Edgar Filing: LANNETT CO INC

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010

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

FOR THE TRANSITION PERIOD FROM TO .

Commission File No. 001-31298

LANNETT COMPANY, INC.

(Exact Name of Registrant as Specified in its Charter)

State of Delaware		23-0787699
(State of Incorporation)		(I.R.S. Employer I.D. No.)

9000 State Road

Philadelphia, PA 19136

(215) 333-9000

(Address of principal executive offices and telephone number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 o

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

Large accelerated filer o		Accelerated filer o

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

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

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

Indicate the number of shares outstanding of each class of the registrant’s common stock, as of the latest practical date.

Class		Outstanding as of November 4, 2010
Common stock, par value $0.001 per share		25,298,503 shares

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			Page No.

PART I. FINANCIAL INFORMATION

ITEM 1.		FINANCIAL STATEMENTS

		Consolidated Balance Sheets as of September 30, 2010 (unaudited) and June 30, 2010	1

		Consolidated Statements of Operations (unaudited) for the three months ended September 30, 2010 and 2009	2

		Consolidated Statement of Changes in Shareholders’ Equity (unaudited) for the three months ended September 30, 2010	3

		Consolidated Statements of Cash Flows (unaudited) for the three months ended September 30, 2010 and 2009	4

		Notes to Consolidated Financial Statements (unaudited)	5

ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	27

ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	39

ITEM 4.		CONTROLS AND PROCEDURES	39

PART II. OTHER INFORMATION

ITEM 1.		LEGAL PROCEEDINGS	40

ITEM 1A.		RISK FACTORS	41

ITEM 6.		EXHIBITS	48

31.1	CERTIFICATION OF PRESIDENT & CHIEF EXECUTIVE OFFICER

31.2	CERTIFICATION OF CHIEF FINANCIAL OFFICER

32	CERTIFICATION PURSUANT TO SECTION 906 OF SARBANES OXLEY ACT OF 2002

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

	(Unaudited)
	September 30, 2010			June 30, 2010
ASSETS
Current Assets
Cash and cash equivalents	$	17,624,554		$	21,895,648
Investment securities - available for sale	212,757			604,464
Trade accounts receivable (net of allowance of $123,192 and $123,192 respectively)	31,189,099			38,324,258
Inventories, net	21,036,591			19,056,868
Interest receivable	9,371			9,631
Prepaid taxes	498,215			—
Deferred tax assets	5,133,873			5,337,391
Other current assets	2,162,319			2,506,114
Total Current Assets	77,866,779			87,734,374

Property, plant and equipment	51,882,758			50,160,114
Less accumulated depreciation	(22,293,000		)	(21,531,845		)
	29,589,758			28,628,269

Construction in progress	3,680,223			2,939,898
Investment securities - available for sale	183,771			183,742
Intangible assets (product rights) - net of accumulated amortization	7,326,945			7,785,298
Deferred tax assets	12,524,544			12,544,330
Other assets	138,858			147,886
Total Assets	$	131,310,878		$	139,963,797

LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES
Current Liabilities
Accounts payable	$	15,763,468		$	16,280,675
Accrued expenses	2,498,862			3,464,181
Accrued payroll and payroll related	2,486,810			6,304,465
Income taxes payable	—			1,479,658
Current portion of long-term debt	4,826,601			4,851,278
Rebates, chargebacks and returns payable	13,359,608			15,249,412
Total Current Liabilities	38,935,349			47,629,669

Long-term debt, less current portion	2,834,973			2,868,549
Unearned grant funds	500,000			500,000
Other long-term liabilities	6,558			7,864
Total Liabilities	42,276,880			51,006,082
Commitment and Contingencies, See notes 10 and 11	—			—

SHAREHOLDERS’ EQUITY
Common stock - authorized 50,000,000 shares, par value $0.001; issued and outstanding, 24,929,131 and 24,882,123 shares, respectively	24,929			24,882
Additional paid in capital	80,410,648			79,862,940
Retained earnings	9,161,071			9,564,632
Noncontrolling interest	121,421			111,982
Accumulated other comprehensive income	52,588			44,692
	89,770,657			89,609,128
Less: Treasury stock at cost - 130,118 and 110,108 shares, respectively	(736,659		)	(651,413		)
TOTAL SHAREHOLDERS’ EQUITY	89,033,998			88,957,715

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	131,310,878		$	139,963,797

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

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LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

	Three months ended
	September 30,
	2010			2009

Net sales	$	25,395,927		$	31,434,989
Cost of sales	18,900,048			19,012,318
Amortization of intangible assets	448,667			448,667
Product royalties	143,271			439,774

Gross profit	5,903,941			11,534,230

Research and development expenses	2,042,369			3,027,841
Selling, general, and administrative expenses	4,600,681			3,763,161
Gain on sale of investments	(12,641		)	—

Operating (loss) income	(726,468		)	4,743,228

Other income (expense):
Foreign currency gain	2,415			—
Interest income	11,231			23,099
Interest expense	(70,844		)	(70,413		)
	(57,198		)	(47,314		)

(Loss) income before income tax (benefit) expense	(783,666		)	4,695,914
Income tax (benefit) expense	(389,544		)	1,827,650
Net (loss) income	(394,122		)	2,868,264
Less net income attributable to noncontrolling interest	(9,439		)	(10,894		)

Net (loss) income attributable to Lannett Company, Inc.	$	(403,561	)	$	2,857,370

Basic (loss) income per common share - Lannett Company, Inc.	$	(0.02	)	$	0.12
Diluted (loss) income per common share - Lannett Company, Inc.	$	(0.02	)	$	0.11

Basic weighted average number of shares	24,899,530			24,533,562
Diluted weighted average number of shares	24,899,530			25,054,661

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

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LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

	Common Stock			Additional											Accum. Other
	Shares			Paid-in			Retained			Treasury			Noncontrolling		Comprehensive		Shareholders’
	Issued	Amount		Capital			Earnings			Stock			Interest		Income		Equity

Balance, June 30, 2010	24,882,123	$	24,882	$	79,862,940		$	9,564,632		$	(651,413	)	$	111,982	$	44,692	$	88,957,715

Shares issued in connection with employee stock purchase plan	14,610	15		54,254			—			—			—		—		54,269
Share based compensation
Restricted stock	—	—		174,755			—			—			—		—		174,755
Stock options	—	—		306,232			—			—			—		—		306,232
Employee stock purchase plan	—	—		12,499			—			—			—		—		12,499
Shares issued in connection with restricted stock grant	32,398	32		(32		)	—			—			—		—		—
Purchase of treasury stock	—	—		—			—			(85,246		)	—		—		(85,246		)
Other comprehensive income, net of income tax	—	—		—			—			—			—		7,896		7,896
Net (loss) income	—	—		—			(403,561		)	—			9,439		—		(394,122		)

Balance, September 30, 2010	24,929,131	$	24,929	$	80,410,648		$	9,161,071		$	(736,659	)	$	121,421	$	52,588	$	89,033,998

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

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LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	For the three months ended September 30,
	2010			2009

OPERATING ACTIVITIES:
Net (loss) income	$	(394,122	)	$	2,868,264
Adjustments to reconcile net (loss) income to net cash used in operating activities:
Depreciation and amortization	1,219,508			1,166,604
Deferred tax expense	227,143			388,427
Stock compensation expense	493,486			297,315
Other noncash expenses (income)	7,722			(26,391		)
Gain on sale of assets	(12,641		)	—
Changes in assets and liabilities which provided (used) cash:
Trade accounts receivable	7,135,159			(1,152,466		)
Inventories	(1,979,723		)	(814,863		)
Prepaid and income taxes payable	(1,977,873		)	513,590
Prepaid expenses and other assets	344,055			58,142
Accounts payable	(517,207		)	(1,155,783		)
Accrued expenses	(965,319		)	289,880
Rebates, chargebacks and returns payable	(1,889,804		)	(871,703		)
Accrued payroll and payroll related	(3,817,655		)	(2,195,495		)
Net cash used in operating activities	(2,127,271		)	(634,479		)

INVESTING ACTIVITIES:
Purchases of property, plant and equipment (including construction in progress)	(2,462,969		)	(1,067,261		)
Purchase of intangible asset (product rights)	—			(500,000		)
Proceeds from sale of investment securities - available for sale	394,721			—
Net cash used in investing activities	(2,068,248		)	(1,567,261		)

FINANCING ACTIVITIES:
Repayments of debt	(58,253		)	(136,285		)
Proceeds from issuance of stock	54,269			185,943
Purchase of treasury stock	(85,246		)	(69,120		)
Net cash used in financing activities	(89,230		)	(19,462		)

Effect of foreign currency rates on cash and cash equivalents	13,655			—

NET DECREASE IN CASH AND CASH EQUIVALENTS	(4,271,094		)	(2,221,202		)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD	21,895,648			25,832,456

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	17,624,554		$	23,611,254

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION -
Interest paid	$	100,856		$	41,762
Income taxes paid	$	1,361,186		$	925,633

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

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LANNETT COMPANY, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED

Note 1. Interim Financial Information

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles for presentation of interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the unaudited financial statements do not include all the information and footnotes necessary for a comprehensive presentation of the financial position, results of operations, and cash flows for the periods presented. In the opinion of management, the unaudited financial statements include all the normal recurring adjustments that are necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. Operating results for the three months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2011. You should read these unaudited financial statements in combination with the other Notes in this section; “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Item 2; and the Financial Statements, including the Notes to the Financial Statements, included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2010.

Note 2. Summary of Significant Accounting Policies

Lannett Company, Inc., a Delaware corporation, and subsidiaries (the “Company” or “Lannett”), develop, manufacture, package, market, and distribute active pharmaceutical ingredients as well as pharmaceutical products sold under generic chemical names. The Company manufactures solid oral dosage forms, including tablets and capsules, topical and oral solutions, and is pursuing partnerships and research contracts for the development and production of other dosage forms, including ophthalmic, nasal and injectable products.

Use of Estimates —The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Principles of Consolidation - The consolidated financial statements include the accounts of the operating parent company, Lannett Company, Inc., and its wholly owned subsidiaries, as well as the consolidation of Cody LCI Realty, LLC, a variable interest entity. See Note 16 regarding the consolidation of this variable interest entity. All intercompany accounts and transactions have been eliminated.

Foreign Currency Translation - The local currency is the functional currency of its foreign subsidiary. Assets and liabilities of the foreign subsidiary are translated into U.S. dollars at the period-end currency exchange rate and revenues and expenses are translated at an average currency exchange rate for the period. The resulting translation adjustment is recorded in a separate component of shareholders’ equity and changes to such are included in comprehensive income. Exchange adjustments resulting from transactions denominated in foreign currencies are recognized in the consolidated statements of operations.

Reclassifications - Certain prior year amounts have been reclassified to conform to the current year financial statement presentation.

Revenue Recognition - The Company recognizes revenue when its products are shipped. At this point, title and risk of loss have transferred to the customer and provisions for estimates, including rebates, promotional adjustments, price adjustments, returns, chargebacks, and other potential adjustments are reasonably

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determinable. Accruals for these provisions are presented in the consolidated financial statements as rebates, chargebacks and returns payable and reductions to net sales. The change in the reserves for various sales adjustments may not be proportionally equal to the change in sales because of changes in both the product and the customer mix. Increased sales to wholesalers will generally require additional accruals as they are the primary recipient of chargebacks and rebates. Incentives offered to secure sales vary from product to product. Provisions for estimated rebates and promotional credits are estimated based upon contractual terms. Provisions for other customer credits, such as price adjustments, returns, and chargebacks, require management to make subjective judgments on customer mix. Unlike branded innovator drug companies, Lannett does not use information about product levels in distribution channels from third-party sources, such as IMS and Wolters Kluwer, in estimating future returns and other credits. Lannett calculates a chargeback/rebate rate based on contractual terms with its customers and applies this rate to customer sales. The only variable is customer mix, and this assumption is based on historical data and sales expectations.

Chargebacks — The provision for chargebacks is the most significant and complex estimate used in the recognition of revenue. The Company sells its products directly to wholesale distributors, generic distributors, retail pharmacy chains, and mail-order pharmacies. The Company also sells its products indirectly to independent pharmacies, managed care organizations, hospitals, nursing homes, and group purchasing organizations, collectively referred to as “indirect customers.” Lannett enters into agreements with its indirect customers to establish pricing for certain products. The indirect customers then independently select a wholesaler from which to actually purchase the products at these agreed-upon prices. Lannett will provide credit to the wholesaler for the difference between the agreed-upon price with the indirect customer and the wholesaler’s invoice price if the price sold to the indirect customer is lower than the direct price to the wholesaler. This credit is called a chargeback. The provision for chargebacks is based on expected sell-through levels by the Company’s wholesale customers to the indirect customers and estimated wholesaler inventory levels. As sales to the large wholesale customers, such as Cardinal Health, AmerisourceBergen, and McKesson increase, the reserve for chargebacks will also generally increase. However, the size of the increase depends on the product mix and the amount of those sales that end up at indirect customers with which the Company has specific chargeback agreements. The Company continually monitors the reserve for chargebacks and makes adjustments when management believes that expected chargebacks on actual sales may differ from actual chargeback reserves.

Rebates — Rebates are offered to the Company’s key chain drug store, distributor and wholesaler customers to promote customer loyalty and increase product sales. These rebate programs provide customers with rebate credits upon attainment of pre-established volumes or attainment of net sales milestones for a specified period. Other promotional programs are incentive programs offered to the customers. At the time of shipment, the Company estimates reserves for rebates and other promotional credit programs based on the specific terms in each agreement. The reserve for rebates increases as sales to certain wholesale and retail customers increase. However, since these rebate programs are not identical for all customers, the size of the reserve will depend on the mix of customers that are eligible to receive rebates.

Returns — Consistent with industry practice, the Company has a product returns policy that allows customers to return product within a specified period prior to and subsequent to the product’s lot expiration date in exchange for a credit to be applied to future purchases. The Company’s policy requires that the customer obtain pre-approval from the Company for any qualifying return. The Company estimates its provision for returns based on historical experience, changes to business practices, and credit terms. While such experience has allowed for reasonable estimations in the past, history may not always be an accurate indicator of future returns. The Company continually monitors the provisions for returns and makes adjustments when management believes that actual product returns may differ from established reserves. Generally, the reserve for returns increases as net sales increase. The reserve for returns is included in the rebates, chargebacks and returns payable account on the balance sheet.

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Other Adjustments — Other adjustments consist primarily of price adjustments, also known as “shelf stock adjustments,” which are credits issued to reflect decreases in the selling prices of the Company’s products that customers have remaining in their inventories at the time of the price reduction. Decreases in selling prices are discretionary decisions made by management to reflect competitive market conditions. Amounts recorded for estimated shelf stock adjustments are based upon specified terms with direct customers, estimated declines in market prices, and estimates of inventory held by customers. The Company regularly monitors these and other factors and evaluates the reserve as additional information becomes available. Other adjustments are included in the rebates, chargebacks and returns payable account on the balance sheet.

The following tables identify the reserves for each major category of revenue allowance and a summary of the activity for the three months ended September 30, 2010 and 2009:

For the three months ended September 30, 2010

Reserve Category	Chargebacks			Rebates			Returns			Other			Total

Reserve Balance as of June 30, 2010	$	6,282,127		$	3,566,031		$	5,401,254		$	—		$	15,249,412
Actual credits issued related to sales recorded in prior fiscal years	(6,112,838		)	(2,558,582		)	(1,151,174		)	—			(9,822,594		)
Reserves or (reversals) charged during Fiscal 2011 related to sales in prior fiscal years	—			—			—			—			—
Reserves charged to net sales during Fiscal 2011 related to sales recorded in Fiscal 2011	11,960,878			3,776,169			2,987,308			1,663,371			20,387,726
Actual credits issued related to sales recorded in Fiscal 2011	(7,056,592		)	(2,347,273		)	(1,387,700		)	(1,663,371		)	(12,454,936		)
Reserve Balance as of September 30, 2010	$	5,073,575		$	2,436,345		$	5,849,688		$	—		$	13,359,608

For the three months ended September 30, 2009

Reserve Category	Chargebacks			Rebates			Returns			Other			Total

Reserve Balance as of June 30, 2009	$	6,089,802		$	2,537,746		$	5,106,992		$	—		$	13,734,540
Actual credits issued related to sales recorded in prior fiscal years	(4,767,581		)	(1,852,708		)	(1,147,720		)	—			(7,768,009		)
Reserves or (reversals) charged during Fiscal 2010 related to sales in prior fiscal years	—			—			—			—			—
Reserves charged to net sales during Fiscal 2010 related to sales recorded in Fiscal 2010	10,272,936			4,066,855			1,140,128			407,784			15,887,703
Actual credits issued related to sales recorded in Fiscal 2010	(7,000,389		)	(1,789,955		)	—			(407,784		)	(9,198,128		)
Reserve Balance as of September 30, 2009	$	4,594,768		$	2,961,938		$	5,099,400		$	—		$	12,656,106

The total reserve for chargebacks, rebates, returns and other adjustments decreased from $15,249,412 at June 30, 2010 to $13,359,608 at September 30, 2010. The decrease in total reserves was due to a decrease in the rebates reserve as a result of a decrease in overall sales, and a decrease in chargeback reserves due primarily to a decrease in inventory levels at wholesaler distribution centers.

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The Company ships its products to the warehouses of its wholesale and retail chain customers. When the Company and a customer enter into an agreement for the supply of a product, the customer will generally continue to purchase the product, stock its warehouse(s), and resell the product to its own customers. The Company’s customer will reorder the product as its warehouse is depleted. The Company generally has no minimum size orders for its customers. Additionally, most warehousing customers prefer not to stock excess inventory levels due to the additional carrying costs and inefficiencies created by holding excess inventory. As such, the Company’s customers continually reorder the Company’s products. It is common for the Company’s customers to order the same products on a monthly basis. For generic pharmaceutical manufacturers, it is critical to ensure that customers’ warehouses are adequately stocked with its products. This is important due to the fact that several generic competitors compete for the consumer demand for a given product. Availability of inventory ensures that a manufacturer’s product is considered. Otherwise, retail prescriptions would be filled with competitors’ products. For this reason, the Company periodically offers incentives to its customers to purchase its products. These incentives are generally up-front discounts off its standard prices at the beginning of a generic campaign launch for a newly-approved or newly-introduced product, or when a customer purchases a Lannett product for the first time. Customers generally inform the Company that such purchases represent an estimate of expected resale for a period of time. This period of time is generally up to three months. The Company records this revenue, net of any discounts offered and accepted by its customers at the time of shipment. The Company’s products generally have 24 months or 36 months of shelf-life at the time of manufacture. The Company monitors its customers’ purchasing trends to attempt to identify any significant lapses in purchasing activity. If the Company observes a lack of recent activity, inquiries will be made to such customer regarding the success of the customer’s resale efforts. The Company attempts to minimize any potential return (or shelf life issues) by maintaining an active dialogue with the customers.

The products that the Company sells are generic versions of brand named drugs. The consumer markets for such drugs are well-established markets with many years of historically-confirmed consumer demand. Such consumer demand may be affected by several factors, including alternative treatments and costs. However, the effects of changes in such consumer demand for the Company’s products, like generic products manufactured by other generic companies, are gradual in nature. Any overall decrease in consumer demand for generic products generally occurs over an extended period of time. This is because there are thousands of doctors, prescribers, third-party payers, institutional formularies and other buyers of drugs that must change prescribing habits and medicinal practices before such a decrease would affect a generic drug market. If the historical data the Company uses and the assumptions management makes to calculate its estimates of future returns, chargebacks, and other credits do not accurately approximate future activity, its net sales, gross profit, net income and earnings per share could change. However, management believes that these estimates are reasonable based upon historical experience and current conditions.

Cash and cash equivalents — The Company considers all highly liquid securities purchased with original maturities of 90 days or less to be cash equivalents. Cash equivalents are stated at cost, which approximates fair value, and consist of certificates of deposit that are readily convertible to cash. The Company maintains cash and cash equivalents with several major financial institutions. Such amounts frequently exceed Federal Deposit Insurance Corporation (“FDIC”) limits.

Accounts Receivable - The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customer’s current credit worthiness, as determined by a review of current credit information. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon historical experience and any specific customer collection issues that have been identified. While such credit losses have historically been within both the Company’s expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same credit loss rates that it has in the past.

Fair Value of Financial Instruments - The Company’s financial instruments consist primarily of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and debt obligations. The carrying values

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of these assets and liabilities approximate fair value based upon the short-term nature of these instruments. The Company has estimated that the fair value of long-term debt associated with the 20 year mortgage on its land and building in Cody, Wyoming approximates the discounted amount of future payments to the mortgage-holder.

Investment Securities - The Company’s investment securities consist of marketable debt securities, primarily in U.S. government and agency obligations. All of the Company’s marketable debt securities are classified as available-for-sale and recorded at fair value, based on quoted market prices. Unrealized holding gains and losses are recorded, net of any tax effect, as a separate component of accumulated other comprehensive income. No gains or losses on marketable debt securities are realized until they are sold or a decline in fair value is determined to be other-than-temporary. The Company reviews its marketable securities and determines whether the investments are other-than-temporarily impaired. If the investments are deemed to be other-than-temporarily impaired, the investments are written down to their then current fair market value with a new cost basis being established. There were no securities determined by management to be other-than-temporarily impaired during the three months ended September 30, 2010 or the fiscal year ended June 30, 2010.

Shipping and Handling Costs — The cost of shipping products to customers is recognized at the time the products are shipped, and is included in cost of sales.

Research and Development — Research and development expenses are charged to operations as incurred.

Intangible Assets — In March 2004, the Company entered into an agreement with Jerome Stevens Pharmaceuticals, Inc. (JSP) for the exclusive marketing and distribution rights in the United States to the current line of JSP products in exchange for four million (4,000,000) shares of the Company’s common stock. As a result of the JSP agreement, the Company recorded an intangible asset for the exclusive marketing and distribution rights obtained from JSP. As of September 30, 2010 and June 30, 2010, management concluded the carrying value of the intangible asset was less than its fair value and, therefore, no impairment was required. The Company will incur annual amortization expense of approximately $1,785,000 for the JSP intangible asset over the remaining term of the agreement.

On April 10, 2007, the Company entered into a Stock Purchase Agreement to acquire Cody by purchasing all of the remaining shares of common stock of Cody. The consideration for the April 10, 2007 acquisition was approximately $4,438,000, which represented the fair value of the tangible net assets acquired. The agreement also required Lannett to issue to the sellers up to 120,000 shares of unregistered common stock of the Company contingent upon the receipt of a license from a regulatory agency. This license was subsequently received in July 2008 and triggered the payment of 105,000 shares (87.5% of the 120,000 shares to be issued as the Company already owned 12.5% of Cody) of Lannett stock to the former owners of Cody Labs, which was completed in October 2008. Therefore, the Company recorded an intangible asset related to the acquisition of a drug import license in the original amount of $581,175 and recorded a corresponding deferred tax liability of approximately $150,700 due to the non-deductibility of the amortization for tax purposes. The Company has assigned a 15 year life to this intangible asset based on average life cycles of Lannett products.

In January 2005, Lannett Holdings, Inc. entered into an agreement in which the Company purchased for $100,000 and future royalty payments the proprietary rights to manufacture and distribute a product for which Pharmeral, Inc. owned the ANDA. In May 2008, the Company and Pharmeral waived their rights to any royalty payments on the sales of the drug by Lannett under Lannett’s current ownership structure. Should Lannett undergo a change in control transaction with a third party, this royalty will be reinstated. In Fiscal 2008, the Company obtained FDA approval to use these proprietary rights. Accordingly, the Company originally capitalized these purchased product rights as an indefinite lived intangible asset and tested this asset for impairment at least on an annual basis. During the fourth quarter of fiscal 2009, it was determined that this intangible asset no longer has an indefinite life. No impairment existed because the estimated fair value exceeded the carrying amount on that date. Accordingly, the $100,000 carrying amount of this intangible asset is being amortized on a straight line basis prospectively over its 10 year remaining estimated useful life.

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In August 2009, the Company acquired eight new ANDAs covering three separate product lines from another generic drug manufacturer for a purchase price of $500,000. The Company began shipping one of these product lines in October 2010 and it is expected that the Company will be able to produce the other two product lines by the second half of Fiscal 2011. Amortization will begin when the Company starts shipping these products. An intangible asset that is not subject to amortization shall be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. An impairment loss is measured as the excess of the asset’s carrying value over its fair value, calculated using a discounted future cash flow method. Our discounted cash flow models are highly reliant on various assumptions which are considered level 3 inputs, including estimates of future cash flow (including long-term growth rates), discount rate, and expectations about variations in the amount and timing of cash flows and the probability of achieving the estimated cash flows. As of September 30 and June 30, 2010, no impairment existed with respect to these assets.

For the three months ended September 30, 2010 and 2009, the Company incurred amortization expense of approximately $458,000 and $458,000, respectively. As of September 30, 2010 and June 30, 2010, accumulated amortization totaled approximately $9,916,000 and $9,458,000, respectively.

Future annual amortization expense consists of the following as of September 30, 2010:

Fiscal Year Ending June 30,	Annual Amortization Expense
2011	$	1,375,059
2012	1,833,412
2013	1,833,412
2014	1,387,245
2015	48,745
Thereafter	349,072
	$	6,826,945

The amounts above do not include the ANDAs purchased in August 2009 for $500,000 as amortization will begin when the Company starts shipping these products. As noted above, the Company began shipping one of these product lines in October 2010.

Advertising Costs - The Company charges advertising costs to operations as incurred. Advertising expense for the three months ended September 30, 2010 and 2009 was approximately $19,000 and $10,000, respectively.

Income Taxes - The Company uses the liability method to account for income taxes. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense/(benefit) is the result of changes in deferred tax assets and liabilities. The Company may recognize the tax benefit from an uncertain tax position claimed on a tax return only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The authoritative standards issued by the FASB also provide guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.

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Segment Information - The Company operates one business segment - generic pharmaceuticals; accordingly the Company has one reporting segment. The Company aggregates its financial information for all products and reports as one operating segment. The following table identifies the Company’s approximate net product sales by medical indication for the three months ended September 30, 2010 and 2009:

	For the Three Months Ended September 30,
Medical Indication	2010		2009

Migraine Headache	$	2,525,000	$	2,663,000
Epilepsy	521,000		611,000
Prescription Vitamin	869,000		1,489,000
Heart Failure	3,229,000		4,852,000
Thyroid Deficiency	10,336,000		13,024,000
Antibiotic	1,381,000		1,661,000
Pain Management	2,900,000		3,880,000
Other	3,635,000		3,255,000

Total	$	25,396,000	$	31,435,000

Concentration of Market and Credit Risk - Five of the Company’s products, defined as generics containing the same active ingredient or combination of ingredients, accounted for approximately 41%, 13%, 10%, 4% and 3%, respectively of net sales for the three months ended September 30, 2010. Those same products accounted for 41%, 15%, 8%, 3% and 5% respectively, of net sales for the three months ended September 30, 2009.

Four of the Company’s customers accounted for 23%, 13%, 9%, and 9%, respectively, of net sales for the three months ended September 30, 2010, and 25%, 12%, 8%, and 8%, respectively, of net sales for the three months ended September 30, 2009. At September 30, 2010, four customers accounted for 64% of the Company’s accounts receivable balances. At June 30, 2010, four customers accounted for 69% of the Company’s accounts receivable balances.

Share-based Compensation - The Company recognizes compensation cost for share-based compensation issued to or purchased by employees, net of estimated forfeitures, under share-based compensation plans using a fair value method.

At September 30, 2010, the Company had three stock-based employee compensation plans (the “Old Plan,” the “2003 Plan,” and the 2006 Long-term Incentive Plan, or “2006 LTIP”).

At September 30, 2010, there were 2,058,851 options outstanding. Of those, 1,032,925 were options issued under the 2006 LTIP, 820,693 were issued under the 2003 Plan, and 205,233 under the Old Plan. There are no further shares authorized to be issued under the Old Plan. 1,125,000 shares were authorized to be issued under the 2003 Plan, with 49,365 shares under options having already been exercised under that plan since its inception, leaving a balance of 254,942 shares in that plan for future issuances. 2,500,000 shares were authorized to be issued under the 2006 LTIP, with 94,725 shares under options having already been exercised under that plan since its inception. At September 30, 2010, there were 237,500 nonvested restricted shares outstanding which were issued under the 2006 LTIP, with 372,689 shares having already vested under that plan since its inception. At September 30, 2010, a balance of 762,161 shares is available in the 2006 LTIP for future issuances.

During the fiscal year ended June 30, 2010, the Company awarded 237,500 shares of restricted stock to management employees under the 2006 LTIP which vest in equal portions on October 29, 2010, 2011 and 2012.

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Stock compensation expense of $144,787 was recognized during the three months ended September 30, 2010 related to these shares of restricted stock.

During the fiscal year ended June 30, 2008, the Company awarded 209,264 shares of restricted stock to management employees under the 2006 LTIP, of which 74,464 of these shares vested 100% on January 1, 2008, and the remainder vested in equal portions on September 18, 2008, 2009 and 2010. Stock compensation expense of $29,968 and $43,007 was recognized during the three months ended September 30, 2010 and 2009, respectively, related to these shares of restricted stock.

The Company measures the fair value of share-based compensation cost for options using the Black-Scholes option pricing model. The following table presents the weighted average assumptions used to estimate fair values of the stock options granted and the estimated forfeiture rates during the three months ended September 30:

	Incentive Stock Options			Non-qualified Stock Options			Incentive Stock Options			Non-qualified Stock Options
	FY 2011			FY 2011			FY 2010			FY 2010
Risk-free interest rate	—		%	—		%	2.4		%	—		%
Expected volatility	—		%	—		%	67.1		%	—		%
Expected dividend yield	—		%	—		%	—		%	—		%
Forfeiture rate	—		%	—		%	5.0		%	—		%
Expected term	n/a			n/a			5.0 years			n/a
Weighted average fair value at date of grant	$	—		$	—		$	4.86		$	—

Expected volatility is based on the historical volatility of the price of our common shares since the date we commenced trading on the NYSE-Amex, April 2002, or a historical period equal to the expected term of the option, whichever is shorter. We use historical information to estimate expected term within the valuation model. The expected term of awards represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Compensation cost is recognized using the straight-line method over the vesting or service period and is net of estimated forfeitures.

The forfeiture rate assumption is the estimated annual rate at which unvested awards are expected to be forfeited during the vesting period. This assumption is based on our historical forfeiture rate. Periodically, management will assess whether it is necessary to adjust the estimated rate to reflect changes in actual forfeitures or changes in expectations. For example, adjustments may be needed if forfeitures were affected by turnover that resulted from a business restructuring that is not expected to recur. The Company will incur additional expense if the actual forfeiture rate is lower than originally estimated. A recovery of prior expense will be recorded if the actual rate is higher than originally estimated.

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The following table presents all share-based compensation costs recognized in our statements of operations, substantially all of which is reflected in the selling, general and administrative expense line:

	Three Months Ended September 30,
	2010		2009
Share based compensation
Stock options	$	306,232	$	232,868
Employee stock purchase plan	12,499		21,440
Restricted stock	174,755		43,007
Tax benefit at statutory rate	31,467		27,604

Options outstanding that have vested and are expected to vest as of September 30, 2010 are as follows:

	Awards	Weighted - Average Exercise Price		Aggregate Intrinsic Value		Weighted Average Remaining Contractual Life
Options vested	1,306,240	$	7.96	$	330,755	5.1
Options expected to vest	694,084	$	6.55	$	106,299	9.0
Total vested and expected to vest	2,000,324	$	7.47	$	437,054	6.5

A summary of nonvested restricted stock award activity as of September 30, 2010 and changes during the three months then ended, is presented below:

	Awards		Weighted Average Grant Date Fair Value
Nonvested at July 1, 2010	269,898		$	1,778,814
Granted	—		—
Vested	(32,398	)	(130,564		)
Forfeited	—		—
Nonvested at September 30, 2010	237,500		$	1,648,250

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A summary of award activity under the Plans as of September 30, 2010 and 2009, and changes during the three months then ended, is presented below:

	Incentive Stock Options						Nonqualified Stock Options
						Weighted						Weighted
		Weighted-				Average		Weighted-				Average
		Average		Aggregate		Remaining		Average		Aggregate		Remaining
		Exercise		Intrinsic		Contractual		Exercise		Intrinsic		Contractual
	Awards	Price		Value		Life	Awards	Price		Value		Life

Outstanding at July 1, 2010	1,309,254	$	6.11				749,597	$	9.77
Granted	—	$	—				—	$	—
Exercised	—	$	—				—	$	—
Forfeited, expired or repurchased	—	$	—				—	$	—
Outstanding at September 30, 2010	1,309,254	$	6.11	$	353,362	7.3	749,597	$	9.77	$	89,926	5.2
Outstanding at September 30, 2010 and not yet vested	599,953	$	6.45	$	112,533	8.9	152,658	$	6.99	$	—	9.1
Exercisable at September 30, 2010	709,301	$	5.83	$	240,829	5.9	596,939	$	10.48	$	89,926	4.2

	Incentive Stock Options							Nonqualified Stock Options
							Weighted					Weighted
			Weighted-				Average		Weighted-			Average
			Average		Aggregate		Remaining		Average		Aggregate	Remaining
			Exercise		Intrinsic		Contractual		Exercise		Intrinsic	Contractual
	Awards		Price		Value		Life	Awards	Price		Value	Life

Outstanding at July 1, 2009	958,909		$	5.60				626,772	$	10.52
Granted	20,000		$	8.48				—	$	—
Exercised	(36,100	)	$	4.23				—	$	—
Forfeited, expired or repurchased	(6,400	)	$	5.38				—	$	—
Outstanding at September 30, 2009	936,409		$	5.71	$	2,217,739	7.2	626,772	$	10.52	551,242	5.3
Outstanding at September 30, 2009 and not yet vested	350,474		$	4.64	1,015,723		8.7	63,067	$	4.51	187,483	8.1
Exercisable at September 30, 2009	585,935		$	6.36	$	1,202,016	6.3	563,705	$	11.19	373,133	4.9

Options with a fair value of $342,556 vested during the three months ended September 30, 2010. As of September 30, 2010, there was $2,786,917 of total unrecognized compensation cost related to nonvested share-based compensation awards granted under the Plans. That cost is expected to be recognized over a weighted average period of 2.0 years. The Company issues new shares when stock options are exercised.

Unearned Grant Funds — The Company records all grant funds received as a liability until the Company fulfills all the requirements of the grant funding program.

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Earnings (loss) per Common Share — A dual presentation of basic and diluted earnings (loss) per share is required on the face of the Company’s consolidated statement of operations as well as a reconciliation of the computation of basic earnings (loss) per share to diluted earnings per share. Basic earnings (loss) per share excludes the dilutive impact of common stock equivalents and is computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding for the period. Diluted earnings per share include the effect of potential dilution from the exercise of outstanding common stock equivalents into common stock using the treasury stock method. A reconciliation of the Company’s basic and diluted income (loss) per share follows:

	Three Months Ended September 30,
	2010				2009
	Net (Loss) Attirbutable to Lannett			Shares	Net Income Attirbutable to Lannett		Shares
	(Numerator)			(Denominator)	(Numerator)		(Denominator)

Basic (loss) earnings per share factors	$	(403,561	)	24,899,530	$	2,857,370	24,533,562

Effect of potentially dilutive option and restricted stock plans	—			—	—		521,099

Diluted (loss) earnings per share factors	$	(403,561	)	24,899,530	$	2,857,370	25,054,661

Basic (loss) earnings per share	$	(0.02	)		$	0.12
Diluted (loss) earnings per share	$	(0.02	)		$	0.11

Dilutive shares have been excluded in the weighted average shares used for the calculation of earnings per share in periods of net loss because the effect of such securities would be anti-dilutive. The number of anti-dilutive shares that have been excluded in the computation of diluted earnings per share for the three months ended September 30, 2010 and 2009 were 2,296,351 and 352,845, respectively.

Note 3. New Accounting Standards

In June 2009, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance for determining whether an entity is a variable interest entity and modifies the methods allowed for determining the primary beneficiary of a variable interest entity. This guidance requires an enterprise to perform an analysis to determine whether the enterprise’s variable interest or interests give it a controlling financial interest in a variable interest entity. It also requires ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity. The authoritative guidance is effective for the annual reporting period that begins after November 15, 2009. We do not expect the adoption of this authoritative guidance to have a significant impact on our consolidated financial statements.

In January 2010, the FASB issued authoritative guidance which requires reporting entities to make new disclosures about recurring or nonrecurring fair-value measurements including significant transfers into and out of Level 1 and Level 2 fair-value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair- value measurements. The FASB’s Accounting Standards Update (“ASU”) 2010-6 is effective for annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual periods beginning after December 15, 2010. We do not anticipate that this update will have a material impact on our consolidated financial statements.

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Note 4. Inventories

The Company values its inventory at the lower of cost (determined by the first-in, first-out method) or market, regularly reviews inventory quantities on hand, and records a provision for excess and obsolete inventory based primarily on estimated forecasts of product demand. The Company’s estimates of future product demand may fluctuate, in which case estimated required reserves for excess and obsolete inventory may increase or decrease. If the Company’s inventory is determined to be overvalued, the Company recognizes such costs in cost of goods sold at the time of such determination. Likewise, if inventory is determined to be undervalued, the Company may have recognized excess cost of goods sold in previous periods and would recognize such additional operating income at the time of sale.

Inventories consist of the following:

	September 30, 2010		June 30, 2010

Raw materials	$	7,840,599	$	5,183,735
Work-in-process	2,588,395		2,375,396
Finished goods	9,865,669		10,527,630
Packaging supplies	741,928		970,106
	$	21,036,591	$	19,056,868

The preceding amounts are net of excess and obsolete inventory reserves of $3,115,605 and $2,481,810 at September 30, 2010 and June 30, 2010, respectively.

Recently, the FDA has increased its efforts to force companies to file and seek FDA approval for GRASE or Grandfathered products. GRASE products are those “old drugs that do not require prior approval from FDA in order to be marketed because they are generally recognized as safe and effective based on published scientific literature.” Similarly, Grandfathered products are those which “entered the market before the passage of the 1906 act, the 1938 act or the 1962 amendments to the act.” Efforts have included granting market exclusivity to approved GRASE or Grandfathered products and issuing notices to discontinue marketing certain products to companies currently producing these products. Lannett currently manufactures and markets several products that are considered GRASE or Grandfathered products, including Morphine Sulfate Oral Solution. The Company is currently litigating the issue of Grandfathered drugs with the FDA. The FDA is currently undertaking activities to force all companies who manufacture Morphine Sulfate Oral Solution to file applications and seek approval for this product or remove their product from the market. As of July 24, 2010, Lannett has stopped manufacturing and distributing Morphine Sulfate Oral Solution and as of September 30, 2010, the Company has approximately $2.0 million of Morphine Sulfate Oral Solution finished goods inventory. Lannett has filed a 505(b)(2) New Drug Application and currently awaits FDA approval on the submission. If the Company is rejected on its current application, if the current application takes significantly longer than eleven months to be approved, or if the FDA were to prevail on the current lawsuit filed by Lannett which seeks determination that Morphine Sulfate Oral Solution is a Grandfathered product, the Company is at risk of losing some or all of the approximately $2.0 million of Morphine Sulfate Oral Solution inventory as of September 30, 2010. Lannett also has approximately $2.7 million of inventory value at September 30, 2010 of other Grandfathered products which would also be at risk if the FDA were to pursue enforcement actions on these products similar to their actions on Morphine Sulfate Oral Solution.

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Note 5. Property, Plant and Equipment

Property, plant and equipment are stated at cost. Depreciation is provided for by the straight-line method for financial reporting purposes over the estimated useful lives of the assets. Depreciation expense for the three months ended September 30, 2010 and 2009 was approximately $762,000 and $708,000, respectively.

Property, plant and equipment consist of the following:

		September 30,			June 30,
	Useful Lives	2010			2010
Land	-	$	1,375,103		$	1,375,103
Building and improvements	10 - 39 years	23,970,883			23,101,751
Machinery and equipment	5 - 10 years	25,436,336			24,638,754
Furniture and fixtures	5 - 7 years	1,100,436			1,044,506
		$	51,882,758		$	50,160,114
Accumulated depreciation		(22,293,000		)	(21,531,845		)
		$	29,589,758		$	28,628,269

Note 6. Investment Securities - Available-for-Sale

On July 1, 2008, the Company adopted the authoritative guidance which clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The authoritative guidance also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs were established that may be used to measure fair value:

Level 1 — Quoted prices in active markets for identical assets or liabilities. The Company does not have any Level 1 available-for-sale securities as of September 30, 2010 or June 30, 2010.

Level 2 — Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices for identical or similar instruments in markets that are not active; or model-derived valuations whose inputs are observable or whose significant value drivers are observable. The Company’s Level 2 assets and liabilities primarily include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, corporate bonds, U.S. government and agency securities and certain mortgage-backed and asset-backed securities whose values are determined using pricing models with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. The fair value of the Company’s available-for-sale securities in the table below are derived solely from Level 2 inputs.

Level 3 — Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation. The Company does not have any Level 3 available-for-sale securities as of September 30, 2010 or June 30, 2010.

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

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The amortized cost, gross unrealized gains and losses, and fair value of the Company’s available-for-sale securities are summarized as follows:

September 30, 2010

Available-for-Sale

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value

U.S. Government Agency	$	208,671	$	4,086	$	—	$	212,757
Corporate Bonds	179,507		4,264		—		183,771
	$	388,178	$	8,350	$	—	$	396,528

June 30, 2010

Available-for-Sale

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value

U.S. Government Agency	$	590,751	$	13,713	$	—	$	604,464
Corporate Bonds	179,507		4,235		—		183,742
	$	770,258	$	17,948	$	—	$	788,206

The amortized cost and fair value of the Company’s current available-for-sale securities by contractual maturity at September 30, 2010 and June 30, 2010 are summarized as follows:

	September 30, 2010				June 30, 2010
	Available for Sale				Available for Sale
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less	$	208,671	$	212,757	$	590,751	$	604,464
Due after one year through five years	179,507		183,771		179,507		183,742
Due after five years through ten years	—		—		—		—
Due after ten years	—		—		—		—

Total available-for-sale securities	388,178		396,528		770,258		788,206
Less current portion	208,671		212,757		590,751		604,464

Long term available-for-sale securites	$	179,507	$	183,771	$	179,507	$	183,742

The Company uses the specific identification method to determine the cost of securities sold. For the three months ended September 30, 2010, the Company had realized gains of $12,641, whereas for the three months ended September 30, 2009, the Company had no realized gains or losses.

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As of September 30, 2010 and June 30, 2010, there were no securities held from a single issuer that represented more than 10% of shareholders’ equity. As of September 30, 2010, there were no individual securities in a continuous unrealized loss position.

Note 7. Bank Line of Credit

The Company has a $3,000,000 line of credit from Wells Fargo, N. A., formerly Wachovia Bank, N.A. (“Wells Fargo”) that bears interest at the prime interest rate less 0.25% (3.00% at September 30, 2010 and June 30, 2010, respectively). As of September 30, 2010 and June 30, 2010, the Company had $3,000,000 of availability under this line of credit. The line of credit is collateralized by substantially all of the Company’s assets. The agreement contains covenants with respect to working capital, net worth and certain ratios, as well as other covenants. As of September 30, 2010, the Company was not in compliance with all financial covenants under the agreement, but received a waiver from its lending institution with respect to the failed covenant as of September 30, 2010. The noncompliance was caused by the direct use of cash to purchase and fit out Lannett’s third facility during the December 2009, March 2010 and June 2010 quarters over a period where the Company experienced reduced earnings caused by the DEA withholding production quota for Morphine Sulfate Oral Solution and the FDA actions barring Lannett from shipping Morphine Sulfate Oral Solution. As a result of the expected refinancing of the $4.5 million PIDC Regional Center, LP III loan which is due on January 1, 2011, the Company will consider renegotiation of its current covenant requirements.

The existing line of credit, which was scheduled to expire on November 30, 2010, was renewed and extended during the first quarter of Fiscal 2011 to November 30, 2011. As part of the renewal agreement last fiscal year, the Company is no longer required to maintain any minimum deposit balances with Wells Fargo, and the availability fee on the unused balance of the line of credit was reduced to 0.375%.

Note 8. Unearned Grant Funds

In July 2004, the Company received $500,000 of grant funding from the Commonwealth of Pennsylvania, acting through the Department of Community and Economic Development. The grant funding program requires the Company to use the funds for machinery and equipment located at their Pennsylvania locations, hire an additional 100 full-time employees by June 30, 2006, operate its Pennsylvania locations a minimum of five years and meet certain matching investment requirements. If the Company fails to comply with any of the requirements above, the Company would be liable to repay the full amount of the grant funding ($500,000). The Company has recorded the unearned grant funds as a liability until the Company complies with all of the requirements of the grant funding program. As of September 30, 2010, the Company has had preliminary discussions with the Commonwealth of Pennsylvania to determine whether it will be required to repay any of the funds provided under the grant funding program. Based on information available at September 30, 2010, the Company has recorded the grant funding as a long-term liability under the caption of Unearned Grant Funds.

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Note 9. Long-Term Debt

Long-term debt consists of the following:

	September 30,		June 30,
	2010		2010
PIDC Regional Center, LP III loan	$	4,500,000	4,500,000
Pennsylvania Industrial Development Authority loan	914,726		933,820
Pennsylvania Department of Community & Economic Development loan	61,923		88,141
Tax-exempt bond loan (PAID)	555,000		555,000
First National Bank of Cody mortgage	1,629,925		1,642,866

Total debt	7,661,574		7,719,827
Less current portion	4,826,601		4,851,278

Long term debt	$	2,834,973	$	2,868,549

	September 30,		June 30,
Current Portion of Long Term Debt	2010		2010
PIDC Regional Center, LP III loan	$	4,500,000	$	4,500,000
Pennsylvania Industrial Development Authority loan	77,600		77,091
Pennsylvania Department of Community & Economic Development loan	61,923		88,141
Tax-exempt bond loan (PAID)	130,000		130,000
First National Bank of Cody mortgage	57,078		56,046

Total current portion of long term debt	$	4,826,601	$	4,851,278

In December 2005, the Company financed $4,500,000 through the Philadelphia Industrial Development Corporation (PIDC). The Company pays a bi-annual interest payment at a rate equal to two and one-half percent per annum. The outstanding principal balance is due and payable on January 1, 2011. The Company intends to refinance this loan prior to its maturity date.

The Company financed $1,250,000 through the Pennsylvania Industrial Development Authority (PIDA). The Company is required to make equal payments each month for 180 months starting February 1, 2006 with interest of two and three-quarter percent per annum.

An additional $500,000 was financed through the Pennsylvania Department of Community and Economic Development Machinery and Equipment Loan Fund. The Company is required to make equal payments for 60 months starting May 1, 2006 with interest of two and three quarter percent per annum.

In April 1999, the Company entered into a loan agreement (the “Agreement”) with a governmental authority, the Philadelphia Authority for Industrial Development (the “Authority” or “PAID”), to finance future construction and growth projects of the Company. The Authority issued $3,700,000 in tax-exempt variable rate demand and fixed rate revenue bonds to provide the funds to finance such growth projects pursuant to a trust indenture (“the Trust Indenture”). A portion of the Company’s proceeds from the bonds was used to pay for bond issuance costs of approximately $170,000. The Trust Indenture requires that the Company repay the Authority loan through installment payments beginning in May 2003 and continuing through May 2014, the year the bonds mature. The bonds bear interest at the floating variable rate determined by the organization responsible for selling the bonds

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(the “remarketing agent”). The interest rate fluctuates on a weekly basis. The effective interest rate at September 30, 2010 and June 30, 2010 was 0.49% and 0.52%, respectively.

The Company has executed Security Agreements with Wells Fargo, PIDA and PIDC in which the Company has agreed to pledge substantially all of its assets to collateralize the amounts due.

The Company is the primary beneficiary to a variable interest entity (“VIE”) called Cody LCI Realty, LLC. See Note 16, Consolidation of Variable Interest Entity for additional description. The VIE owns land and a building which is being leased to Cody. A mortgage loan with First National Bank of Cody has been consolidated in the Company’s financial statements, along with the related land and building. Principal and interest payments of $14,782, at a fixed interest rate of 7.5%, are being made on a monthly basis through June 2026. The mortgage loan is collateralized by the land and building.

Long-term debt amounts due, for the twelve month periods ending September 30 are as follows:

Twelve	Amounts Payable
Month Periods	to Institutions

2011	$	4,826,601
2012	276,284
2013	288,522
2014	305,716
2015	163,608
Thereafter	1,800,843

	$	7,661,574

Note 10. Contingencies

In January 2010, the Company initiated an arbitration proceeding against Olive Healthcare (“Olive”) for damages arising out of Olive’s delivery of defective soft-gel prenatal vitamin capsules. The Company seeks damages in excess of $3.5 million. Olive has denied liability and filed a counterclaim in February 2010 for breach of contract.

In June 2008, the Company filed a declaratory judgment suit in the Federal District Court of Delaware (Civil Action No. 08-338 (JJF)) against KV Pharmaceuticals, DrugTech Corp. and Ther-Rx Corp (collectively, “KV”). The complaint sought declaratory judgment for non-infringement and invalidity of certain patents owned by KV. The complaint further sought declaratory judgment of anti-trust violations and federal and state unfair competition violations for actions taken by KV in securing and enforcing these patents. After the complaint was filed, KV countered with a motion for a Temporary Restraining Order (“TRO”) to prevent the Company from launching its Multivitamin with Mineral Capsules (“MMCs”), due to alleged patent and trademark infringement issues. The TRO was heard and, ultimately, resulted in a conclusion by the court that the Company’s product label on the MMCs should be modified. KV also countered with claims of infringement by the Company of KV’s patents seeking the Company’s profits for sales of MMCs or other monetary relief, preliminary and permanent injunctive relief, attorney’s fees and a finding of willful infringement. In March 2009, the Company and KV settled the litigation. In light of the withdrawal of KV’s innovator prenatal product due to FDA enforcement actions, and the resulting anticipated decline in sales and declining market for written prescription, the Company decided it was pointless to continue the litigation and entered into the settlement arrangement with KV. Pursuant to the settlement, the Company received a license from KV and became an authorized generic

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provider. During the terms of the license, the Company is to pay KV a royalty on all future sales of its Prenatal vitamin product. Lannett will cease offering its Prenatal vitamin product if and when the brand is restored to the marketplace. In May 2010, the Company filed an action for declaratory relief in the Delaware Superior Court against KV seeking a declaration that KV breached its obligations under a settlement agreement entered into with the Company (the “Binding Agreement”). In June 2010, KV filed a counterclaim to the complaint and asserted claims for breach of contract, declaratory judgment, negligent misrepresentation and fraud in connection with the Binding Agreement, alleging among other things that the Company has improperly withheld royalties from KV arising out of its sales of a pre-natal vitamin product. KV filed a motion for summary judgment, which the Company opposed. The Court has not yet held a hearing on the motion or ruled on it.

Note 11. Commitments

Leases

In June 2006, Lannett signed a lease agreement on a 66,000 square foot facility located on approximately seven acres in Philadelphia. The Company purchased this building in October 2009 for approximately $3.8 million plus the cost of fit out of approximately $2.0 million. A significant portion of the purchase price and fit out costs are expected to be financed through a series of loans with a bank and a Pennsylvania state run development agency. These loans can not be put in place until all construction has been completed and a proper certificate of occupancy has been obtained, due to a requirement by the state run development agency. Construction was substantially complete by June 30, 2010. A certificate of occupancy was obtained by September 2010. The financing is expected to be completed and funded by the second quarter of Fiscal 2011. This new facility is being used for certain administrative functions, warehouse space, shipping and possibly additional manufacturing space in the future.

Lannett’s subsidiary, Cody leases a 73,000 square foot facility in Cody, Wyoming. This location houses Cody’s manufacturing and production facilities. Cody leases the facility from Cody LCI Realty, LLC, a Wyoming limited liability company which is 50% owned by Lannett. See Note 16.

Rental and lease expense for the three months ended September 30, 2010 and 2009 was approximately $22,000 and $82,000, respectively.

Employment Agreements

The Company has entered into employment agreements with Arthur P. Bedrosian, President and Chief Executive Officer, Keith R. Ruck, Vice President of Finance and Chief Financial Officer, Kevin Smith, Vice President of Sales and Marketing, William Schreck, Senior Vice President and General Manager, Ernest Sabo, Vice President of Regulatory Affairs and Chief Compliance Officer, and Stephen Kovary, Vice President of Operations. Each of the agreements provide for an annual base salary and eligibility to receive a bonus. The bonus amounts of these executives are determined by the Board of Directors. Additionally, these executives are eligible to receive stock options and restricted stock awards, which are granted at the discretion of the Board of Directors, and in accordance with the Company’s policies regarding stock option and restricted stock grants. Under the agreements, these executive employees may be terminated at any time with or without cause, or by reason of death or disability. In certain termination situations, the Company is liable to pay severance compensation to these executives of between 18 months and three years.

During the third quarter of Fiscal Year 2009, the Company’s former Vice President of Finance, Treasurer, Secretary and Chief Financial Officer resigned. As part of his separation agreement, the Company is obligated to pay to him approximately $670,000 to settle any outstanding obligations from his employment agreement, including any salary,

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bonus, vacation, stock options and medical benefits. Of this amount, $300,440 was paid in Fiscal 2009 with $165,000 designated for the payment of pro rated bonus, and $11,440 was designated for the payment of accrued but unused paid time off. As part of the settlement, $124,000 was designated as the portion of the settlement related to the repurchase of his outstanding stock options. The Company therefore charged this amount to Additional Paid in Capital, as it represents the fair value of the options repurchased on the repurchase date. Additional payments totaling approximately $369,000 for severance and benefits were paid in the first quarter of Fiscal 2011 pursuant to the separation agreement.

Fiscal 2010 Bonus

The Company accrued approximately $4,812,000 of incentive compensation costs at June 30, 2010, of which approximately $3,421,000 was paid in cash during the first quarter of Fiscal 2011. The remaining $1,391,000 is expected to be paid in unrestricted shares of Company stock, and which shares are expected to vest immediately upon grant. These shares will only be granted upon the timely approval by the FDA of Lannett’s 505(b)(2) New Drug Application to manufacture and distribute its Morphine Sulfate Oral Solution product. The determination of the actual payment of this portion of the bonus is at the discretion of the CEO, dependent on the timing of the approval and the financial results of the Company dictated by the events surrounding the approval.

Note 12. Comprehensive (Loss) Income

The Company’s other comprehensive (loss) income is comprised of unrealized gains (losses) on investment securities classified as available-for-sale as well as foreign currency translation adjustments. There is no other comprehensive income (loss) attributable to the noncontrolling interest. The components of comprehensive (loss) income and related taxes consisted of the following:

	For the Three Months Ended September 30,
	2010			2009

Net (Loss) Income	$	(394,122	)	$	2,868,264
Foreign currency translation adjustments	13,655			—
Unrealized holding loss on securities	(9,598		)	(3,751		)
Tax effect	3,839			1,500

Total Other Comprehensive Income (Loss)	7,896			(2,251		)

Total Comprehensive (Loss) Income	$	(386,226	)	$	2,866,013

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Note 13. Employee Benefit Plan

The Company has a defined contribution 401k plan (the “Plan”) covering substantially all employees. Pursuant to the Plan provisions, the Company is required to make matching contributions equal to 50% of each employee’s contribution, but not to exceed 4% of the employee’s compensation for the Plan year. Contributions to the Plan during the three months ended September 30, 2010 and 2009 were $140,000 and $153,000, respectively.

Note 14. Employee Stock Purchase Plan

In February 2003, the Company’s shareholders approved an Employee Stock Purchase Plan (“ESPP”). Employees eligible to participate in the ESPP may purchase shares of the Company’s stock at 85% of the lower of the fair market value of the common stock on the first day of the calendar quarter, or the last day of the calendar quarter. Under the ESPP, employees can authorize the Company to withhold up to 10% of their compensation during any quarterly offering period, subject to certain limitations. The ESPP was implemented on April 1, 2003 and is qualified under Section 423 of the Internal Revenue Code. The Board of Directors authorized an aggregate total of 1,125,000 shares of the Company’s common stock for issuance under the ESPP. As of September 30, 2010, 231,803 shares have been issued under the ESPP. Compensation expense of $12,499 and $21,440 relating to the ESPP was recognized for the three months ended September 30, 2010 and 2009, respectively.

Note 15. Income Taxes

The Company uses the liability method to account for income taxes. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense/(benefit) is the result of changes in deferred tax assets and liabilities.

The provision for federal, state and local income taxes for the three months ended September 30, 2010 and 2009 was tax (benefit) expense of approximately $(390,000) and $1,828,000, respectively, with effective tax rates of 50% and 39%, respectively. The effective tax rate for the three months ended September 30, 2010 was higher compared to the three months ended September 30, 2009 due primarily to nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2011. The Company expects its overall effective tax rate will be approximately 48% to 50% for the full year ended June 30, 2011.

The Company may recognize the tax benefit from an uncertain tax position claimed on a tax return only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The authoritative standards issued by the FASB also provide guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.

As of September 30, 2010 and June 30, 2010, the Company reported total unrecognized tax benefits of $399,034. As a result of the positions taken during the period, the Company has not recorded any interest and penalties for the period ended September 30, 2010 in the statement of operations and no cumulative interest and penalties have been recorded either in the Company’s statement of financial position as of September 30, 2010 and June 30, 2010. The Company will recognize interest accrued on unrecognized tax benefits in interest expense and any related penalties in operating expenses. The Company does not believe that the total unrecognized tax benefits will significantly increase or decrease in the next twelve months.

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The Company files income tax returns in the United States federal jurisdiction, Pennsylvania, New Jersey and California. The Company’s tax returns for Fiscal 2006 and prior generally are no longer subject to review as such years generally are closed. The Company believes that an unfavorable resolution for open tax years would not be material to the financial position of the Company.

Note 16. Consolidation of Variable Interest Entity

Lannett consolidates any Variable Interest Entity (“VIE”) of which it is the primary beneficiary. The liabilities recognized as a result of consolidating a VIE do not represent additional claims on our general assets; rather, they represent claims against the specific assets of the consolidated VIE. Conversely, assets recognized as a result of consolidating a VIE do not represent additional assets that could be used to satisfy claims against our general assets. Reflected in the September 30, 2010 and June 30, 2010 balance sheets are consolidated VIE assets of approximately $1.9 million and $1.9 million, which are comprised mainly of land and building. VIE liabilities consist of a mortgage on that property in the amount of approximately $1.6 and $1.6 million at September 30, 2010 and June 30, 2010, respectively.

Cody LCI Realty LLC (“Realty”) is the only VIE that is consolidated. Realty had been consolidated by Cody prior to its acquisition by Lannett. Realty is a 50/50 joint venture with a former shareholder of Cody. Its purpose was to acquire the facility used by Cody. Until the acquisition of Cody in April 2007, Lannett had not consolidated the VIE because Cody Labs had been the primary beneficiary of the VIE. The risks associated with our interests in this VIE is limited to a decline in the value of the land and building as compared to the balance of the mortgage note on that property, up to Lannett’s 50% share of the venture. Realty owns the land and building, and Cody leases the building and property from Realty for $20,000 per month effective October 2009, when the lease increased from $15,000 per month. All intercompany rent expense is eliminated upon consolidation with Cody. The Company is not involved in any other VIE.

Note 17. Related Party Transactions

The Company had sales of approximately $177,000 and $213,000 during the three months ended September 30, 2010 and 2009, respectively, to a generic distributor, Auburn Pharmaceutical Company (“Auburn”). Jeffrey Farber (the “related party”), who is a current board member and the son of the Chairman of the Board of Directors and principal shareholder of the Company, is the owner of Auburn. Accounts receivable includes amounts due from the related party of approximately $164,000 and $161,000 at September 30, 2010 and June 30, 2010, respectively. In the Company’s opinion, the terms of these transactions were not more favorable to the related party than would have been to a non-related party.

In January 2005, Lannett Holdings, Inc. entered into an agreement in which the Company purchased for $100,000 and future royalty payments the proprietary rights to manufacture and distribute a product for which Pharmeral, Inc. (“Pharmeral”) owned the ANDA. In Fiscal 2008, the Company obtained FDA approval to use the proprietary rights. Accordingly, the Company originally capitalized these rights as an indefinite lived intangible asset and tested this asset for impairment at least on an annual basis. During the fourth quarter of Fiscal 2009, it was determined that this intangible asset no longer has an indefinite life. No impairment existed because the estimated fair value exceeded the carrying amount on that date. Accordingly, the $100,000 carrying amount of this intangible asset is being amortized on a straight line basis prospectively over its 10 year remaining estimated useful life.

Arthur Bedrosian, President and Chief Executive Officer, currently owns 100% of Pharmeral. This transaction was approved by the Board of Directors of the Company and in their opinion the terms were not more favorable to the related party than they would have been to a non-related party. In May 2008, Mr. Bedrosian and Pharmeral waived their rights to any royalty payments on the sales of the drug by Lannett under Lannett’s current ownership

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structure. Should Lannett undergo a change in control where a third party is involved, this royalty would be reinstated. The registered trademark OB-Natal® was transferred to Lannett for one dollar from Mr. Bedrosian.

Lannett Company, Inc. paid a management consultant who is related to Mr. Bedrosian $37,100 in fees during the three months ended September 30, 2010 and $21,420 in fees and $ 4,533 in reimbursable expenses during the three months ended September 30 2009. This consultant provided management, construction planning, laboratory set up and administrative services in regards to the Company’s initial set up of its Bio-study laboratory in a foreign country. It is expected that this consultant will continue to be utilized into Fiscal 2011. In the Company’s opinion, the fee rates paid to this consultant and the expenses reimbursed to him were not more favorable than what would have been paid to a non-related party.

Note 18. Material Contract with Supplier

Jerome Stevens Pharmaceuticals agreement:

The Company’s primary finished product inventory supplier is Jerome Stevens Pharmaceuticals, Inc. (“JSP”), in Bohemia, New York. Purchases of finished goods inventory from JSP accounted for approximately 56% and 67% of the Company’s inventory purchases during the three months ended September 30, 2010 and 2009, respectively. On March 23, 2004, the Company entered into an agreement with JSP for the exclusive distribution rights in the United States to the current line of JSP products, in exchange for four million (4,000,000) shares of the Company’s common stock. The JSP products covered under the agreement included Butalbital, Aspirin, Caffeine with Codeine Phosphate capsules, Digoxin tablets and Levothyroxine Sodium tablets, sold generically and under the brand name Unithroid®. The term of the agreement is ten years, beginning on March 23, 2004 and continuing through March 22, 2014. Both Lannett and JSP have the right to terminate the contract if one of the parties does not cure a material breach of the contract within thirty (30) days of notice from the non-breaching party.

During the term of the agreement, the Company is required to use commercially reasonable efforts to purchase minimum dollar quantities of JSP’s products being distributed by the Company. The minimum quantity to be purchased in the first year of the agreement was $15 million. Thereafter, the minimum quantity to be purchased increases by $1 million per year up to $24 million for the last year of the ten-year contract. The Company has met the minimum purchase requirement for the first six years of the contract, but there is no guarantee that the Company will be able to continue to do so in the future. If the Company does not meet the minimum purchase requirements, JSP’s sole remedy is to terminate the agreement.

Under the agreement, JSP is entitled to nominate one person to serve on the Company’s Board of Directors (the “Board”) provided, however, that the Board shall have the right to reasonably approve any such nominee in order to fulfill its fiduciary duty by ascertaining that such person is suitable for membership on the board of a publicly traded corporation. Suitability is determined by, but not limited to, the requirements of the Securities and Exchange Commission, the American Stock Exchange, and other applicable laws, including the Sarbanes-Oxley Act of 2002. As of September 30, 2010, JSP has not exercised the nomination provision of the agreement.

The Company’s financial condition, as well as its liquidity resources, are very dependent on an uninterrupted supply of product from JSP. Should there be an interruption in the supply of product from JSP for any reason, this event would have a material impact to the financial condition of Lannett.

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

Introduction

The following information should be read in conjunction with the consolidated financial statements and notes in Part I, Item 1 of this Quarterly Report and with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2010.

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

Critical Accounting Policies

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. We believe that our critical accounting policies include those described below.

Revenue Recognition — The Company recognizes revenue when its products are shipped. At this point, title and risk of loss have transferred to the customer and provisions for rebates, promotional adjustments, price adjustments, returns, chargebacks, and other potential adjustments are reasonably determinable. Accruals for these provisions are presented in the consolidated financial statements as rebates, chargebacks and returns payable and as reductions to net sales. The change in the reserves for various sales adjustments may not be proportionally equal to the change in sales because of changes in both the product and the customer mix. Increased sales to wholesalers will generally require additional accruals as they are the primary recipient of chargebacks and rebates. Incentives offered to secure sales vary from product to product. Provisions for estimated rebates and promotional credits are estimated based upon contractual terms. Provisions for other customer credits, such as price adjustments, returns, and chargebacks, require management to make subjective judgments on customer mix. Unlike branded innovator drug companies, Lannett does not use information about product levels in distribution channels from third-party sources, such as IMS and Wolters Kluwer, in estimating future returns and other credits. Lannett calculates a chargeback/rebate rate based on contractual terms with its customers and applies this rate to customer sales. The only variable is customer mix, and this assumption is based on historical data and sales expectations. The chargeback/rebate reserve is reviewed on a monthly basis by management using several ratios and calculated metrics. As we continue to obtain additional information about our historical experience for chargebacks, rebates and returns, we also update our estimates of the required reserves.

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Chargebacks — The provision for chargebacks is the most significant and complex estimate used in the recognition of revenue. The Company sells its products directly to wholesale distributors, generic distributors, retail pharmacy chains, and mail-order pharmacies. The Company also sells its products indirectly to independent pharmacies, managed care organizations, hospitals, nursing homes, and group purchasing organizations, collectively referred to as “indirect customers.” Lannett enters into agreements with its indirect customers to establish pricing for certain products. The indirect customers then independently select a wholesaler from which to actually purchase the products at these agreed-upon prices. Lannett will provide credit to the wholesaler for the difference between the agreed-upon price with the indirect customer and the wholesaler’s invoice price if the price sold to the indirect customer is lower than the direct price to the wholesaler. This credit is called a chargeback. The provision for chargebacks is based on expected sell-through levels by the Company’s wholesale customers to the indirect customers and estimated wholesaler inventory levels. As sales by the Company to the large wholesale customers, such as Cardinal Health, AmerisourceBergen, and McKesson, increase, the reserve for chargebacks will also generally increase. However, the size of the increase depends on the expected mix of product sales to the indirect customers. The Company continually monitors the reserve for chargebacks and makes adjustments when management believes that expected chargebacks on actual sales may differ from the amounts that were assumed in the establishment of the chargeback reserves.

Rebates — Rebates are offered to the Company’s key chain drug store and wholesaler customers to promote customer loyalty and increase product sales. These rebate programs provide customers with rebate credits upon attainment of pre-established volumes or attainment of net sales milestones for a specified period. Other promotional programs are incentive programs offered to the customers. At the time of shipment, the Company estimates reserves for rebates and other promotional credit programs based on the specific terms in each agreement. The reserve for rebates increases as sales to rebate-eligible customers are recognized and decreases when actual rebate payments are made. However, since rebate programs are not identical for all customers, the size of the reserve will depend on the mix of sales to customers that are eligible to receive rebates.

Returns — Consistent with industry practice, the Company has a product returns policy that allows certain customers to return product within a specified period prior to and subsequent to the product’s lot expiration date in exchange for a credit to be applied to future purchases. The Company’s policy requires that the customer obtain pre-approval from the Company for any qualifying return. The Company estimates its provision for returns based on historical experience, adjusted for any changes in business practices or conditions that would cause management to believe that future product returns may differ from those returns assumed in the establishment of reserves. Generally, the reserve for returns increases as sales increase and decrease when credits are issued or payments are made for actual returns received. The reserve for returns is included in the rebates, chargebacks and returns payable account on the balance sheet.

Other Adjustments — Other adjustments consist primarily of price adjustments, also known as “shelf stock adjustments,” which are credits issued to reflect decreases in the selling prices of the Company’s products that customers have remaining in their inventories at the time of a price reduction. Decreases in selling prices are discretionary decisions made by management to reflect competitive market conditions. Amounts recorded for estimated shelf stock adjustments are based upon specified terms with direct customers, estimated declines in market prices, and estimates of inventory held by customers. The Company regularly monitors these and other factors and evaluates the reserve as additional information becomes available. Other adjustments are included in the rebates, chargebacks and returns payable account on the balance sheet. When competitors enter the market for existing products, shelf stock adjustments may be issued to maintain price competitiveness.

The following tables identify the reserves for each major category of revenue allowance and a summary of the activity for the nine months ended September 30, 2010 and 2009:

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For the three months ended September 30, 2010

Reserve Category	Chargebacks			Rebates			Returns			Other			Total
Reserve Balance as of June 30, 2010	$	6,282,127		$	3,566,031		$	5,401,254		$	—		$	15,249,412
Actual credits issued related to sales recorded in prior fiscal years	(6,112,838		)	(2,558,582		)	(1,151,174		)	—			(9,822,594		)
Reserves or (reversals) charged during Fiscal 2011 related to sales in prior fiscal years	—			—			—			—			—
Reserves charged to net sales during Fiscal 2011 related to sales recorded in Fiscal 2011	11,960,878			3,776,169			2,987,308			1,663,371			20,387,726
Actual credits issued related to sales recorded in Fiscal 2011	(7,056,592		)	(2,347,273		)	(1,387,700		)	(1,663,371		)	(12,454,936		)
Reserve Balance as of September 30, 2010	$	5,073,575		$	2,436,345		$	5,849,688		$	—		$	13,359,608

For the three months ended September 30, 2009

Reserve Category	Chargebacks			Rebates			Returns			Other			Total
Reserve Balance as of June 30, 2009	$	6,089,802		$	2,537,746		$	5,106,992		$	—		$	13,734,540
Actual credits issued related to sales recorded in prior fiscal years	(4,767,581		)	(1,852,708		)	(1,147,720		)	—			(7,768,009		)
Reserves or (reversals) charged during Fiscal 2010 related to sales in prior fiscal years	—			—			—			—			—
Reserves charged to net sales during Fiscal 2010 related to sales recorded in Fiscal 2010	10,272,936			4,066,855			1,140,128			407,784			15,887,703
Actual credits issued related to sales recorded in Fiscal 2010	(7,000,389		)	(1,789,955		)	—			(407,784		)	(9,198,128		)
Reserve Balance as of September 30, 2009	$	4,594,768		$	2,961,938		$	5,099,400		$	—		$	12,656,106

The total reserve for chargebacks, rebates, returns and other adjustments decreased from $15,249,412 at June 30, 2010 to $13,359,608 at September 30, 2010. The decrease in total reserves is due to a decrease in the rebates reserve as a result of a decrease in overall sales, and a decrease in chargeback reserves due primarily to a decrease in inventory levels at wholesaler distribution centers.