that the Company must restructure its debt to levels that are more in line with its operations. Thus, it is highly likely that the Company and its U.S. subsidiaries will seek relief under chapter 11 of Title 11 of the U.S. Code (the “Bankruptcy Code”) which would substantially dilute and may eliminate the interests of the holders of the Company’s common stock. On April 29, 2005, the Company accepted a commitment letter from Silver Point Finance, LLC to provide debtor-in-possession financing if the Company and its U.S. subsidiaries commence bankruptcy proceedings under the Bankruptcy Code. This debtor-in-possession financing would be subject to a number of conditions, including approval by the bankruptcy court. See Note 10 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.”

These conditions raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classifications of liabilities that may result from the outcome of this uncertainty.

Because of the defaults under the Company’s senior credit facilities and the senior subordinated notes at March 31, 2005, all $350.5 million of debt under the Company’s senior credit facilities and the notes was classified as current liabilities on the Company’s consolidated balance sheet at March 31, 2005.

Impact of Recently Issued Accounting Standards

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which amends SFAS 123, and supersedes APB 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) requires compensation expense to be recognized for all share-based payments made to employees based on the fair value of the award at the date of grant, eliminating the intrinsic value alternative allowed by SFAS 123. SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in

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the financial statements based on their fair values (i.e., pro forma disclosure is no longer an alternative to financial statement recognition). SFAS 123(R) must be adopted in the first annual period beginning after June 15, 2005.

The Company currently plans to adopt SFAS 123(R) on January 1, 2006. This change in accounting is not expected to materially impact the Company’s financial position. However, because the Company currently accounts for share-based payments to its employees under APB No. 25, the results of operations have not included the recognition of compensation expense for the issuance of stock option awards. Had the Company applied the fair-value criteria established by SFAS 123(R) to previous stock option grants, the impact to its results of operations would have approximated the impact of applying SFAS 123, which was a reduction to net income of approximately $1.1 million and $3.1 million in the three months ended March 31, 2005 and 2004, respectively.

No other recently issued, but not yet effective, accounting standards are believed to have a material impact on the Company.

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

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 certain 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 was held in escrow to satisfy post-closing obligations under the agreement. The Company received approximately $1.6 million from this escrow in September 2004 and does not anticipate receiving any additional payments out of this escrow. The M.V.I. and Aquasol Sale resulted in a preliminary 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; 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. 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.

3. Income taxes

The Company recorded no net federal income tax benefit or expense in the first quarter of 2005, primarily as a result of current period net loss before taxes. Any tax benefit would be 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.

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4. Loss per share

Basic loss per share is based on the weighted average number of common shares outstanding during the year. Diluted loss per share is computed assuming that the actual weighted average number of common shares outstanding was increased by the exercise of stock options issued to employees and members of the Company’s Board of Directors under the treasury stock method. The diluted per share amounts reflect a change in the number of shares outstanding (the “denominator”) to include the options as if they were exercised and converted to shares and issued, unless their inclusion would be anti-dilutive. During the three months ended March 31, 2004, approximately 360,000 options were exercised for aggregate proceeds to the Company of $3.6 million. No options were exercised in the three months ended March 31, 2005. In the three months ended March 31, 2005 and 2004, 5.9 million and 2.0 million options, respectively, which were all of the outstanding options, were excluded as they were anti-dilutive. In each period presented, each of the net loss (the “numerator”) and the weighted average number of common shares (the denominator) is the same for both basic and diluted per share computations.

5. Financial information by business segment and geographic area

In 2004 and the first quarter of 2005, the Company operated 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.

In late March 2005, the Company reorganized its operating structure to reflect the Company’s decision to curtail its research and development activities in light of its financial condition. At that time, the Company’s Research and Development Division was no longer actively engaged in any shared-risk development projects. Personnel involved in the development of proprietary products were assigned to the Company’s Pharmaceuticals Division, while personnel who had focused on independent research or shared-risk development projects were assigned to fee-for-service development projects in the Company’s AAI Development Services Division. As a result of this reorganization of the operating structure, the Company began operating in only two business segments in April 2005 – proprietary pharmaceutical product development and sales through the Pharmaceuticals Division and development services offered to third parties through the AAI Development Services Division. The majority of the Company’s non-U.S. operations are located in Germany.

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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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6. Accounts receivable, net

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

Accounts receivable are presented net of an allowance for uncollectible accounts and net of an allowance for customer credits, including discounts, rebates, chargebacks, product returns and other allowances. The decrease in the allowance for customer credits is due to decreases in product returns reserves primarily related to decreases in wholesaler inventory levels due to wholesaler shipments, product returns and related decreases in chargeback reserves.

7. Inventories, net

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

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8. Debt