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A N N U A L R E P O R T

FISCAL YEAR ENDED

JULY 31, 2000

NASDAQ: ZILA

E X P A N D I N GH O R I Z O N S

Zila, Inc., produces and markets quality products and services to

dental/medical professionals and consumers worldwide. In fiscal year 2000,

the Company had three operating groups:

THE PHARMACEUTICALS GROUP: Zila Pharmaceuticals, marketer of

prescription and non-prescription oral healthcare products; Zila

Biomedical, developer of OraTest® oral cancer detection products; and

Zila BioTech, producer of pharmaceutical-grade Zila® Tolonium

Chloride.

THE PROFESSIONAL PRODUCTS GROUP: Zila Dental Supply, a

national dental supplies distributor.

THE NUTRACEUTICALS GROUP: Oxycal Laboratories and its Inter-Cal

subsidiary, manufacturer and supplier of value-added ingredients,

including patented Ester-C® branded products and botanicals such as

Palmettx® saw palmetto extract, for the global nutrition industry.

C O N T E N T S

Financial Highlights. . . . . . . . . . . . . . . . . . . . . . . . . 1

Letter To Shareholders . . . . . . . . . . . . . . . . . . . . . . . 2

Operations Review. . . . . . . . . . . . . . . . . . . . . . . . . . 4

Management’s Discussion and Analysis . . . . . . . . . . 12

Consolidated Financial Statements . . . . . . . . . . . . . 17

Shareholder Information. . . . . . . . . . . . . . . . . . . . . 32

Directors and Officers . . . . . . . . . . . . . . . . . . . . . . 33

Z I L A , I N C .

2000 Annual Report 1

Years Ended July 31, 2000 1999 1998 1997 1996

Operating Statement Data:Revenues:

Net Sales $ 77,491,741 $ 71,159,241 $ 61,942,765 $ 38,592,252 $ 37,479,546

Licensing Fees and Royalty Revenue 89,167 135,510 164,345 72,640 2,100,484

Net Income (Loss) 2,932,027 (1,966,982) 2,301,068 (6,458,377) 1,217,298

Net Income (Loss) Per Share .07 (0.05) 0.07 (0.20) 0.04

Series A Embedded Dividend $ (7,314,600)Loss Per Share (0.15)

During the second quarter of Fiscal Year 1998, Zila issued Series A Convertible Preferred Stock to raise a gross amount of $30 million to fund the acquisition ofOxycal Laboratories, Inc. Based on the conversion terms of the shares, embedded dividends of $7,314,600 were deducted after net income in order to compute anon-cash, non-operating loss per share of $0.15 for the year ended July 31, 1998.

Balance Sheet Data:Current Assets $ 31,380,071 $ 30,750,624 $ 27,992,138 $ 10,779,049 $ 13,251,960

Total Assets 77,711,459 76,555,933 69,863,877 23,604,032 25,309,781

Current Liabilities 11,050,668 8,704,760 8,777,242 5,804,965 6,672,497

Long-Term Debt* 4,548,953 9,577,755 1,355,547 375,908 382,006

Total Liabilities 15,599,621 18,282,515 10,132,789 6,180,873 7,054,503

Preferred Stock — 8,787,191 33,801,930 — —

Shareholders’ Equity 62,111,838 49,486,227 25,929,158 17,423,159 18,255,278

* FY 2000 Long-Term Debt included $4.4 million in Yavapai County IDA (Industrial Development Authority) bonds. The funds, which were used for the con-struction of a new manufacturing facility for Oxycal Laboratories, Inc., are classified as cash held by trustee on the balance sheet. Long-Term Debt in fiscal year1999 also included $4.2 million related to the Company’s bank line of credit.

On January 8, 1997, the Company completed a merger with Bio-Dental Technologies Corporation (“Bio-Dental”). The merger was accounted for as a poolingof interests and, accordingly, the above financial information gives retroactive effect to the Bio-Dental merger and includes the combined operations of theCompany and Bio-Dental for all periods presented.

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2 Zila, Inc.

The Company generated record revenue of $77,581,000 in fiscal year 2000 (ended July 31, 2000) — a nine percent

increase over fiscal 1999 revenue of $71,295,000. Fiscal 1999 and the first two quarters of fiscal 2000, however,

included revenue from the Company’s PracticeWorks and Cygnus divisions, which were divested during the

second quarter of fiscal 2000. Excluding all revenue from PracticeWorks and Cygnus for both years, fiscal 2000 revenue of

$75,872,000 increased 17 percent from $64,998,000 in the prior year.

In fiscal 2000, Zila reported net income of $2,932,000, or $0.07 per share (diluted), compared to a net loss of $1,967,000,

or a $0.05 per share loss in the prior year. EBITDA (earnings before interest, taxes, depreciation and amortization) for fiscal 2000

was $7,994,000, of which approximately $4,700,000 related to the sale of PracticeWorks.

Also during the year, $5,856,000 was expended on the Zila® Tolonium Chloride development program and the OraTest® oral

cancer detection project. In addition to expenditures relating to the new clinical trial, regulatory affairs, legal matters and inter-

national market development, Company-funded research led to the discovery of Zila Tolonium Chloride’s cancer-detecting method

of action and the technology’s ability to detect otherwise unobserved pre-cancerous genetic changes, suggesting much broader

potential markets for Zila Tolonium Chloride. Management believes that in addition to its value in detecting oral cancer, our

patented technology has potential for detecting and treating squamous cell carcinoma throughout the body, validating the

Company’s on-going investment in the program.

At the close of fiscal 2000, Zila had net working capital of $20,329,000, a current ratio of 2.8:1, and total assets of

$77,712,000. Shareholders’ equity rose to $62,112,000 from $49,486,000 at the end of the prior year.

Significant strides were made in fiscal 2000 toward bringing new products to market, increasing market share for existing

product lines, and identifying synergistic technologies and products for development and acquisition. Important advances were

also made in research projects pertaining to Oxycal’s nutraceutical technologies and the Company’s OraTest and Zila Tolonium

Chloride products. As this data becomes public, management believes it will increase the credibility of our technologies and

generate greater demand for our products. Zila’s clinical research consultants for the OraTest program are continuing in their

efforts to obtain domestic regulatory approval of this important product.

With the divestiture of our Cygnus and PracticeWorks divisions during the second quarter, the Company refocused on its

oral care and nutraceuticals consumable products businesses.

Three major business segments produced record revenues in fiscal 2000 – Zila Pharmaceuticals consumer products, Zila

Dental Supply and Oxycal Laboratories. At Zila Pharmaceuticals, sales of the growing Zilactin® line of non-prescription oral

healthcare products surged 28 percent to a record level. A fresh emphasis is being placed on expanding the division’s array of

consumer products and the extent of its international marketing. Zila Dental Supply recorded a solid 26 percent sales growth for

the year, with expanded full-service operations, growing Internet sales and major new marketing alliances. Oxycal’s Inter-Cal

marketing unit turned in an equally impressive 28 percent revenue gain for the year, benefiting from improved Asian market

conditions, newly introduced products and targeting of new markets. This division, with its aggressive R&D and strategic

marketing initiatives, was poised to move into a new state-of-the-art facility in October 2000, ready to take full advantage of the

three-times greater space and important operating efficiencies the new building will provide.

On May 25, 2000, the Surgeon General of the United States released the nation’s first-ever Report on Oral Health.

Dr. David Satcher focused on a “silent epidemic” of dental and oral diseases, and called for a national effort to improve oral health

among all Americans. Issuance of the report signals the start of a long and comprehensive national drive to place all aspects of

oral health at the forefront of medical education, public education and government support. The Surgeon General observed that

L E T T E R T O S H A R E H O L D E R S

Z I L A , I N C .


expenditures for dental services alone totaled $53.8 billion in 1998. Management believes that this new focus will have positive

implications for Zila’s oral care products and technologies.

Among the Surgeon General’s points relating to Zila’s Peridex®, Zilactin and OraTest markets:

▲ Most adults show signs of periodontal or gingival diseases. Severe periodontal disease affects about 14 percent

of adults aged 45-54.

▲ 23 percent of 65 to 74-year-olds have severe periodontal disease.

▲ Clinical symptoms of viral infections, such as cold sores and canker sores are common in adulthood, affecting

about 19 percent of adults 25-44 years of age.

▲ Population growth as well as diagnostics that are enabling earlier detection of cancer means that more patients

than ever before are undergoing cancer treatments. More than 400,000 of these patients will develop oral

complications annually.

Oral cancer was a major focus of the report. As the Associated Press put it: “The report… looked at disparities in peo-

ple suffering from oral and throat cancers, which affect over 30,000 Americans each year and kill more than 8,000. Tobacco

and alcohol use are the primary risk factors for oral cancers. The report calls for more screening for oral cancers and more studies

of dental health disparities [among races and income levels]…”

Management remains fully committed to its goal of making OraTest oral cancer detection products the global standard of care.

The Company is dedicated to completing the regulatory review process at home and bringing these valuable products to the U.S.

market.

In mid-April, at the conclusion of a lengthy search, Zila selected Thomas M. Laughlin to fill the new position of Vice

President and Chief Operating Officer. Mr. Laughlin brings a wealth of knowledge and strong leadership capability based on

extensive and successful experience in several of the world’s largest healthcare products companies.

With a strengthened executive group, solid balance sheet, strong cash position, increasing revenue trend and

valuable product franchises, management believes the Company is well positioned for continued growth.

Joseph Hines

President and Chairman

Zila revenue growth, as reported 1996-2000 (before pooling of interestadjustments)

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O P E R A T I O N S R E V I E W

Sales of Zila Pharmaceuticals’ over-the-counterproducts set new records, posting the highest salesever in fiscal 2000, and a 28 percent increase over

fiscal 1999. Zilactin®-B and Zilactin®-L demonstrated particularly strong sales growth. Clearly benefiting fromprofessional and consumer loyalty to the Zilactin name,Zilactin®Toothache Swabs, which were first introduced in mid-1999, recorded $1 million in sales faster than any product inthe Company’s history. That product is now available in allnational mass merchandise and drug store chains, as well asmost national supermarket chains.

The Zilactin line was advertised in leading consumerpublications, such as Prevention, Health and Psychology Today.Product samples were mailed to households known to beusing competing products. In-store coupons featured theentire Zilactin line. An extensive year-long promotional cam-paign targeted dental professionals via direct mail, productsampling, professional journal advertising and trade showexhibits, with added support from the Company’s contractdetailing force. The nation’s pharmacists were also providedwith details on the features and benefits of new ZilactinToothache Swabs. Pharmacists once again ranked Zilactin their#1 recommended product for canker sores, as reported in theannual Pharmacy Times magazine survey.

In the second quarter, the Company made a strategicmove to reposition Zilactin-L from “oral care” to “lip care”,

The Company’s original product, Zilactin® medicated gel,has evolved into a profitable and growing line of dentist-and pharmacist-recommended non-prescription oralhealthcare pharmaceuticals.

4 Zila, Inc.

producing very positive sales results. (Lip/cough/cold aisleshave some of the highest consumer traffic in food and drugstores.) Zilactin-L sales also benefited from introduction of anew single-use “prep pad” trial package, which was distributedto dentists and hygienists. Each cotton prep pad is saturatedwith Zilactin-L and sealed in a handy foil pouch.


Aggressive marketing continued inCanada for the Zilactin line and forPeridex prescription mouthrinse. A special Canadian pharmacisteducation program was con-ducted to generate higherbrand recognition andmore frequent recommen-dations to customers.Combined Zilactin andPeridex Canadian dollar salesincreased 31 percent in fiscal2000, compared to the prior year.

In the U.S., Peridex sales were negativelyimpacted by generic competition. (Generics do not present asignificant challenge in Canada.) In response, a number ofnew Peridex promotions and marketing initiatives werelaunched in 2000. In a special February cross-promotion withZila Dental Supply, Peridex marketing materials were includ-ed with every shipment of supplies, contributing to a signifi-cant increase in Zila Dental Supply’s Peridex sales revenue.

A major step was taken in the Peridex program inAugust 2000, when the Company contracted with OmniiProducts to be the exclusive dental profession sales and dis-tribution organization for the product. Omnii Products is aFlorida-based national marketer of proprietary professionaldental products, with an extensive and growing national net-work of field sales representatives. They provide excellentcoverage of dental professionals in key markets, plus animpressive inside (telemarketing) sales force. Managementbelieves that with their resources and large existing customerbase, Omnii Products has the capability to increase marketpenetration and revenue growth for the Peridex brand – the#1 recommended brand in its category.

Research and negotiations conducted in fiscal 2000resulted in the acquisition in August of all rights to newpatent-pending Pro-Ties™ elastomeric banding devices.Stretchable Pro-Ties, which are made from medical-grade

silicone, will be sold in boxes of six as a superior bundlingsystem for the cleaning and sterilization of dental and med-ical instruments. Current bundling techniques typicallyrequire that instruments be reorganized at multiple stages inthe process – requiring extra time and effort. Pro-Ties solvethis problem and improve office productivity. Long-lastingPro-Ties replace “ponytail holders” and other devices thatvariously stretch out of shape, rust, breed bacteria or failduring the sterilizing process.

Pro-Ties are expected to perform well in its market niche,and will further extend Zila’s marketing activity in the broad-er professional products arena, adding important incrementalgrowth. The sales launch is scheduled to coincide with theOctober 2000 American Dental Association convention.

Management’s aggressive growth agenda for ZilaPharmaceuticals includes the introduction of a number ofinternally-developed new products; expansion of marketinginto Western Europe, Asia and Latin America; and significantacquisitions of products, technologies and businesses.

Zila Pharmaceuticals introduceda new bundling system for thesterilization of dental and med-ical instruments. Pro-Ties™,produced from medical-gradesilicone, are stretchable andlong-lasting.

Zila Dental Supply™ sales of $39.8 million in fiscal 2000 set a new record, and exceeded prioryear sales by 26 percent. Sales from Internet

sources grew almost 800 percent over the previous year, supported by a national advertising campaign for OLÉ™, thedivision’s on-line marketing site. Full service operations inSacramento, Houston and Lexington continued their cam-paigns to boost regional sales, particularly of high-end equip-ment. To cope with increased business, the Company restruc-tured its Sacramento warehouse by adding a second shippingline and began restructuring its Lexington distribution center.

Fiscal year 2000 was the first complete operating year forall three full-service locations. Combined, the sites produced a66 percent increase in sales over the prior year. Full-service salesnow account for nearly half of Zila Dental Supply’s total sales.

Dramatic growth in Sacramento and Houston resultedfrom the addition of more sales and service personnel. In contrast, the Lexington operation, which was started in themid-1980s, had little change in sales and service staff, and yetachieved 17 percent growth due to several factors: the qualityand experience of its veteran personnel, excellent fulfillmentrate, competitive pricing, timely delivery, and strong market-ing support. The Lexington showroom and office facilitieswere moved out of the warehouse building and into nearbyoffices. The move allowed the warehouse to be expanded forfuture growth, increasing space by 25 percent. As a result ofthe move, Zila Dental Supply-Lexington now has the largestequipment showroom in the state of Kentucky.

The division experienced solid growth in the Houston areain fiscal 2000. In August 2000, Zila Dental Supply startedwarehousing high-volume items in the Houston facility toincrease customer service and reduce freight costs. TheCompany transferred an experienced individual out of theLexington operation to manage the Houston warehouse.

In November 1999, the full-service operation forNorthern California moved into new facilities in Rocklin, asuburb of Sacramento. The location is in the center of a highgrowth area and features a complete equipment showroom,equipment warehouse, sales specialists and service personnel.This operation experienced a 122 percent increase in businessover the prior year. Using this location as a base, Zila DentalSupply is well positioned for possible future growth in the SanFrancisco Bay area.

The OLÉ web site was honored for e-business excellencein the RSM McGladrey “Outstanding Mid-Market BusinessWeb Site Awards,” co-sponsored by AT&T and the NationalAssociation of Manufacturers. The site, officially launchedin 1998, has exceeded all expectations. Its software and

functions were refined and upgraded throughout the year,and supported with special advertising in the Company’s catalogs and sales flyers, professional journal advertising, andsales promotions on third-party Internet marketing sites. Atthe end of fiscal 2000, Zila Dental Supply completed planningfor a major new Internet marketing strategy to be launched inearly 2001. This strategy combines a comprehensive market-ing campaign with a website re-design, adding many new features and functions. The first step will be the installation ofa powerful new IBM RS6000 computer in Sacramento to provide the backbone for this exciting initiative.

During the third quarter, the division completed its firstpromotional mailing to Aetna US Healthcare’s 40,000 dentaloffices. Aetna US Healthcare is one of the latest insurancecompanies to endorse Zila Dental Supply to its network ofdental providers. The mailing was received favorably and isproducing new customers and incremental sales growth.

Following a brief hiatus, nationally-recognized dentalpractice management guru Dr. Woody Oakes renewed hisendorsement with the Company. The July 2000 issue ofDr. Oakes’ Profitable Dentist Buyers Club newsletterprominently featured Zila Dental Supply and its “Buyer’sClub” program for Dr. Oakes’ 4,000 subscribers. Severalmarketing initiatives are planned to drive more ProfitableDentist subscribers into the Buyer’s Club.

With an eye toward reducing costs, increasing buyingpower and gaining access to additional lines of capitalequipment, Zila Dental Supply joined the American DentalCooperative (ADC). ADC is a subsidiary of NationalDistribution & Contracting, which represents over 200medical and dental suppliers, accounting for $3.5 billion inannual buying power and providing considerable leverage involume purchasing. ADC’s bargaining position gives ZilaDental Supply an advantage as it competes with larger companies in the growing dental supplies business.

6 Zila, Inc.

Zila DentalSupply's award-winning OLÉ™Internet shopping site – alreadypopular withdental offices –is scheduledfor majorupgrades in computingpower and sophistication in fiscal 2001.

Z I L A D E N T A L S U P P L Y ™


Inter-Cal Corporation, the marketing arm ofOxycal Laboratories, posted record results in fiscal year 2000. Revenues increased 28 percent

over the prior year and production volume and overallyield were the highest in the Company’s history.Management attributes the division’s outstanding growthto several factors, including the quality of its products,careful targeting of markets, extensive research and devel-opment of new products and applications, and aggressivenew marketing programs. Moreover, the economicimprovement in Asia and the implementation of an exportinsurance program contributed to a 104 percent increasein international sales. This occurred despite a downturn insales reported by many players in the U.S. and global vitamin and nutraceutical industry.

During fiscal 2000, Inter-Cal began a campaign toheighten awareness of Ester-C® mineral

ascorbates for dogs, cats, and horses,emphasizing the importance ofVitamin C as a conditionally essentialnutrient for these species.

Veterinarians in Europe and theU.S. have published studies showing the

effects of Ester-C ingredients on dogs with non-specificlameness (such as that caused by canine hip dysplasia orarthritis) and on horses with degenerative joint diseaseand respiratory problems (such as chronic obstructive pulmonary disease).

Coinciding with the campaign, Inter-Cal intro-duced Ester-C Chelated MineralBlend, an ingredient formulatedspecifically for animals. Thisingredient can be readilyincorporated into animalfeeds, supplements, andtreats to assist utilizationand uptake of mineralsand antioxidant nutri-ents. Clinical evidenceindicates the helpful-ness of this ingredientfor animals recoveringfrom the wear and tear

of strenuous work, recuperating from surgical procedures, orbattling the onset of aging.

The response to the new ingredient was extremelypositive. Many new customers, including one of thelargest manufacturers of equine supplements, were addedto Inter-Cal’s growing customer list. Ester-C/glucosamineproducts appeared on the shelves of major national petretailers PETCO and PETsMART as well as independentpet and natural product stores.

Sales of Ester-C ascorbates for use in animal productsare expected to grow as more veterinarians and animalnutritionists recognize that supplemental Ester-C ascorbatesmay, indeed, help animals live healthier… and, hopefully,longer lives.

Another initiative was launched when Inter-Cal signedan exclusive licensing agreement with Nutraceutix, Inc., tomanufacture and market Ester-C mineral ascorbates contain-ing the patented CDT™ Controlled Delivery Technology.This technology allows nutraceutical ingredients to bereleased into the gastrointestinal tract at a constant rate overan extended period of time, or pulsed at various time inter-vals. The technology provides a precise and timed delivery ofeach active ingredient, providing optimum bioavailability.Preparations are under way to introduce this new Ester-C for-mulation in 2001.

KV Pharmaceutical Company introduced the firstchewable prenatal vitamin, PreCare® chewables and aneasy-to-swallow PreCare caplet, containing a proprietary

pharmaceutical-grade blend of Ester-C. Naturalproduct retailers, pharmacists and

physicians are more readily

O X Y C A L L A B O R A T O R I E S A N DI N T E R - C A L C O R P O R A T I O N

Palmettx™ saw palmettoextract is the Company'sfirst botanical product,manufactured usingInter-Cal’s proprietaryPureXtrax™ method.

®

accepting the growing evidence that daily supplementationis a practical way for most people to get enough nutrients toremain healthy. We believe this bodes well for the Ester-Cbrand of Vitamin C.

Inter-Cal introduced an Ester-C Beverage Grade mineralascorbate, using a proprietary manufacturing process thatallows Ester-C mineral ascorbates to readily disperse andrapidly dissolve in liquids with minimal agitation. TheBeverage Grade product offers a uniform particle size andshape, the precise physical characteristics that are sought bythe beverage industry. Production volume is scheduled toramp up following installation and validation of newequipment at Inter-Cal’s new facility.

Ester-C Topical, a liquid productfor the personal care industry, offerssuperior stability and the abilityto deliver the benefits ofVitamin C to the deep layersof the skin, without the useof unwanted chemicals. Ascientific paper on Ester-CTopical was presented at ameeting of the Society ofCosmetic Chemists inNovember 1999. Thisreport enhanced the credi-bility of the product and generated interest in additionalcommercial applications.

In order to keep the Company’s Ester-C brand fresh inthe minds of health care professionals, Inter-Cal stepped upits campaign to provide them with scientifically-basedingredient information. Advertising in trade and profes-sional magazines further enhanced Inter-Cal’s image andbrand recognition with physicians, pharmacists and naturalproduct retailers.

Sophisticated laboratory and clinical research will becritical to future sales growth, helping to identify new appli-cations and new markets for Inter-Cal’s technologies. As anexample, a team of researchers at the University ofCalifornia/San Francisco School of Dentistry reported thatin laboratory tests, the Ester-C vitamin product increasedproduction of bone-regeneration substances in human tissue. The positive effects were significantly enhanced bythe presence of calcium threonate, a Vitamin C metabolitewhich is present in Ester-C calcium ascorbate, but which isnot present in generic Vitamin C products, like ascorbicacid. Writing in the Journal of Periodontology in September1999, the researchers noted, “Identifying a factor which isable to facilitate the formation of greater amounts of min-eralized tissue would have significant clinical ramificationsin terms of wound healing and bone regeneration.”

In other Company-sponsored Ester-C studies, pre-clinical results involving intestinal absorption of

analgesic drugs, and cancer chemotherapyare leading to increased intellectual

property protection (via newpatent applications) for Inter-

Cal’s proprietary technology.It is anticipated that the

Company will eventuallylicense newly developedtechnologies to pharma-ceutical research andmarketing partners.

Inter-Cal opened animportant new chapter in

its growth with the intro-duction of its first botanical

ingredient, Palmettx™, a stan-dardized extract of Saw Palmetto.

8 Zila, Inc.

According to the International Research Institute, U.S.retail sales of botanical medicines in 1998 totaled $4 billion,with Saw Palmetto sales contributing $27 million. Bulkshipping of the Palmettx product began in July 2000.

Overseas, Saw Palmetto is used to treat a problem thataffects as much as 50 percent of the male population by age60 — Benign Prostatic Hyperplasia (BPH).Phytotherapeutic preparations such as Saw Palmettoextracts are already the first line of treatment for BPH inGermany, France and Italy. Palmettx is grown, hand-harvested, processed and supercritically extracted entirely inthe U.S. to guarantee the highest quality and potency aswell as consistent batch-to-batch levels of active ingredients.

Palmettx is manufactured using Inter-Cal’s propri-etary PureXtrax™ supercritical (CO2) extraction method,which extracts botanicals naturally, without hydrocarbonsolvents such as hexane and alcohol. It is non-hazardousto the environment and assures product integrity, superiorstability, and virtual elimination of all enzymes, microor-ganisms, viruses, molds and spores.

Even greater development and production efficienciesshould be obtained for the entire division following Inter-Cal’s move to its new state-of-the-art facility in October2000. The new manufacturing and administrative buildingin Prescott, Arizona, totals 65,000 square feet and can accom-modate an additional 35,000 square foot expansion in thefuture. It has four production areas and space for two more,an impressive laboratory, and a total of more than three timesthe space formerly occupied by this fast-growing division.


Oxycal Laboratories’ move to this new custom-designedfacility in October 2000 will triple the division's space, supporting the Company’s drive to expand its product lineand increase sales volume worldwide.

In fiscal 2000, the Company invested nearly $6 mil-lion in the OraTest and Zila Tolonium Chlorideprogram. Over the nine-year life of this on-going

program, we have invested a total of more than $20 million.As a result of this effort, in fiscal 2000 some of the mostrespected researchers in their fields produced data suggestingthat our technology is much more sensitive than even webelieved, and that it may play a key role in improving detec-tion and treatment of squamous cell cancer that occurs in themouth, throat, esophagus, stomach, colon, cervix and otherorgans of the body. In view of the potentially significantworldwide applications for Zila Tolonium Chloride, manage-ment is committed to further researching, protecting and ulti-mately pursuing U.S. regulatory approval for this technology.

The section that follows outlines related fiscal 2000developments.

▲ ▲ ▲

Following the assumption of United Kingdom marketingresponsibility by Zila Europe in April 2000, unit sales of theOraTest product in the UK began to improve. (Marketing hadbeen managed by a licensee in prior years.) Plans were laid fora range of fresh marketing initiatives, and a dedicated profes-sional detailing force was placed under contract.

In April 2000, for the first time anywhere, insurance coverage was extended to OraTest by British carrier Smilecare.The clinical advisory panel for Smilecare stated: “The GeneralDental Practitioner has a pivotal role to play in contributingto the prevention of oral cancer and helping to reduce themorbidity and mortality from this terrible disease. The use ofa rinse such as OraTest could be of tremendous benefit inenhancing the visual examination and detecting the cancerswhen they are very small.”

The British Dental Association, in March 2000, published a 34-page text entitled, “Opportunistic Oral CancerScreening: A management strategy for dental practice.” The publication, which the BDA mailed to all its members and tosome 150 national dental associations around the globe, makesa thorough and convincing case for routine use of toloniumchloride (OraTest) in all dental practices. It can be found at theBDA Internet site, http://www.bda-dentistry.org.uk/public/faqs/index.html, under “Preventing dental problems.” The publica-tion includes endorsements of screening from virtually all UK-based dental organizations, including the FDI World DentalFederation. A British dental malpractice carrier supplied thiscomment: “By implementing protocols for regular screening,dentists can protect their patients … while also minimizing the

dento-legal risk to themselves.” And all three British dentalinsurers give the screening initiative their full support.

Marketing approvals for OraTest were obtained inBelgium and Luxembourg in September 1999. In February2000, OraTest was introduced in Athens, Greece. Distributorsare being qualified for these countries. Bahrain, one of theGulf states, approved OraTest in March 2000.

Zila has relationships with 24 Chinese companies for distribution of OraTest products in that populous country.China’s likely admission to the World Trade Organization mayresult in a significant reduction in the import duty China currently imposes on OraTest products.

The Company has developed the first line extension ofthe OraTest product – new OraTest Swab, which allows full-mouth swabbing or selected application (painting) of ZilaTolonium Chloride. The product consists of three swabs, eachindividually packaged in a plastic snap-open tube. Swab #1 ispre-moistened with the OraTest pre-rinse solution; swab #2with Zila Tolonium Chloride solution; and swab #3 with apost-rinse solution. The OraTest Swab product is expected tocost dentists up to 50 percent less than the original OraTestrinse product. The OraTest Swab packaging concept is thesame one used by the Company for its highly successfulZilactin Toothache Swabs.

Because healthcare professionals sometimes prefer oneapplication technique over the other, based on training, patientcondition or cost, Zila will offer both the new swab and the

10 Zila, Inc.

Z I L A B I O M E D I C A L A N DB I O T E C H

Computers help Zila BioTech professionals maintain stringentquality control in the manufacturing of Zila® ToloniumChloride, the active ingredient in the OraTest® product.

original rinse product in global markets where they are approvedfor use. Management believes the lower-cost delivery systemshould improve the acceptability of the OraTest system in ThirdWorld regions.

In the U.S., all of the comments received from the Food &Drug Administration on the Company’s OraTest Phase III clinical study protocol were satisfactorily resolved before Zila’sclinical research organization, ILEX™ Oncology Services, Inc.,began moving forward with the research. The study involves 40research institutions in the U.S., Europe and the Pacific Rim.Oncologists, oral surgeons and dentists at some of the world’smost prestigious cancer research institutions have been enlistedin the effort. The project requires the enrollment of approxi-mately 600 patients – 300 in each arm of the randomized study.The primary objective is to compare the proportion of patientsdiagnosed with recurrent or new disease using a visual examwith the OraTest product vs. the current standard, visual examalone. Secondary objectives include comparison of the time todetection of cancer in each arm of the study, and evaluation ofthe OraTest product’s ability to detect certain early geneticchanges indicative of cancer but not apparent by traditional histology (microscopic examination of biopsies).

The protocol was designed in close collaboration withthe FDA. The Company is proceeding in a manner intendedto accomplish this research in the most expeditious fashion. In order to avoid the chance of negatively impacting the regulatory review process, management has been advised not todiscuss further details relating to the study.

In February 2000, researchers at the University ofCalifornia/Los Angeles (UCLA), under the direction ofSamuel D. Bernal, MD, PhD, Chief, Hematology/Oncology, UCLA-San Fernando Valley Program andDirector, Cancer Center, Greater Los Angeles VA Health system, reported their discovery of the mechanism of actionof the active ingredient in the OraTest product. Their workprovides the scientific explanation for selective staining ofcancerous tissue. This data may also support the developmentof additional products to promote the detection and treat-ment of a variety of cancers. In addition to the many patentsZila has already obtained for the OraTest technology, theCompany has filed for even broader patent protection basedon this newest research.

Earlier research supported a patent that was issued in July2000, broadening protection for the manufacture and sale ofpharmaceutical-grade toluidine blue. The patent covers thesophisticated manufacturing process that Zila perfected over aperiod of several years. It also increases protection of the drugsubstance and broadens protection of diagnostic proceduresthat use this drug substance to detect cancer in body tissuesbeyond the oral cavity. Management believes that the marketfor Zila Tolonium Chloride should grow as additional applica-tions and markets are established around the world.

All of the Zila Tolonium Chloride used in OraTest productsis produced at Zila BioTech’s sophisticated, computer-controlled manufacturing facility in Phoenix. Operations weresignificantly upgraded and expanded, with a second produc-tion line – with five times the capacity of the original – broughton-line in the first quarter of fiscal 2000. Construction hadbegun in 1998, in anticipation of expected U.S. demand forOraTest, following regulatory approval.

The division is also responsible for conducting and managing research to validate or expand uses and protection ofthe Company’s Zila Tolonium Chloride technology, and for liai-son with ILEX Oncology Services. Operating and staffing thisfacility, which is run in full compliance with demanding FDAGood Manufacturing Practices (required in the production ofdrug materials), is a major expense in the OraTest program.

In fiscal 2000, the considerable knowledge and talents ofZila BioTech personnel were put to added use – researching,evaluating and otherwise assisting in the analysis of productsand technologies for possible internal development or acquisition.


The new OraTest ® Swab product features three pre-moistened swabs in break-open tubes, giving healthcareprofessionals the option of “painting” Zila® ToloniumChloride on suspicious tissue.

This Annual Report contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934. The words“believe,” “expect,” “anticipate,” “intend,” “estimate” and otherexpressions, which are predictions of or indicate future events andtrends and which do not relate to historical matters, identify for-ward-looking statements. These forward-looking statements arebased largely on the Company’s expectations or forecasts of futureevents, can be affected by inaccurate assumptions and are subject tovarious business risks and known and unknown uncertainties, anumber of which are beyond the Company’s control. Therefore,actual results could differ materially from the forward-looking state-ments contained in this document, and readers are cautioned not toplace undue reliance on such forward-looking statements. TheCompany undertakes no obligation to publicly update or revise anyforward-looking statements, whether as a result of new information,future events or otherwise. There can be no assurance that the for-ward-looking statements contained in this document will, in fact,transpire or prove to be accurate.

Company OverviewThe following discussion and analysis should be read in con-

junction with “Selected Financial Data” and the auditedConsolidated Financial Statements and Notes thereto.

Zila is a worldwide manufacturer and marketer of pharmaceuti-cal, biomedical, dental and nutritional products. The Companyhas three major operating groups: Pharmaceuticals, ProfessionalProducts and Nutraceuticals. The Pharmaceuticals Group consistsof over-the-counter and prescription products, including theZilactin® family of over-the-counter products, Peridex® prescrip-tion mouth rinse, and OraTest®, an oral cancer detection system.The Professional Products Group includes Zila Dental Supply, anational distributor of professional dental supplies, ZilaTechnologies, Inc., formerly Cygnus Imaging Inc. (“Cygnus”) andIntegrated Dental Technologies, Inc. (“IDT”). The NutraceuticalsGroup is presently comprised of Oxycal Laboratories, Inc.(“Oxycal”) and its Inter-Cal subsidiary (“Inter-Cal”), a manufac-turer and distributor of mineral and botanical products includinga patented and unique form of vitamin C under the trademarkEster-C® and the Palmettx botanical line of products.

On November 5, 1997, the Company’s Zila Pharmaceuticals,Inc. (“Zila Pharmaceuticals”) subsidiary completed its acquisitionof the Peridex® product line, a prescription anti-bacterial oral rinsefrom The Procter & Gamble Company (“P&G”). The purchaseprice was $12.0 million plus the value of acquired inventory.

On November 10, 1997, the Company acquired Oxycal, paying$28.0 million for all outstanding shares of Oxycal. The Companyraised the funds to consummate the merger through a privateplacement of 30,000 shares of the Company’s Series A ConvertibleRedeemable Preferred Stock (“Preferred Stock”) and warrants to

purchase 360,000 shares of the Company’s common stock for$30.0 million.

The Peridex® and Oxycal acquisitions were accounted for usingthe purchase method of accounting for business combinations. Inconnection with the Oxycal acquisition, the excess of assets over lia-bilities assumed relate principally to trademarks and goodwill, whichare amortized over 25 and 20 years, respectively. In connection withthe Peridex® acquisition, the excess has been allocated to goodwilland is being amortized over 12 years. Results of operations ofPeridex® and Oxycal have been included in the Company’s statementof operations from their respective acquisition dates.

On October 28, 1999, Cygnus completed the sale of substantiallyall of its assets and certain liabilities to Procare Laboratories, Inc.(“Procare”), of Scottsdale, Arizona for approximately $4.0 million.Procare is controlled by the former owner and President of Cygnus.

On December 20, 1999, IDT completed the sale of substantiallyall of its assets and liabilities related to its PracticeWorks divisionlocated in Gold River, California to InfoCure Corporation(“InfoCure”), of Atlanta, Georgia for approximately $4.65 million.InfoCure is a national provider of healthcare practice managementsoftware products and services to targeted healthcare practice spe-cialties and is listed on NASDAQ under the symbol INCX. Underthe terms of the agreement, 10% of the sales price will be held inescrow for one year in order to secure the representations, warranties,and covenants made by the Company to InfoCure.

Operating ResultsFiscal year ended July 31, 2000. Total net revenues grew 8.8% to

$77.6 million for the 2000 fiscal year, compared to revenues of $71.3million for the prior fiscal year.

Net revenues in 2000 for Zila Dental Supply increased 26.3% to$39.8 million compared to $31.5 million for the previous fiscal year.This increase was primarily attributable to an increase in full-serviceoperations due to the contribution of the two additional branchoffices opened in fiscal 1999 and increases in internet sales. ZilaPharmaceuticals had net revenues of $16.8 million for the 2000 fiscalyear, a 7.6% decrease from the $18.1 million recorded during the cor-responding period last year. The decrease was due primarily to a44.1% decline in sales of Peridex® due to increased pricing pressuresfrom generic equivalents. In order to increase sales of Peridex®, ZilaPharmaceuticals has signed a distribution agreement with OmniiProducts. Omnii is a national marketer and detailer of dental prod-ucts that targets dispensing dentist professionals in the United States.Over-the-counter product sales of the Zilactin® family of productsincreased 28.4% when compared to the corresponding period lastyear, primarily due to increased sales of the Zilactin® Toothache Swaband Zilactin®-L product lines. Net revenues for Inter-Cal for fiscalyear 2000 were $19.1 million, a 27.5% increase when compared to$15.0 million for fiscal year 1999. Inter-Cal’s international salesincreased 104% to $6.1 million during the current fiscal year as com-

12 Zila, Inc.

M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A L Y S I SOf Financial Condition and Results of Operations ▲ Zila, Inc. and Subsidiaries


pared to the previous year due to improved economic conditions inforeign markets, primarily in the Pacific Rim region. In addition,Inter-Cal had increased demand for all of its major domestic productlines in fiscal 2000 when compared to the fiscal 1999 year.

Cost of products sold were $40.0 million for the fiscal year endedJuly 31, 2000, a 16.5% increase from $34.3 million for the previousfiscal year. Cost of products sold as a percentage of net revenuesincreased to 51.6% in fiscal year 2000 from 48.2% in the corre-sponding 1999 period. The increase for the period reflects thegrowth of Zila Dental Supply as a percentage of total revenues,51.3% for fiscal 2000 compared to 44.2% for same period of theprevious fiscal year. The gross profit margin for Zila Dental Supplyis lower as compared to the other operating groups resulting in ahigher cost of products sold as a percentage of revenues.

Cost of products sold as a percentage of net revenues for ZilaDental Supply decreased slightly to 74.3% in fiscal year 2000 from74.6% in fiscal year 1999 primarily due to an increase in vendorrebate programs in the first quarter of fiscal 2000. Cost of productssold as a percentage of net revenues for Zila Pharmaceuticals increasedto 23.2% in fiscal year 2000, compared to 17.9% for the corre-sponding period in fiscal 1999. The increase for the period is a resultof a change in the mix of products sold as well as a promotional pro-gram for Peridex® that offered the product at reduced pricing duringthe second half of the year. Cost of products sold as a percentage ofnet revenues for Inter-Cal decreased slightly to 27.2% for the currentfiscal year from 27.9% due primarily to favorable raw material con-tracts in effect for fiscal year 2000 as compared to fiscal year 1999.

The Company incurred selling, general and administrativeexpenses of $32.4 million, or 41.8% of net revenues during the fiscal year ended July 31, 2000 compared to $31.9 million, or44.7% of net revenue in fiscal year 1999. The decrease in selling,general and administrative expenses as a percentage of revenue isattributable to a reduction in costs related to the Cygnus andPracticeWorks businesses partially offset by increased costs relatedto the expansion of the sales force and service department at ZilaDental Supply’s full service branches, increased selling and adminis-trative costs related to the OraTest® international product launches,increased marketing and selling expenses at Inter-Cal and increasedcorporate legal, professional and insurance expenses.

Research and development expenses decreased $2.4 million or59.2%, from $4.0 million incurred in fiscal year 1999 to $1.6 millionfor the same period in fiscal year 2000. The decrease was primarilydue to reduced expenses related to research and clinical activities associated with the OraTest® product, and reduced expenses related toseeking international approval of OraTest® and a reduction of costsincurred in the Cygnus and PracticeWorks businesses which were soldin fiscal year 2000.

Depreciation and amortization expenses decreased $104,000 from$3.6 million in fiscal year 1999 to $3.5 million in fiscal year 2000.The decrease was mainly related to the sale of the Cygnus andPracticeWorks businesses.

The Company recorded interest expense of $212,000 for the yearended July 31, 2000 compared to $393,000 in the prior fiscal year,a decrease of $181,000. The decrease was attributable to decreasesin debt obligations incurred during fiscal year 2000 as compared tothe previous year period.

In the year ended July 31, 2000, the Company recorded incometax expense of $1.8 million which is net of $2.9 million in incometax benefit resulting from the reversal of a valuation allowance ($1million of which was attributable to the exercise of common stockoptions and therefore credited to capital in excess of par value) ascompared to an income tax benefit of $846,000 ($250,000 of whichwas attributable to the exercise of common stock options and there-fore credited to capital in excess of par value) for the fiscal year endedJuly 31, 1999. The reversal of the valuation allowance was based onthe Company’s estimate that it is more likely than not that certainnet operating losses of prior years will be realized. Excluding theeffects of the reversal of the valuation allowance, the Company’seffective tax rate for the current fiscal year is higher than the statuto-ry rate due primarily to the amortization of intangible assets that isnot deductible for tax purposes and the non-deductibility of theCompany’s foreign operating losses. Additionally, approximately$1.7 million of goodwill related to the sale of Cygnus was notdeductible for tax purposes.

For the fiscal year ended July 31, 2000, the Company had netincome of $2.9 million compared to a net loss of $2.0 for 1999. Theincrease in profitability is due primarily to the increased profitabilityin the Nutraceuticals Group, the sale of the PracticeWorks businessand the elimination of losses associated with the Cygnus business.

Fiscal year ended July 31, 1999. Net revenues during the 1999 fis-cal year totaled $71.3 million compared to net revenues of $62.1million for the prior fiscal year, an increase of 14.8%.

Net revenues in 1999 for Zila Dental Supply were $31.5 millioncompared to $28.1 million for the previous fiscal year, an increase of12.4%. The increase was mainly due to improved mail order sales,expansion of the sales force in conjunction with the opening of twoadditional branch offices and increased internet sales. ZilaPharmaceuticals, marketer of Peridex® and the Zilactin® family ofproducts, had net revenues of $18.1 million for the fiscal year endedJuly 31, 1999, an increase of 17.5% over fiscal year 1998 sales of$15.4 million. The main increase in net revenues was due to theacquisition of Peridex® in the second quarter of fiscal year 1998. Asa result, the twelve months ended July 31, 1998 reflect nine monthsof Peridex® revenues whereas the twelve months ended July 31, 1999reflect a full twelve months of Peridex® revenues. Also contributingto the increased revenues was the addition of the Zilactin® ToothacheSwab product launched during fiscal year 1999, increased revenues inthe Zilactin®-L, Zilactin® Baby and Zilactin®-B product lines. Netrevenues in 1999 for Oxycal were $15.0 million compared to $12.2million for the previous fiscal year, an increase of 22.6%. Oxycal wasacquired during the second quarter of fiscal year 1998 and thereforethe net revenues for fiscal year 1998 reflect nine months of revenueswhereas the twelve months ended July 31, 1999 reflect a full twelvemonths of Oxycal revenues. PracticeWorks had net revenues of $4.5million for fiscal year 1999, an increase of 32.1% over net revenues of$3.4 million in fiscal year 1998. The increase was primarily due toexpansion of its dealer network and increased demand for Windowsbased and Year 2000 ready dental software systems. Net revenues in1999 for Cygnus were $1.8 million compared to $2.7 million for theprevious fiscal year, a decrease of 34.4%. Technical difficulties withthe digital x-ray systems were the primary reason for the decrease insales as compared to the previous year.

14 Zila, Inc.

Cost of products sold were $34.3 million for the fiscal year endedJuly 31, 1999, an increase of 11.9% as compared to $30.7 million forthe previous fiscal year. Cost of products sold as a percentage of netrevenues decreased to 48.2% compared to 49.4% in fiscal year 1998.Cost of products sold as a percentage of net revenues for Zila DentalSupply decreased to 74.6% in fiscal year 1999 from 75.8% in fiscalyear 1998. This decrease was mainly due to reduced costs resultingfrom vendor rebate programs. Cost of products sold as a percentageof net revenues for Zila Pharmaceuticals increased to 17.9% in fiscalyear 1999 as compared to 16.7% in fiscal year 1998. This increasewas due mainly to the introduction and market expansion of newerproducts, which have higher costs as compared to the existing prod-ucts. Also contributing to the increase in 1999, were promotions forPeridex®, which offered the product at reduced pricing throughoutfiscal year 1999. Cost of products sold as a percentage of net revenuesfor Oxycal decreased to 27.9% in fiscal year 1999 as compared to29.7% in fiscal year 1998. The decrease was a result of favorable rawmaterials purchase contracts in effect for fiscal year 1999 as comparedto fiscal year 1998. PracticeWorks had a decrease in cost of productssold as a percentage of net revenues from 10.3% in fiscal year 1998 to6.2% in fiscal year 1999. The decrease is mainly due to an increasein higher software and support revenue and lower training costs.Cygnus had an increase in cost of sales as a percentage of net revenuesfrom 76.9% in fiscal year 1998 to 98.8% in fiscal year 1999. Theincrease is primarily related to the technical difficulties with the digi-tal x-ray systems and related inventory write-offs.

The Company incurred selling, general and administrativeexpenses of $31.9 million or 44.7% of net revenues during the fiscalyear ended July 31, 1999 compared to $25.5 million or 41.0% of netrevenues in the fiscal year ended July 31, 1998. This increase wasmainly attributable to selling, general and administrative expensesresulting from the Oxycal and Peridex® acquisitions in the secondquarter of fiscal year 1998, corporate regulatory affairs, legal, publicrelations and professional services as well as increased selling expenseat Zila Dental Supply. Costs associated with resolving technicalproblems with the CygnusRay2™, Cygnus digital x-ray system, alsocontributed to the increase.

Research and development expenses increased $1.3 million, or49.9%, from $2.7 million in fiscal year 1998 to $4.0 million in fis-cal year 1999. The increase was mainly related to research and clin-ical activities associated with OraTest® and Ester-C®, as well as prod-uct development expenses related to the digital x-ray systems anddental practice management software.

Depreciation and amortization expenses increased $800,000 from$2.8 million in fiscal year 1998 to $3.6 million in fiscal year 1999.The increase was mainly due to the additional amortization of intan-gibles and goodwill from the Oxycal and Peridex® acquisitions,which occurred during the second quarter of fiscal year 1998.

Interest income decreased $31,000 from $320,000 in the prior fis-cal year to $289,000 during the fiscal year 1999 due to decreasedbank balances. Interest expense increased from $335,000 in fiscalyear 1998 to $393,000 in fiscal year 1999. The increase was attrib-utable to additional debt obligations during fiscal year 1999 relatedto the funding of a new manufacturing and laboratory facility forOxycal and additional financing to support OraTest® clinical, regu-latory, manufacturing and marketing costs.

The benefit for income taxes was $846,000 ($250,000 of whichwas attributable to the exercise of common stock options and there-fore credited to capital in excess of par value) for the fiscal year endedJuly 31, 1999 compared to an income tax benefit of $2.6 million($800,000 of which was attributable to the exercise of commonstock options and therefore credited to capital in excess of par value)during the year ended July 31, 1998. In the past, the Company hadoffset its net deferred tax asset with valuation allowance due to theCompany’s lack of earnings history.

For the fiscal year ended July 31, 1999, the Company had a netloss of $2.0 million compared to net income of $2.3 million for1998. The decrease in profitability is primarily due to increasedspending in OraTest®, increased losses at Cygnus resulting from thetechnical difficulties with the digital x-ray system and lower tax ben-efit recognized in 1999 compared to 1998. In fiscal year 1998, netincome was reduced in the amount of $7.3 million by the accretionof an embedded dividend on the Series A Preferred Stock issued inNovember 1997 to arrive at net loss attributable to common share-holders. As a result, for the fiscal year 1998, the Company had a netloss attributable to common shareholders of $5.0 million after tak-ing into account the embedded dividend.

Inflation and SeasonalityInflation has had no material effect on the operations or financial

condition of the Company. The Company’s operations are not con-sidered seasonal in nature.

Liquidity and Capital ResourcesAt July 31, 2000, the Company had cash and cash equivalents of

$5.6 million compared to $5.8 million at July 31, 1999. Excess cashand cash equivalents are invested primarily in money marketaccounts. The Company’s working capital was $20.3 million at July31, 2000 as compared to $22.0 million at July 31, 1999. Workingcapital decreased primarily due to a reduction in deferred incometaxes related to the use of tax loss carryforwards in fiscal 2000. TheCompany’s current ratio was 2.8 at July 31, 2000, compared to 3.5at July 31, 1999.

During the year ended July 31, 2000, cash provided by operatingactivities totaled $1.1 million primarily related to net income of $2.9million plus non-cash depreciation and amortization of $3.5 millionand deferred taxes of $1.5 million, reduced by the gain on sale ofassets of $4.7 million. Significant changes in operating assets and lia-bilities were comprised of (i) an increase in accounts receivable of$2.0 million due to increased sales at Zila Dental Supply and Inter-Cal during the current fiscal year, (ii) an increase in inventories of$2.9 million primarily because of new product introductions atInter-Cal and increased purchases of dental supplies and equipmentto support the growing sales at Zila Dental Supply and (iii) anincrease in prepaid expenses of $1.0 million primarily related to thedeposit paid to ILEX™, all of which was partially offset by anincrease in accounts payable and accrued expenses of $3.6 millionrelated to the increase in inventory purchases.

The Company generated cash from investing activities of $2.4million during the year ended July 31, 2000, primarily due to the

$7.7 million net proceeds from the sale of the Cygnus andPracticeWorks assets. Part of these proceeds were used to purchaseproperty and equipment of $5.2 million, consisting of manufactur-ing additions for the Oxycal and OraTest® businesses. Additionally,$3.7 million was used in financing activities during the 2000 fiscalyear. The Company retired outstanding debt of $5.4 million, com-prised of the final payment of $1.0 million made to P & G relatedto the acquisition of the Peridex® product line and $4.2 million torepay in full its line of credit with Bank One. The Company used$409,750 to repurchase 135,000 shares of Zila common stock onthe open market.

At July 31, 2000, the Company had federal income tax net oper-ating loss carryforwards of approximately $ 9.8 million, which expirein years 2007 through 2019.

In February 1999, the Company increased its line of credit withBank One to $9.0 million and extended the commitment period toDecember 1, 2000. Interest is payable monthly on the unpaid bal-ance outstanding at the bank’s prime rate (9.5% at July 31, 2000)plus .25%. At July 31, 2000, the Company had no borrowingsunder the line of credit. Under the line of credit, the Company isrequired to comply with financial covenants based on certain finan-cial ratios. At July 31, 2000, the Company was in compliance withsuch covenants.

During the second quarter of fiscal year 2000, Inter-Cal beganconstruction of a new manufacturing and laboratory facility that isexpected to be completed by October 2000. In April 1999, Inter-Calentered into a transaction with The Industrial DevelopmentAuthority of the County of Yavapai (the “Authority”) in which theAuthority issued $5.0 million in Industrial Development RevenueBonds (the “Bonds”), the proceeds of which were loaned to Inter-Calfor the construction of the facility. The trustee, Bank One, Arizona,is holding the Bond proceeds but released $1.9 million during fiscalyear 2000 to pay for construction costs and equipment. The Bondsconsist of $3.9 million Series A and $1.1 million Taxable Series Bwhich, as of July 31, 2000, carried interest rates of 4.5% and 6.7%,respectively. The Bonds were marketed and sold by Banc OneCapital Markets and carry a maturity of 20 years. In connectionwith the issuance of the Bonds, the Authority required that Inter-Calobtain, for the benefit of the Bondholders, an irrevocable direct-payletter of credit to secure payment of principal and interest. The let-ter of credit is guaranteed by Zila.

On December 20, 1999, IDT completed the sale of substantiallyall of its assets and liabilities related to its PracticeWorks divisionlocated in Gold River, California to InfoCure of Atlanta, Georgia forapproximately $4.65 million. InfoCure is a national provider ofhealthcare practice management software products and services totargeted healthcare practice specialties and is listed on NASDAQunder the symbol INCX. Under the terms of the agreement, 10%of the sales price will be held in escrow for one year in order to securethe representations, warranties, and covenants made by theCompany to InfoCure.

In November 1999, the Company contracted with ILEX™Oncology Services, Inc. (“ILEX”), a wholly owned subsidiary ofILEX™ Oncology, Inc. of San Antonio, Texas, for management ofclinical research and liaison with the U.S. Food and DrugAdministration (“FDA”) related to the Company’s pursuit of regula-

tory approval for the OraTest® oral cancer detection product. InMarch 2000, the Company paid approximately $792,000 to ILEXas a deposit on estimated expenses related to an FDA-required clin-ical study associated with the Company’s ongoing efforts to obtainFDA approval of OraTest®. Current commitments under the ILEXagreement include a monthly installment payment of $76,000 plusreimbursement for out of pocket expenses as they occur during thecourse of the study. The contract or any workplan may be terminat-ed at any time by Zila upon not less than 90 days prior writtennotice of termination to ILEX. If the agreement is so terminated,Zila shall pay ILEX any amount owed, but not yet paid, for workperformed prior to the date of termination.

On November 10, 1999, the Company announced that theCompany’s Board of Directors authorized the repurchase of up to onemillion shares of Zila common stock. Purchases will be made on theopen market depending on market conditions and other factors. As ofJuly 31, 2000, 135,000 shares had been repurchased for $409,750.

The Company believes that cash generated from its operations, itsinvesting activities and the availability of cash under its line of cred-it are sufficient to finance its level of operations, anticipated capitalexpenditures and stock repurchase program through the next 12months. The Company may require additional financing to supportthe production and future OraTest® clinical, regulatory, manufactur-ing and marketing costs or to make any significant acquisitions.There can be no assurances that such funds will be available on termsacceptable to the Company.

New Accounting Pronouncements The Securities and Exchange Commission released Staff

Accounting Bulletin (“SAB”) No. 101 Revenue Recognition inFinancial Statements on December 3, 1999, SAB No. 101A onMarch 24, 2000 and SAB No. 101B on June 26, 2000. SAB No.101 sets forth revenue recognition issues, including conceptual issuesas well as certain industry specific guidance. The Company isrequired to report the impact of SAB No. 101, as amended by SABNo. 101A and SAB No. 101B, no later than the fourth quarter ofthe fiscal year 2001. The effect of the change, if any, would be rec-ognized as a cumulative effect of a change in accounting principle asof August 1, 2000. Prior year financial statements will not be restat-ed. The Company has not yet made an evaluation of the impact ofadopting these statements on the Company’s financial position oroperating results.

SFAS No. 133, Accounting for Derivative Instruments and HedgingActivities, (“SFAS No. 133”), establishes accounting and reportingstandards for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities.SFAS No. 133 requires that an enterprise recognize all derivatives aseither assets or liabilities in the balance sheet and measure thoseinstruments at fair value. If certain conditions are met, a derivativemay be specifically designated as a hedge. The accounting forchanges in the fair value of a derivative instrument depends on theintended use of the derivative and resulting designation. TheCompany adopted SFAS No. 133 effective August 1, 2000 and theadoption did not have a material impact on the Company’s results ofoperations as the Company has no significant derivative financialinstruments or hedging activities.


16 Zila, Inc.

Board of Directors and ShareholdersZila, Inc.Phoenix, Arizona

We have audited the consolidated balance sheets of Zila, Inc. and subsidiaries (the“Company”) as of July 31, 2000 and 1999, and the related consolidated statementsof operations and comprehensive income, convertible redeemable preferred stockand shareholders’ equity, and of cash flows for each of the three years in the periodended July 31, 2000. These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on these finan-cial statements based on our audits.

We conducted our audits in accordance with auditing standards generally acceptedin the United States of America. Those standards require that we plan and performthe audit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An audit alsoincludes assessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation. Webelieve that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all materialrespects, the financial position of Zila, Inc. and subsidiaries at July 31, 2000 and1999, and the results of their operations and their cash flows for each of the threeyears in the period ended July 31, 2000 in conformity with accounting principlesgenerally accepted in the United States of America.

DELOITTE & TOUCHE LLPPhoenix, ArizonaSeptember 29, 2000

I N D E P E N D E N T A U D I T O R S ’ R E P O R T

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Zila, Inc. 17

C O N S O L I D A T E D B A L A N C E S H E E T SZila, Inc. and Subsidiaries

At July 31, 2000 1999

Assets

Current assets:Cash and cash equivalents $ 5,558,487 $ 5,770,970Trade receivables, less allowance for doubtful accounts

of $345,857 (2000) and $459,083 (1999) 9,893,587 8,741,283Inventories — net 13,204,137 11,405,883Prepaid expenses and other current assets 2,479,072 1,126,773Deferred income taxes 244,788 3,705,715

Total current assets 31,380,071 30,750,624

Property and equipment — net 9,442,278 5,680,281Purchased technology rights — net 5,600,975 6,037,415Goodwill — net 12,725,978 15,679,969Trademarks and other intangible assets — net 12,423,632 13,214,636Cash held by trustee 2,928,001 4,834,755Other assets 3,210,524 358,253

Total $ 77,711,459 $ 76,555,933

Liabilities and Shareholders’ Equity

Current liabilities:Accounts payable $ 6,599,702 $ 3,724,820Accrued liabilities 3,622,330 2,760,735Deferred revenue 982,037Short-term borrowings 51,770 72,769Current portion of long-term debt 776,866 1,164,399

Total current liabilities 11,050,668 8,704,760

Long-term debt — net of current portion 4,548,953 9,577,755

Total liabilities 15,599,621 18,282,515

Commitments and contingencies (Notes 12 and 13)

Series A Convertible Redeemable Preferred Stock:Issued and outstanding 0 shares (2000) and 7,482 shares (1999) 8,787,191

Shareholders’ Equity:

Preferred stock, $.001 par value - authorized 2,500,000 shares;None issued other than Series A Convertible Redeemable Preferred Stock above

Common stock, $.001 par value - authorized, 65,000,000 shares;Issued 43,362,658 shares (2000) and 40,378,588 shares (1999) 43,363 40,379

Capital in excess of par value 79,424,235 69,395,551Accumulated other comprehensive income 71,666Deficit (17,017,676) (19,949,703)Less: 135,000 shares of common stock in treasury, at cost (409,750)

Total shareholders’ equity 62,111,838 49,486,227

Total $ 77,711,459 $76,555,933

See notes to consolidated financial statements.

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18 Zila, Inc.

C O N S O L I D A T E D S T A T E M E N T S O F O P E R A T I O N SA N D C O M P R E H E N S I V E I N C O M E

Zila, Inc. and Subsidiaries

Years ended July 31, 2000 1999 1998

Net revenues $ 77,580,908 $ 71,294,751 $ 62,107,110

Operating costs and expenses: Cost of products sold 40,004,391 34,335,344 30,676,673Selling, general and administrative 32,449,161 31,853,421 25,469,787Research and development 1,628,580 3,988,028 2,660,135Depreciation and amortization 3,478,120 3,581,768 2,769,956

77,560,252 73,758,561 61,576,551

Income (loss) from operations 20,656 (2,463,810) 530,559

Other income (expenses): Interest income 388,773 288,918 319,774Interest expense (212,671) (392,805) (334,646)Other income (expense) (182,921) 4,715 (14,619)Gain on sale of assets 4,677,860

4,671,041 (99,172) (29,491)

Income (loss) before income taxes 4,691,697 (2,562,982) 501,068Income tax (expense) benefit (1,759,670) 596,000 1,800,000

Net income (loss) 2,932,027 (1,966,982) 2,301,068

Preferred stock dividend requirement: Series A embedded dividend 7,314,600

Net income (loss) attributable to common shareholders $ 2,932,027 $ (1,966,982) $ (5,013,532)

Net income (loss) per share: Basic $ 0.07 $ (0.05) $ (0.15)

Diluted $ 0.07 $ (0.05) $ (0.15)

Weighted average number of shares outstanding Basic 42,180,236 38,013,058 33,990,947 Diluted 43,576,180 38,013,058 33,990,947

Net income $ 2,932,027 Other comprehensive income (loss), net of tax

Foreign currency translation adjustment 75,166Net unrealized loss on available-for-sale-securities (3,500)

Other comprehensive income 71,666

Comprehensive income $ 3,003,693


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Zila, Inc. 19

C O N S O L I D A T E D S T A T E M E N T S O F C A S H F L O W SZila, Inc. and Subsidiaries


Operating activities:Net income (loss) $ 2,932,027 $ (1,966,982) $ 2,301,068 Adjustments to reconcile net income (loss) to

net cash provided by (used in) operating activities:Depreciation and amortization 3,478,120 3,581,768 2,769,956Gain on sale of assets (4,677,860)Discount on contractual obligation and other 122,189 117,046 288,365Warrants issued for services 30,000Deferred income taxes 1,545,378 (670,285) (1,800,000)Change in assets and liabilities:

Receivables - net (1,983,531) (1,580,043) 1,766,866Inventories (2,871,820) 144,126 (3,010,557)Prepaid expenses and other assets (1,140,726) (103,935) (418,875)Accounts payable and accrued liabilities 3,618,248 (727,357) 585,526 Deferred revenue 83,281 414,081 172,362

Net cash provided by (used in) operating activities 1,135,306 (791,581) 2,654,711

Investing activities:Net proceeds from sale of assets 7,749,927Purchases of property and equipment (5,198,064) (1,762,927) (1,276,262)Acquisitions, net of cash acquired (33,595,322)Purchases of intangible assets (159,210) (686,236) (942,284)

Net cash provided by (used in) investing activities 2,392,653 (2,449,163) (35,813,868)

Financing activities:Net (repayments) proceeds from short-term borrowings (20,999) 29,352 87,598 Net proceeds from issuance of common stock 224,477 259,312 10,559,611 Net proceeds from issuance of preferred stock 28,647,250 Net proceeds from issuance of long-term debt 9,209,486 93,753 Cash released (held) by trustee 1,906,754 (4,834,755)Purchase of common stock for treasury (409,750)Principal payments on long-term debt (5,440,924) (892,882) (3,059,417)

Net cash (used in) provided by financing activities (3,740,442) 3,770,513 36,328,795

Net (decrease) increase in cash and cash equivalents (212,483) 529,769 3,169,638

Cash and cash equivalents, beginning of period 5,770,970 5,241,201 2,071,563

Cash and cash equivalents, end of period $ 5,558,487 $ 5,770,970 $ 5,241,201

Cash paid for interest $ 172,813 $ 229,318 $ 46,029

Cash paid for income taxes $ 128,074 $ 23,000

continues

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20 Zila, Inc.

C O N S O L I D A T E D S T A T E M E N T S O F C A S H F L O W SZila, Inc. and Subsidiaries


Supplemental disclosures of non-cash investing and financing activities:

Income tax benefit attributable to exercise of common stock options $ 990,000 $ 250,000 $ 800,000

Conversion of Series A Convertible Redeemable Preferred Stock to common stock $ 8,787,191 $ 25,014,739 $ 1,400,320

Non-cash aspects of Oxycal acquisition:Fair value of assets acquired other than cash and cash equivalents $ 12,787,836

Liabilities assumed $ 1,213,729

Intangible assets recorded in connection with acquisition of Oxycal $ 14,795,040

Non-cash aspects of Peridex acquisition:Fair value of assets acquired other than cash and cash equivalents $ 220,000

Contractual obligation recorded in connection with the acquisition of Peridex $ 5,570,000

Goodwill recorded in connection with the acquisition of Peridex $ 11,570,637

Embedded dividend recorded in connection with issuance of Series A Convertible Redeemable Preferred Stock $ 7,314,600


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Zila, Inc. 21

CONSOLIDATED STATEMENTS OF CONVERTIBLE REDEEMABLE PREFERREDSTOCK AND SHAREHOLDERS’ EQUITY

Zila, Inc. and Subsidiaries

Shareholders’ Equity

Convertible Redeemable Accumulated Total

Preferred Stock Common Stock Capital Other Common

in Excess of Treasury Comprehensive Shareholders’

Shares Amount Shares Par Value Par Value Deficit Stock Income (Loss) Equity

Balance, August 1, 1997 — — 32,326,581 $ 32,327 $ 30,360,021 $ (12,969,189) — — $ 17,423,159

Issuance of preferred stock 30,000 $ 36,555,000

Preferred stock issuance fees (1,352,750)

Conversion of preferred stock

into common stock (1,200) (1,400,320) 190,543 190 1,400,130 1,400,320

Issuance of common stock 1,588,869 1,589 10,177,534 10,179,123

Exercise of common

stock warrants 214,609 215 609,862 610,077

Exercise of common

stock options 422,973 423 529,588 530,011

Income tax benefit-stock options 800,000 800,000

Net income 2,301,068 2,301,068

Series A embedded dividend (7,314,600) (7,314,600)

Balance, July 31, 1998 28,800 33,801,930 34,743,575 34,744 43,877,135 (17,982,721) — -— 25,929,158


into common stock (21,318) (25,014,739) 5,483,371 5,483 25,009,256 25,014,739

Exercise of common

stock warrants 35,975 36 107,889 107,925

Exercise of common

stock options 115,667 116 151,271 151,387

Income tax benefit-stock options 250,000 250,000

Net income (1,966,982) (1,966,982)

Balance July 31, 1999 7,482 8,787,191 40,378,588 40,379 69,395,551 (19,949,703) — — 49,486,227


into common stock (7,482) (8,787,191) 2,904,472 2,904 8,784,287 8,787,191

Warrants issued for

services provided 30,000 30,000

Purchase of common

stock for treasury (409,750) (409,750)

Exercise of common

stock warrants 49,074 49 76,280 76,329

Exercise of common

stock options 30,524 31 148,117 148,148

Income tax benefit -

stock options 990,000 990,000

Foreign currency translation 75,166 75,166

Net unrealized loss on

available-for-sale securities (3,500) (3,500)

Net income 2,932,027 2,932,027

Balance July 31, 2000 — — 43,362,658 $ 43,363 $ 79,424,235 $ (17,017,676) $ (409,750) $ 71,666 $ 62,111,838


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22 Zila, Inc.

N O T E S T O C O N S O L I D A T E D F I N A N C I A L S T A T E M E N T SYears Ended July 31, 2000, 1999 and 1998 ▲ Zila, Inc. and Subsidiaries

1. Nature of Business Activities and Summary of SignificantAccounting Policies

Nature of Business Activities — Zila, Inc. (“Zila” or the“Company”), a Delaware corporation, is a worldwide manufactur-er and marketer of pharmaceutical, biomedical, dental and nutri-tional products. The Company has three major operating groups:Pharmaceuticals, Professional Products and Nutraceuticals. ThePharmaceuticals Group consists of over-the-counter and prescrip-tion products, including the Zilactin® family of over-the-counterproducts, Peridex® prescription mouth rinse, and OraTest®, an oralcancer diagnostic system. The Professional Products Groupincludes Zila Dental Supply (“Zila Dental”), a national distributorof professional dental supplies, Zila Technologies, Inc, formerlyknown as Cygnus Imaging Inc. (“Cygnus”), a manufacturer andmarketer of digital x-ray systems and intraoral cameras, andIntegrated Dental Technologies, Inc. (“IDT”), which distributedPracticeWorks, a dental practice management software product.The Nutraceuticals Group is presently comprised of OxycalLaboratories, Inc. (“Oxycal”) and its Inter-Cal subsidiary, a manu-facturer and distributor of mineral and botanical products includ-ing a patented and unique form of vitamin C under the trademarkEster-C® and the Palmettex™ botanical line of products.

On October 28, 1999, Cygnus completed the sale of substantial-ly all of its assets and certain liabilities to Procare Laboratories, Inc.(“Procare”), of Scottsdale, Arizona for approximately $4.0 million.Procare is controlled by the former owner and President of Cygnus.

On December 20, 1999, the Company, through IDT, complet-ed the sale of substantially all of IDT’s assets and liabilities relatedto its PracticeWorks division located in Gold River, California toInfoCure Corporation (“InfoCure”), of Atlanta, Georgia forapproximately $4.65 million. InfoCure is a national provider ofhealthcare practice management software products and services totargeted healthcare practice specialties and is listed on the NAS-DAQ under the symbol INCX. Under the terms of the agreement,10% of the sales price will be held in escrow for one year in orderto secure the representations, warranties, and covenants made bythe Company to InfoCure.

The Company prepares its financial statements in accordancewith accounting principles generally accepted in the United Statesof America. Significant accounting policies are as follows:

Principles of Consolidation — The consolidated financialstatements include the accounts of Zila, Inc. and its wholly-owned subsidiaries, Zila Pharmaceuticals, Inc., ZilaInternational Inc., Zila Ltd., Bio-Dental TechnologiesCorporation (“Bio-Dental”), Zila Technologies, Inc, andOxycal Laboratories, Inc. Zila International Inc. has no opera-tions. All significant intercompany balances and transactionsare eliminated in consolidation.

Use of Estimates — The preparation of financial statementsin conformity with generally accepted accounting principlesnecessarily requires management to make estimates andassumptions that affect the reported amounts of assets and lia-bilities, disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenueand expenses during the reporting period. Actual results coulddiffer from those estimates.

Cash Equivalents — The Company considers highly liquidinvestments purchased with original maturities of three months orless to be cash equivalents.

Inventories, which consist of finished goods and raw materials,are stated at the lower of cost (first-in, first-out method) or market.

Property and equipment are stated at cost and are depreciatedusing straight-line methods over their respective estimated usefullives, ranging from 2 to 40 years. Leasehold improvements aredepreciated over the lease term or the estimated useful life,whichever is shorter.

Goodwill and trademarks are being amortized on a straight-linebasis over 15 to 40 years.

Other intangible assets consist of deferred patent and licensingcosts, software rights, and covenants not to compete. Deferredpatent and licensing costs incurred in connection with the acqui-sition of patent rights, obtaining Food and Drug Administration(“FDA”) regulatory approvals and obtaining other licensingrights for treatment compositions are capitalized and amortizedover the estimated benefit period not exceeding 17 years.Covenants not to compete are amortized over the term of theagreement. Research and development costs totaling approxi-mately $1,629,000, $3,988,000 and $2,660,000 in 2000, 1999and 1998, respectively, were expensed.

Net income (loss) per common share – Basic net income (loss)per common share is computed by dividing net income (loss) avail-able to common shareholders by the weighted average number ofcommon shares outstanding during the year before giving effect tostock options considered to be dilutive common stock equivalents.Diluted net income (loss) per common share is computed by divid-ing net income (loss) available to common shareholders by theweighted average number of common shares outstanding duringthe year after giving effect to convertible preferred stock, stockoptions and warrants considered to be dilutive common stockequivalents. For the years ended July 31, 1999 and 1998, convert-ible preferred stock, options and warrants that would otherwisequalify as common stock equivalents are excluded because theirinclusion would have the effect of decreasing the loss per share.

Financial instruments — The carrying amounts and estimatedfair value of the Company’s financial instruments are as follows:

The carrying values of cash and cash equivalents, receivables,accounts payable and accrued expenses approximate fair values dueto the short-term maturities of these instruments.

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Zila, Inc. 23

The carrying amount of long-term debt and short-term borrow-ings are estimated to approximate fair value as the actual interestrate is consistent with the rate estimated to be currently availablefor debt of similar term and remaining maturity.

Financial instruments, which potentially subject the Companyto credit risk, consist principally of trade receivables. The Companyprovides credit, in the normal course of business, to pharmaceuti-cal wholesalers and chains, food wholesalers and chains, rack job-bers, convenience stores, and dentists. The Company performsongoing credit evaluations of its customers and maintains anallowance for credit losses. Amounts included in selling, generaland administrative expenses related to increases in the allowance fordoubtful accounts receivable during fiscal 2000, 1999 and 1998were $178,000, $371,000 and $90,000, respectively.

Comprehensive income consists of net income and other gainsand losses affecting shareholders’ equity that, under generallyaccepted accounting principles are excluded from net income. Forthe Company, such items consist primarily of unrealized gains andlosses on marketable equity investments and foreign translationgains and losses.

Certain reclassifications have been made to the 1999 and 1998financial statements to conform to the classifications used in 2000.

Accounting for Derivative Instruments and Hedging Activities —SFAS No. 133, Accounting for Derivative Instruments and HedgingActivities, (“SFAS No. 133”), establishes accounting and reportingstandards for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activi-ties. SFAS No. 133 requires that an enterprise recognize all deriv-atives as either assets or liabilities in the balance sheet and measurethose instruments at fair value. If certain conditions are met, aderivative may be specifically designated as a hedge. The account-ing for changes in the fair value of a derivative instrument dependson the intended use of the derivative and resulting designation.The Company adopted SFAS No. 133 effective August 1, 2000,and the adoption did not have a material impact on the Company’sresults of operations as the Company has no significant derivativefinancial instruments or hedging activities.

New Accounting Pronouncements — The Securities andExchange Commission released Staff Accounting Bulletin (“SAB”)No. 101 Revenue Recognition in Financial Statements on December3, 1999, SAB No. 101A on March 24, 2000 and SAB No. 101B onJune 26, 2000. SAB No. 101 sets forth revenue recognition issues,including conceptual issues as well as certain industry specific guid-ance. The Company is required to report the impact of SAB No.101, as amended by SAB No. 101A and SAB No. 101B, no laterthan the fourth quarter of the fiscal year 2001. The effect of thechange, if any, would be recognized as a cumulative effect of achange in accounting principle as of August 1, 2000. Prior yearfinancial statements will not be restated. The Company has not yetmade an evaluation of the impact of adopting these statements onthe Company’s financial position or operating results.

2. Acquisitions

On November 5, 1997, the Company’s Zila Pharmaceuticals,Inc. subsidiary completed its acquisition of the Peridex® productline (“Peridex”), a prescription anti-bacterial oral rinse from TheProcter & Gamble Company (“P&G”). The purchase price was$12,000,000 plus the value of acquired inventory.

On November 10, 1997, the Company acquired, by merger,Oxycal. Oxycal develops, manufactures and markets a patented,unique form of Vitamin C under the trademark Ester-C®. TheCompany paid $28,000,000 for all outstanding shares of Oxycal.The Company raised the funds to consummate the merger in a pri-vate placement of 30,000 shares of the Company’s Series AConvertible Redeemable Preferred Stock (“Preferred Stock”) andwarrants to purchase 360,000 shares of the Company’s commonstock for $30,000,000.

The Peridex and Oxycal acquisitions were accounted for usingthe purchase method of accounting for business combinations. Inconnection with the Oxycal acquisition, trademarks and goodwillof $11,096,280 and $3,698,760, respectively, were recorded andare amortized on a straight-line basis over 25 and 20 years. In con-nection with the Peridex acquisition, goodwill of $11,570,637 wasrecorded and is amortized on a straight-line basis over 12 years.Results of operations of Peridex and Oxycal have been included inthe Company’s statement of operations from their respective acqui-sition dates.

The following unaudited pro forma summary presents the con-solidated results of operations as if the acquisitions had occurred asof the beginning of the period presented and do not purport to beindicative of what would have occurred had the acquisitions beenmade as of those dates or of results which may occur in the future.The unaudited pro forma summary data for the year ended July 31,1998, combines actual financial results of the Company for theyear ended July 31, 1998, which includes Peridex and Oxycalresults for the nine months ended July 31, 1998, and Peridex andOxycal for the three months ended September 30, 1997. Theembedded dividend for the year ended July 31, 1998 represents270 days of accretion and is based on the assumption that thePreferred Stock had been issued at the beginning of the period.

1998Revenues $ 68,329,759Net income $ 4,991,556Series A Preferred Stock embedded dividend $ 7,314,600Net loss attributable to common shareholders $ (2,323,044)Basic loss per share $ (0.07)

These pro forma results have been prepared for comparative pur-poses only and include certain adjustments such as the increase inamortization expense associated with goodwill as a result of apply-ing the purchase method of accounting for the acquisitions.

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24 Zila, Inc.

4. Inventories

Inventories consist of the following at July 31:

2000 1999Finished goods $ 9,219,343 $ 7,531,175Raw materials 4,168,834 4,174,321Inventory reserves (184,040) (299,613)

Total inventories $ 13,204,137 $ 11,405,883

Amounts included in cost of products sold related to increases ininventory reserves during fiscal 2000, 1999 and 1998 were$33,040, $-0- and $129,880, respectively.

5. Property and Equipment

Property and equipment consists of the following at July 31:

2000 1999Land $ 1,221,097 $ 1,221,097Construction in progress 3,618,340 —Building and improvements 2,174,869 2,112,065Furniture and equipment 2,995,821 2,989,752Leasehold improvements

and other assets 475,941 526,828Production and warehouse

equipment 3,470,101 2,715,507

Total property and equipment 13,956,169 9,565,249Less accumulated depreciation

and amortization 4,513,891 3,884,968

Property and equipment — net $ 9,442,278 $5,680,281

Depreciation and amortization expense related to property andequipment for 2000, 1999 and 1998 was $1,112,995, $1,038,507and $769,866, respectively.

3. Sale of Assets

As described in Note 1, on October 28, 1999, Cygnus completed the sale of substantially all of its assets and certain liabilities and onDecember 20, 1999, the Company completed the sale of substantially all of IDT’s assets and liabilities related to its PracticeWorks division.

The following unaudited pro forma condensed statement of operations data for the year ended July 31, 2000, present historical statementof operations data for the Company, Cygnus and IDT as if the Cygnus and IDT transactions had occurred as of August 1, 1999. The proforma data are not necessarily indicative of the results of operations that would actually have been reported had the transactions been con-summated at the date mentioned above or which may be reported in the future.

Unaudited Pro Forma Condensed Statement of Operations

Year ended July 31, 2000 Historical

(in thousands except per share data) Zila Pro formaConsolidated Cygnus IDT Adjustments Pro Forma

(a) (a) (b)

Net revenues $ 77,581 $ 193 $ 1,515 $ 75,873Cost of products sold 40,004 110 69 39,825Selling, general and administrative expenses 32,449 491 1,188 30,770Research and development expenses 1,629 155 120 1,354Depreciation and amortization 3,478 110 35 3,333Income (loss) from operations 21 (673) 103 591Other income (expense) 4,671 (4,678) (7)Income tax (expense) benefit (1,760) (2,761) 1,001Net income (loss) 2,932 (673) 103 (1,917) 1,585

Net income per share (basic) $0.07 $0.04Basic shares outstanding 42,180 42,180Net income per share (diluted) $0.07 $0.04Diluted shares outstanding 43,576 43,576

(a) Represents Cygnus and IDT balances for the year ended July 31, 2000. These amounts are removed to reflect the sale of assets and thecorresponding revenue and expenses thereby reducing the consolidated balances for pro forma purposes.

(b) The Company believes that no pro forma adjustments are required other than the elimination of the gain on the sale of the assets andthe resulting income tax effect recorded in the consolidated statement of operations.

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Zila, Inc. 25

6. Intangible Assets

Intangible assets consist of the following at July 31:

2000 1999Purchased technology rights –

net of accumulatedamortization of $1,818,498 (2000) and $1,382,058 (1999) $ 5,600,975 $ 6,037,415

Goodwill – net of accumulated amortization of $3,385,783 (2000) and $2,535,283 (1999) $ 12,725,978 $ 15,679,969

Trademarks and other intangible assets:

Trademarks $11,514,218 $ 11,547,965Patents 1,494,021 1,370,300Licensing costs 1,548,818 1,648,133Other 472,736 748,299

Total trademarks and otherintangible assets 15,029,793 15,314,697

Less accumulated amortization 2,606,161 2,100,061

Trademarks and other intangible assets — net $12,423,632 $13,214,636

Licensing costs consist primarily of professional fees associatedwith seeking FDA approval for a new product, OraTest®. Purchasedtechnology rights relate to the acquisition of CTM, Inc in fiscalyear 1996. The recoverability of the deferred licensing costs andpurchased technology rights is dependent upon obtaining FDAapproval and generating sufficient revenues from sales of OraTest®

(see Note 12).

Amortization of the Company’s intangible assets during fis-cal 2000, 1999 and 1998 was $2,365,125, $2,543,261 and$2,000,090, respectively.

7. Short-term Borrowings and Long-Term Debt

Short-term borrowings consisted of $51,770 at 7.12% and$72,769 at 6.29% at July 31, 2000 and 1999, respectively, forinstallments due on the Company’s various insurance policies.

Long-term debt consisted of the following at July 31:

2000 1999Revolving line of credit, (1) $ 4,200,000IDA bond payable, Series A, (2) $ 3,789,296 3,900,000IDA bond payable, Series B, (2) 1,068,776 1,100,000Mortgage note payable, interest

rate 9%, monthly payments of $2,315 with a balloon due April 1, 2001 298,659 326,440

Note payable, P&G, paid in 1999, net of unamortized discount (see Note 2) 975,411

Notes payable for equipment with interest rates between 3.06% and 9.44% with maturities no later than 2001 169,088 240,303

5,325,819 10,742,154Less current portion 776,866 1,164,399

Long-term portion $ 4,548,953 $ 9,577,755

(1) The Company obtained a $9,000,000 bank line of credit inFebruary 1999, which is collateralized by trade accounts receivable,inventories and rights to payment. This line of credit expiresDecember 1, 2000. Interest is payable monthly on the unpaid bal-ance outstanding at the bank’s prime rate (9.50% at July 31, 2000)plus .25%. At July 31, 2000, the Company had no borrowingsagainst this line. All borrowings are secured by Zila, Inc. corporateassets and guarantees of its subsidiaries.

(2) In April 1999, Oxycal entered into a transaction with TheIndustrial Development Authority of the County of Yavapai (the“Authority”) in which the Authority issued $5.0 million inIndustrial Development Revenue Bonds (the “Bonds”), the pro-ceeds of which were loaned to Oxycal for the construction of a newmanufacturing and laboratory facility. The trustee, Bank One,Arizona is holding the bond proceeds but released approximately $1.9 million during fiscal year 2000 to pay for construction andequipment costs. The Bonds consist of $3.9 million Series A and$1.1 million Taxable Series B which, as of July 31, 2000, carriedinterest rates of 4.5% and 6.7%, respectively. The Bonds weremarketed and sold by Banc One Capital Markets and carry a matu-rity of 20 years. In connection with the issuance of the Bonds, theAuthority required that Oxycal obtain, for the benefit of theBondholders, an irrevocable direct-pay letter of credit to securepayment of principal and interest. The letter of credit is guaranteedby the Company.

Aggregate annual maturities of long-term debt for the years end-ing July 31 are as follows:

2001 $ 776,8662002 469,8362003 473,4692004 450,7112005 425,7842006 and beyond 2,729,153

Total 5,325,819Less current portion 776,866

Long-term portion $ 4,548,953

Under the mortgage note and line of credit, the Company isrequired to comply with financial covenants based on certain finan-cial ratios. At July 31, 2000, the Company was in compliance withall of the covenants.

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26 Zila, Inc.

8. Stock Options and Warrants

a. Options — The Company adopted the 1997 Stock Option Award Plan, which became effective on February 5, 1997, authorizing theBoard of Directors to grant options to employees and certain employee directors of the Company to purchase up to 1,000,000 shares of theCompany's common stock. The options are issuable at an exercise price no less than market value at the date of grant. Options may be exer-cised up to five to ten years from the date of grant. In fiscal 1997, 1998 and 1999 the Company granted 51,000, 74,900 and 285,000 options,respectively, to employees. These option grants will be effective under the Plan only if the stockholders approve an amendment to the Planat the Company’s 2000 annual meeting of stockholders to increase the number of shares covered by it. At July 31, 2000, no shares were avail-able for grant under this plan and the Company had granted 410,900 more shares than authorized by the plan.

The Company adopted a Stock Option Award Plan that became effective on September 1, 1988, authorizing the Board of Directors togrant options to employees and certain employee-directors of the Company to purchase up to 4,000,000 shares of the Company’s commonstock. The plan was amended December 8, 1995 to increase the authorized number of shares to 5,000,000. The options are issuable at anexercise price no less than the market value at the date of grant. Options may be exercised at any time up to five to ten years from the dateof grant. At July 31, 2000, no shares were available for grant under this plan.

The Company adopted a Non-Employee Directors Stock Option Plan that became effective October 20, 1989, authorizing the Board ofDirectors to grant options of 100,000 shares to non-employee members of the Board of Directors in increments of 2,500 shares per directoreach year. The plan was amended December 8, 1995 to increase the authorized number of shares to 200,000. The options are issuable at anexercise price equal to the market value at the date of grant. All options may be exercised at any time up to five years from the date of grant.At July 31, 2000, 137,500 shares were available for grant under this plan.

A summary of the option plans as of July 31, 2000, 1999, 1998 and changes during the years then ended is presented below:

2000 1999 1998Weighted Weighted WeightedAverage Average AverageExercise Exercise Exercise

Shares Price Shares Price Shares Price

Outstanding at beginning of year 2,306,678 $ 5.41 2,275,918 $ 5.25 2,281,373 $ 4.03

Granted 513,000 3.25 419,500 7.40 666,000 5.97

Exercised (30,524) 4.85 (115,667) 2.61 (422,973) 3.15

Cancelled (212,800) 4.37 (273,073) 6.34 (248,482) 3.87

Outstanding at end of year 2,576,354 5.07 2,306,678 5.41 2,275,918 5.26

Options exercisable at year-end 1,877,559 1,488,078 1,494,866

Weighted average fair value ofoptions granted during the year $ 2.22 $ 5.98 $ 1.96

The following table summarizes information about fixed stock options outstanding at July 31, 2000:

Options Outstanding Options Exercisable

Number Weighted NumberRange of Outstanding at Average Remaining Weighted Average Exercisable at Weighted Average

Exercise Prices July 31, 1999 Contractual Life Exercise Price July 31, 1999 Exercise Price

$ .12 – 1.50 249,752 0.4 $ 1.19 249,752 $ 1.191.51 – 3.00 211,710 1.1 2.94 211,710 2.943.01 – 4.50 704,471 7.8 3.37 206,471 3.644.51 – 6.00 498,218 6.9 5.60 418,751 5.566.01 – 8.00 675,203 6.1 6.87 648,535 6.868.01 – 9.92 237,000 8.4 9.88 142,340 9.88.12 – 9.92 2,576,354 6.0 5.07 1,877,559 5.25

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Zila, Inc. 27

The Company applies APB Opinion No. 25 and related inter-pretations in accounting for its stock-based employee compensa-tion plans. Accordingly, no compensation cost has been recognizedfor its stock-based employee compensation plans. Had compensa-tion cost been computed based on the fair value of awards on thedate of grant, utilizing the Black-Scholes option-pricing model,consistent with the method stipulated by SFAS No. 123, theCompany’s net income (loss) attributable to common shareholdersand income (loss) per share attributable to common shareholdersfor the years ended July 31, 2000, 1999 and 1998 would have beenreduced (increased) to the pro forma amounts indicated below, fol-lowed by the model assumptions used:

July 31, 2000 1999 1998Net income (loss)

attributable to commonshareholders:

As reported $ 2,932,000 $ (1,967,000) $ (5,014,000)Pro forma $ 2,539,000 $ (2,838,000) $ (6,114,000)

Net income (loss) attributable to common shareholders per basic share outstanding:

As reported $ .07 $ (.05) $ (.15)Pro forma $ .06 $ (.07) $ (.18)

Black-Scholes model assumptions:

Risk-freeinterest rate 5.3% 4.4 — 4.5% 4.2 — 4.4%

Expected volatility 78% 82% 38%Expected term 3 — 6 years 3 — 6 years 2 — 6 yearsDividend yield 0% 0% 0%

b. Warrants —The Company has issued warrants to variousinvestors, shareholders and other third parties in connection withservices provided and purchases of the Company’s stock. Activityrelated to such warrants, which expire at various dates throughMarch 2005, is summarized as follows:

Number of Warrant PriceShares Per Share

Outstanding, August 1, 1997 902,015 $0.60 – 8.6125Issued 456,000 7.625 – 9.92Exercised (214,609) .60 – 3.00

Outstanding, July 31, 1998 1,143,406 $3.00 – 9.915Exercised (35,975) 3.00

Outstanding, July 31, 1999 1,107,431 $3.00 – 9.915Issued 10,000 4.90Exercised (49,074) 3.00

Outstanding, July 31, 2000 1,068, 357 $3.00 – 9.915

9. Income TaxesThe consolidated income tax expense (benefit) consists of the

following for the years ended July 31:

2000 1999 1998Current:

Federal $ 154,000 $ 63,000 $ (51,000)State 60,000 11,000 (9,000)

Total current 214,000 74,000 (60,000)

Deferred:Federal 1,314,000 (570,000) (1,479,000)State 232,000 (100,000) (261,000)

Total deferred 1,546,000 (670,000) (1,740,000)

Total consolidated income taxprovision (benefit) $ 1,760,000 $ (596,000) $(1,800,000)

The reconciliation of the federal statutory rate to the effectiveincome tax rate for the years ended July 31 is as follows:

2000 1999 1998Federal statutory rate 34% (34)% 34%Adjustments:

State income taxes – net of federal benefit 10 (6) 6

Effect of foreign taxes 2Non-deductible meal

and entertainmentexpenses 1 4 7

Non-deductible acquisitionexpenses and other 16 14

Non-deductible intangibleamortization 9 23 74

Non-deductible goodwillrelated to sale of assets 14

Decrease in valuation allowance (32) (26) (494)

Effective tax rate 38% (23)% (359)%

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28 Zila, Inc.

The components of the Company’s deferred income tax assetsand liabilities for the years ended July 31 are shown below:

2000 1999 1998Deferred income

tax assets:Net operating loss

carryforwards $ 3,767,000 $ 6,635,000 $7,062,000Allowance for obsolete or

discontinued inventory 59,000 164,000 146,000Alternative minimum

tax credit 154,000Book basis vs. tax

basis differences (547,000) 370,000 49,000Reserve for litigation 16,000 29,000 27,000Product warranty

allowance 78,000 45,000Allowance for doubtful

accounts 136,000 151,000 112,000Accrued vacation 93,000 78,000 79,000Accrued bonus 264,000 32,000Other 156,000 29,000 36,000

Total deferred income tax assets 4,098,000 7,566,000 7,556,000

Valuation allowance (948,000) (3,860,000) (4,771,000)

Net deferred incometax assets $ 3,150,000 $ 3,706,000 $2,785,000

Deferred income taxes reflect the tax effect of temporary differ-ences between the amounts of assets and liabilities recognized forfinancial reporting and tax purposes. The Company had offset itsnet deferred tax assets with a valuation allowance due to theCompany’s lack of earnings history. Management believes the val-uation allowance reduces deferred tax assets to an amount that rep-resents management’s best estimate of the amount of such deferredtax assets that more likely than not will be realized.

At July 31, 2000, approximately $1,117,000 of the deferred taxasset before valuation allowance relates to deductions generated bythe exercise of stock options, which, if realized, will result in anincrease in capital in excess of par value and the Company record-ed income tax expense of $1.8 million which is net of $2.9 millionin income tax benefit resulting from the reversal of a valuationallowance ($1 million of which was attributable to the exercise ofcommon stock options and therefore credited to capital in excess ofpar value). The benefit for income taxes was $846,000 ($250,000of which was attributable to the exercise of common stock optionsand therefore credited to capital in excess of par value) for the fis-cal year ended July 31, 1999, compared to an income tax benefit of$2.6 million ($800,000 of which was attributable to the exercise ofcommon stock options and therefore credited to capital in excess ofpar value) during the year ended July 31, 1998.

At July 31, 2000, the Company had federal net operating losscarry forwards totaling approximately $9,832,000 that expire, ifnot previously utilized, from 2007 through 2019. Net operatingloss carry forwards for state income tax purposes, totaling approxi-

mately $948,000, must be utilized within five years of the date oftheir origination, and expire from 2001 through 2004.

10. Redeemable Preferred Stock

On November 10, 1997, the Company completed a$30,000,000 financing involving the private placement of Series AConvertible Redeemable Preferred Stock. Proceeds from the salewere used primarily to acquire all the outstanding shares of Oxycal.The Preferred Stock was convertible into shares of the Company’scommon stock at a conversion rate based on the price of such com-mon stock at the date of issuance. However, if the market price ofthe Company’s common stock did not appreciate by a fixed per-centage at various measurement dates, the holders of the PreferredStock had the right to receive additional shares of the Company’scommon stock upon conversion, based on a repricing formula.The intrinsic value of the beneficial conversion feature of thePreferred Stock has been measured and recognized as an embeddeddividend and such non-cash embedded dividend has been deduct-ed from net income in the accompanying fiscal 1998 consolidatedstatement of operations to arrive at the amount of net loss attrib-utable to common shareholders. Additionally, because thePreferred Stock had conditions for redemption that were not sole-ly within the control of the Company, it was classified outside ofpermanent equity in the accompanying consolidated balance sheetand was accreted to its redemption value. During the year endedJuly 31, 2000, the remaining 7,482 shares of the Preferred Stockwere converted into common stock.

11. Treasury Stock

During the quarter ended January 31, 2000, the Companybegan acquiring shares of its common stock in conjunction with astock repurchase program announced in November 1999. Thatprogram authorized the repurchase of up to one million shares ofZila common stock from time to time on the open market depend-ing on market conditions and other factors. As of July 31, 2000,the Company purchased 135,000 shares of common stock at anaggregate cost of $409,750.

12. Commitments and Contingencies

In June 1992, the Company entered into an agreement withDaleco Capital Corporation to form a limited partnership knownas Daleco Zila Partners II, L.P. (the “Partnership”). The Companyand its officers have no partnership interest in the Partnership. Thepurpose of the Partnership was to provide the Company with ameans to fund the marketing program for certain products. Theoriginal Partnership agreement provided for a minimum of$150,000 and a maximum of $1,562,500 to be raised by the saleof partnership units. Under the original agreement, the Partnershipwill expend up to 80% of the gross partnership proceeds for mar-keting and sales-related expenditures on behalf of the Company. In1994, the Partnership agreement was amended to increase the max-imum amount of marketing funds potentially available to the

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Zila, Inc. 29

Company to be raised to $2,250,000. At July 31, 2000, approxi-mately $1,820,000 has been spent.

The Company is committed to pay the Partnership a commis-sion equal to 5% to 10% of the gross sales of certain of theCompany’s products, until such time as three times the amount offunds expended on the Company’s marketing program by thePartnership has been paid to the Partnership. The Company haspaid commissions to the Partnership of approximately $16,000,$31,000 and $16,000 for the years ended July 31, 2000, 1999 and1998, respectively.

In connection with the acquisition of patent rights in 1980, theCompany agreed to pay to Dr. James E. Tinnell, the inventor ofone of the Company’s treatment compositions, a royalty of 5% ofgross sales of the treatment composition. Royalty expense to Dr.Tinnell for the years ended July 31, 2000, 1999 and 1998 was$449,916, $390,170 and $371,943, respectively.

The Company is pursuing approval of a New Drug Application(“NDA”) with the FDA for OraTest®. The initiation of the mar-keting of OraTest® in the United States is dependent upon theapproval of the NDA by the FDA. During 1994, the FDAapproved the Company’s application for an Investigational NewDrug for OraTest®, which allows the Company to manufacture theproduct in the United States for clinical studies and export to cer-tain foreign countries. In November 1998, the FDA notified theCompany that the OraTest® NDA was being given “priorityreview,” which targeted agency review within six months fromSeptember 3, 1998, the date when the Company provided addi-tional data to the FDA. On January 13, 1999, the FDA’sOncologic Drugs Advisory Committee (the “Committee”) met toreview the OraTest® NDA and recommended, among other things,that the FDA not approve the NDA as submitted. Subsequent tothe Committee meeting, Company representatives engaged in adialog with the FDA, culminating in meetings at the agency in1999 and 2000.

On March 3, 1999, the Company received an action letter fromthe FDA outlining certain deficiencies in the OraTest® NDA thatprevented the FDA from approving the product at that time. TheFDA’s letter detailed a procedure for amending the NDA to rectifythose matters. In November 1999, the Company contracted withILEX™ Oncology Services, Inc. (“ILEX”), a wholly-owned sub-sidiary of ILEX™ Oncology, Inc. of San Antonio, Texas, for man-agement of clinical research and liaison with the FDA related to theCompany’s pursuit of regulatory approval for the OraTest® oral can-cer detection product. In March 2000, the Company paid approx-imately $792,000 to ILEX as a deposit on estimated expenses relat-ed to an FDA-required clinical study associated with theCompany’s ongoing efforts to obtain FDA approval of OraTest®.Current commitments under the ILEX agreement include amonthly installment payment of $76,000 plus reimbursement forout of pocket expenses as they occur during the course of the study.The contract or any workplan may be terminated at any time byZila upon not less than 90 days prior written notice of terminationto ILEX. If the agreement is so terminated, Zila shall pay ILEX any

amount owed, but not yet paid, for work performed prior to thedate of termination.

The Company leases offices, warehouse facilities and certainequipment, under operating leases that expire through 2005.Future minimum lease payments under these non-cancelableleases are as follows:

2001 $ 396,8702002 300,0662003 204,0032004 199,5602005 84,275

Total $1,184,774

Rent expense for the years ended July 31, 2000, 1999 and 1998totaled $352,502, $340,170 and $270,297, respectively.

The Company and certain officers of the Company have beennamed as defendants in a consolidated First Amended Class ActionComplaint filed July 6, 1999 in the United States District Courtfor the District of Arizona under the caption In re Zila SecuritiesLitigation, No. CIV 99 0115 PHX EHC. The First AmendedClass Action Complaint seeks damages in an unspecified amounton behalf of a class consisting of purchasers of the Company’s secu-rities from November 14, 1996 through January 13, 1999 foralleged violations of the federal securities laws. Specifically, theplaintiffs allege that in certain public statements and filings withthe Securities and Exchange Commission (the “Commission”) thedefendants made false or misleading statements and concealedmaterial adverse information related to OraTest® that artificiallyinflated the price of the Company’s common stock in violation ofthe federal securities laws. The Company and the individual defen-dants deny all allegations of wrongdoing and are defending them-selves vigorously. In September 2000, the Court denied the defen-dants’ motion to dismiss the First Amended Class ActionComplaint and ordered that the matter proceed to trial on the issueof liability commencing on February 26, 2001.

On September 8, 1999, the Commission entered an orderdirecting an investigation entitled “In the Matter of Zila, Inc.” TheCommission is investigating whether (i) there were purchases orsales of securities of the Company by persons while in possession ofmaterial non-public information concerning the prospects that theOncologic Drugs Advisory Committee for the FDA would recom-mend approval of the OraTest® NDA and whether the FDA wouldsubsequently approve the NDA; (ii) such persons conveyed infor-mation regarding these matters to other persons who effected trans-actions in securities of the Company without disclosing the infor-mation; and (iii) there were false and misleading statements in pressreleases, filings with the Commission, or elsewhere concerningthese matters. The Company does not believe it has violated anyof the federal securities laws and is cooperating fully with theCommission in its investigation.

The Company is subject to other legal proceedings and claims,which arise in the ordinary course of business. In the opinion of

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30 Zila, Inc.

management, the amount of ultimate liability with respect to theseactions will not materially affect the financial position or results ofoperations of the Company.

13. Employee Benefit Plan

During fiscal year 2000, the Company has made available to alleligible employees, the Zila, Inc. 401(k) Savings and RetirementPlan (the “Zila Plan”). Participants may contribute, through payrolldeductions, up to 15% of their basic compensation not to exceed

Internal Revenue Code limitations. The Company may makematching or profit sharing contributions to the Zila Plan. During2000, 1999 and 1998, the Company contributed approximately$293,000, $62,000 and $39,600, respectively, to the Zila Plan.Prior to fiscal year 2000, eligible Oxycal employees participated in adifferent 401(k) defined contribution plan (the “Oxycal Plan”)whereby an employee could contribute up to a certain maximumamount each year. During the 1999 and 1998 fiscal years, Oxycalcontributed approximately $60,488 and $40,653, respectively tothe Oxycal Plan. Effective July 1, 1999, the Oxycal Plan wasmerged into the Zila Plan.

14. Segment Information

The Company is organized into three major product groups and further organized into six segments, all of which have distinct productlines, brand names and are managed as autonomous business units. The Company has identified the following segments for purposes of apply-ing SFAS No. 131: Pharmaceuticals, which includes Zila Pharmaceuticals, Inc., OraTest products, Dental Supply, which includes Bio-DentalTechnologies Corporation and Ryker Dental of Kentucky, Inc. which does business under the name Zila Dental Supply, Dental Software,which includes Integrated Dental Technologies, Inc., the distributor for PracticeWorks, Dental Imaging, which includes Cygnus Imaging, Inc.and Nutraceuticals, which includes Oxycal Laboratories, Inc. The Company evaluates performance and allocates resources to segments basedon operating results. Corporate overhead expenses have been combined with the OraTest segment. See Note 3 regarding the disposition ofthe Dental Software and Dental Imaging businesses.

The table below presents information about reported segments for the three years ended July 31 (in thousands):

Dental Dental Dental Pharmaceuticals OraTest Supply Software Imaging Nutraceuticals Total

Revenues:2000 $ 16,765 $ 153 $ 39,817 $ 1,515 $ 193 $ 19,138 $ 77,5811999 18,148 311 31,534 4,516 1,781 15,005 71,2951998 15,439 237 28,055 3,418 2,716 12,242 62,107

Income (loss) before income taxes:2000 4,758 (10,325) 290 4,855 (734) 5,848 4,6921999 5,801 (8,872) 658 509 (3,662) 3,003 (2,563)1998 5,046 (5,727) 854 (273) (1,573) 2,174 501

Identifiable assets:2000 13,461 18,836 12,292 478 32,644 77,7111999 13,157 18,861 10,136 871 3,734 29,797 76,5561998 15,223 12,888 7,962 618 4,973 28,200 69,864

Capital expenditures:2000 195 441 237 109 16 4,200 5,1981999 13 681 115 85 79 790 1,7631998 57 399 70 76 230 444 1,276

Depreciation and amortization:2000 1,011 1,001 300 35 110 1,021 3,4781999 1,011 920 293 103 422 833 3,5821998 760 830 274 61 237 608 2,770

Revenues from customers attributed to all foreign countries from which the Company derives revenue were $5,680,691, $2,933,610, and$4,135,420 for the years ended July 31, 2000, 1999 and 1998, respectively.

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Zila, Inc. 31

15. Quarterly Financial Data (Unaudited)

Quarterly financial information is presented in the following summary:

Quarters Ended October 31 January 31 April 30 July 31

Fiscal 2000:

Net revenues $ 19,171,593 $ 20,216,797 $ 19,422,777 $ 18,769,741

Gross profit 9,669,362 9,850,710 9,311,819 8,744,626

Net income (loss) (51,382) 1,964,252 16,413 1,002,744

Net income (loss) per share – basic 0.00 0.05 0.00 0.02

Net income (loss) per share – diluted 0.00 0.05 0.00 0.02

Fiscal 1999:

Net revenues $ 16,502,808 $ 18,121,619 $ 16,916,658 $ 19,753,666

Gross profit 8,644,162 9,496,567 8,481,157 10,337,521

Net income (loss) 755,508 (1,147,298) (2,420,984) 845,792

Net income (loss) per share – basic .02 (0.03) (0.06) 0.02

Net income (loss) per share – diluted .02 (0.03) (0.06) 0.02

S H A R E H O L D E R I N F O R M A T I O NZila, Inc. and Subsidiaries

Auditors

Deloitte & Touche LLPPhoenix, Arizona

Counsel

Quarles & Brady Streich Lang P.A.Phoenix, Arizona

Squires, Sanders & DempseyPhoenix, Arizona

Patent Counsel

Drummond & DuckworthNewport Beach, California

Special FDA Counsel

Hogan & HartsonWashington, D.C.

Keller & HeckmanWashington, D.C.

Registrar and Transfer Agent

Computershare Trust Company12039 W. Alameda Pkwy., Ste Z-2Lakewood, Colorado 80228(303) 986-5400

Annual Meeting

Zila, Inc.’s 2000 Annual Meeting ofShareholders will be held on ThursdayDecember 7, 2000, 9:00 a.m. localtime, at Marriott Camelback Inn,Scottsdale, Arizona.

Shareholders

Approximately 3,239 shareholders ofrecord as of July 31, 2000.

Common Stock

The Company’s common stock is tradedon the Nasdaq National Market effectiveApril 1997.Nasdaq symbol: ZILA

Form 10-K and Additional Information

A copy of the Company’s Form 10-KAnnual Report, as filed with theSecurities and Exchange Commission,may be obtained by writing to Ms. Janice Backus, Vice President/Corporate Secretary, at the Company’scorporate headquarters. Investors andothers wishing additional informationabout Zila, Inc. are welcome to contact Ms. Backus at (602) 266-6700.

Share Price Data

Year Ended July 31, 2000

High LowFirst Quarter 3.688 3.000Second Quarter 5.375 2.625Third Quarter 8.000 3.094Fourth Quarter 4.938 3.125

Year Ended July 31, 1999

High LowFirst Quarter 6.625 3.875Second Quarter 12.063 4.125Third Quarter 5.000 3.250Fourth Quarter 4.000 2.750

Dividends

The Company has not paid any cash dividends on its common stock. It is thepresent policy of the Board of Directorsto retain any future earnings to financethe growth of the Company’s business.

32 Zila, Inc.

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ZILA, INC.5227 North 7th StreetPhoenix, Arizona 85014-2800

(602) 266-6700Fax (602) 234-2264

www.zila.com

D I R E C T O R S

Joseph HinesPresident and ChairmanZila, Inc.

Carl SchroederRetired

Michael S. LesserPresidentDental Concepts, LLCElmsford New York

Curtis M. Rocca, IIIChief Executive OfficerDental Partners, Inc.Roseville, California

Christopher D. Johnson, Esq.Squire Sanders & DempseyPhoenix, Arizona

Kevin J. Tourek, Esq.Sr. Vice PresidentLegal & Human ResourcesNational Airlines, Inc.Las Vegas, Nevada

O F F I C E R S

Joseph HinesPresident and ChairmanChief Executive Officer

Thomas M. LaughlinVice PresidentChief Operating Officer

Bradley C. AndersonVice President/TreasurerChief Financial Officer

Janice L. BackusVice PresidentCorporate Secretary

Z I L A , I N C .

5227 North 7th StreetPhoenix, Arizona 85014-2800

602.266.6700www.zila.com

Nasdaq: ZILA

expanding horizonslibrary.corporate-ir.net/.../95158/items/153467/zila2000.pdfnasdaq: zila expanding...

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