Chattem (CHTT) 10-Q 2008 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT

PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended February 29, 2008

Commission file number 0-5905

CHATTEM, INC.

A TENNESSEE CORPORATION

I.R.S. EMPLOYER IDENTIFICATION NO. 62-0156300

1715 WEST 38TH STREET

CHATTANOOGA, TENNESSEE 37409

TELEPHONE:  423-821-4571

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

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

Large accelerated filer  þ  Accelerated filer    Non-accelerated filer    (Do not check if a smaller reporting company)  Smaller reporting company  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).YES   NO þ

As of April 1, 2008, 19,177,048 shares of the Company’s common stock, without par value, were outstanding.

CHATTEM, INC.

INDEX

PART I.  FINANCIAL INFORMATION	PAGE NO.
Item 1.  Financial Statements
Consolidated Balance Sheets as of February 29, 2008 and
November 30, 2007	3
Consolidated Statements of Income for the Three
Months Ended February 29, 2008 and February 28, 2007	5
Consolidated Statements of Cash Flows for the Three Months
Ended February 29, 2008 and February 28, 2007	6
Notes to Consolidated Financial Statements	7
Item 2.  Management's Discussion and Analysis of Financial Condition
and Results of Operations	28
Item 3.  Quantitative and Qualitative Disclosures About Market Risk	37
Item 4.  Controls and Procedures	37
PART II.  OTHER INFORMATION
Item 1. Legal Proceedings	38
Item 1A. Risk Factors	38
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	38
Item 3. Defaults Upon Senior Securities	38
Item 4. Submission of Matters to a Vote of Security Holders	38
Item 5. Other Information	38
Item 6. Exhibits	39
SIGNATURES	40

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PART 1. FINANCIAL INFORMATION

Item 1. Financial Statements

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands)

ASSETS	FEBRUARY 29,    2008		NOVEMBER 30,  2007
	(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents	$	11,619	$	15,407
Accounts receivable, less allowances of $15,575 at     February 29, 2008 and $13,810 at November 30, 2007		58,134		43,753
Inventories		42,538		43,265
Deferred income taxes		7,463		6,750
Prepaid expenses and other current assets		5,806		2,065
Total current assets		125,560		111,240
PROPERTY, PLANT AND EQUIPMENT, NET		32,494		32,349
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net		616,865		616,810
Debt issuance costs, net		14,223		15,430
Other		4,800		4,731
Total other noncurrent assets		635,888		636,971
TOTAL ASSETS	$	793,942	$	780,560

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

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CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands)

LIABILITIES AND SHAREHOLDERS’ EQUITY	FEBRUARY 29,  2008			NOVEMBER 30,  2007
	(Unaudited)
CURRENT LIABILITIES:
Current maturities of long-term debt	$	128,000		$	3,000
Accounts payable and other		20,682			18,239
Bank overdraft		2,850			7,584
Accrued liabilities		24,924			21,537
Total current liabilities		176,456			50,360
LONG-TERM DEBT, less current maturities		370,000			505,000
DEFERRED INCOME TAXES		24,257			21,056
OTHER NONCURRENT LIABILITIES		3,566			2,436
COMMITMENTS AND CONTINGENCIES (Note 19)
SHAREHOLDERS’ EQUITY:
Preferred shares, without par value, authorized 1,000,     none issued		—			—
Common shares, without par value, authorized 100,000,     issued and outstanding 19,177 at February 29, 2008 and     19,092 at November 30, 2007		41,980			36,800
Retained earnings		179,817			165,655
		221,797			202,455
Cumulative other comprehensive income, net of tax:
Interest rate hedge adjustment		(3,320	)		(1,747	)
Foreign currency translation adjustment		1,194			1,008
Unrealized actuarial gains and losses		(8	)		(8	)
Total shareholders’ equity		219,663			201,708
TOTAL LIABILITIES AND SHAREHOLDERS’           EQUITY	$	793,942		$	780,560

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

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CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited and in thousands, except per share amounts)

	FOR THE THREE MONTHS ENDED
	FEBRUARY 29,			FEBRUARY 28,
	2008			2007
TOTAL REVENUES	$	120,773		$	100,831
COSTS AND EXPENSES:
Cost of sales		34,733			30,980
Advertising and promotion		34,496			28,787
Selling, general and administrative		15,466			12,411
Product recall expenses		6,043			–
Acquisition expenses		–			1,171
Total costs and expenses		90,738			73,349
INCOME FROM OPERATIONS		30,035			27,482
OTHER INCOME (EXPENSE):
Interest expense		(6,552	)		(7,236	)
Investment and other income, net		137			593
Loss on early extinguishment of debt		(526	)		–
Total other income (expense)		(6,941	)		(6,643	)
INCOME BEFORE INCOME TAXES		23,094			20,839
PROVISION FOR INCOME TAXES		8,221			7,189
NET INCOME	$	14,873		$	13,650
NUMBER OF COMMON SHARES:   Weighted average outstanding - basic		19,106			18,657
Weighted average and potential dilutive outstanding		19,788			19,224
NET INCOME  PER COMMON SHARE:
Basic	$	.78		$	.73
Diluted	$	.75		$	.71

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

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CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited and in thousands)

	FOR THE THREE MONTHS ENDED
	FEBRUARY 29, 2008			FEBRUARY 28,  2007
OPERATING ACTIVITIES:
Net income	$	14,873		$	13,650
Adjustments to reconcile net income to net cash provided by     operating activities:
Depreciation and amortization		2,119			2,029
Deferred income taxes		4,433			2,794
Tax benefit realized from stock options exercised		(1,812	)		(3,013	)
Stock–based compensation expense		1,339			1,204
Loss on early extinguishment of debt		526			–
Other, net		112			124
Changes in operating assets and liabilities, net of effects from acquisitions:
Accounts receivable and other		(14,381	)		(23,212	)
Inventories		737			358
Refundable income taxes		–			196
Prepaid expenses and other current assets		(3,746	)		680
Accounts payable and accrued liabilities		6,047			15,127
Net cash provided by operating activities		10,247			9,937
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(1,271	)		(453	)
Acquisition of brands		–			(411,888	)
Increase in other assets, net		(1,656	)		(26	)
Net cash used in investing activities		(2,927	)		(412,367	)
FINANCING ACTIVITIES:
Repayment of long-term debt		(35,750	)		–
Proceeds from long-term debt		–			300,000
Proceeds from borrowings under revolving credit facility		69,500			39,000
Repayments of revolving credit facility		(43,750	)		(9,000	)
Bank overdraft		(4,734	)		(3,719	)
Proceeds from exercise of stock options		2,057			4,457
Repurchase of common shares		(240	)		–
Increase in debt issuance costs		–			(6,079	)
Tax benefit realized from stock options exercised		1,812			3,013
Net cash (used in) provided by financing activities		(11,105	)		327,672
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS		(3	)		(20	)
CASH AND CASH EQUIVALENTS:
Decrease for the period		(3,788	)		(74,778	)
At beginning of period		15,407			90,527
At end of period	$	11,619		$	15,749
PAYMENTS FOR:
Interest	$	2,932		$	688
Taxes	$	6,104		$	4,787

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

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CHATTEM, INC.  AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

All monetary and share amounts (other than per share amounts) in these Notes are expressed in thousands.

1.  BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended November 30, 2007.  The accompanying unaudited consolidated financial statements, in the opinion of management, include all adjustments necessary for a fair presentation.  All such adjustments are of a normal recurring nature.

2.  CASH AND CASH EQUIVALENTS

We consider all short-term deposits and investments with original maturities of three months or less to be cash equivalents.

3.  RECENT ACCOUNTING PRONOUNCEMENTS

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition.  Additionally, in May 2007, the FASB published FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”).  FSP FIN 48-1 is an amendment to FIN 48.  It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits.  The provisions of FIN 48 and FSP FIN 48-1 are effective for fiscal years beginning after December 15, 2006.  We adopted the provisions of FIN 48 and FSP FIN 48-1 at the beginning of the first quarter of fiscal 2008, and the details of our adoption of FIN 48 are described in Note 17.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 provides guidance for using fair value to measure assets and liabilities.  SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances.  SFAS 157 also requires expanded disclosure of the effect on earnings for items measured using unobservable data, establishes a fair value hierarchy that prioritizes the information used to develop those assumptions and requires separate disclosure by level within the fair value hierarchy.  We adopted SFAS 157 effective December 1, 2007 as described in Note 8.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value.  Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. We adopted SFAS 159 effective December 1, 2007 without choosing to elect to measure certain financial assets or liabilities at fair value that were not previously measured at fair value.  Thus there was no impact to our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”).  SFAS 141R provides guidance to improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial reports about its business combinations and its effects.  SFAS 141R establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, liabilities assumed, the intangible assets acquired and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  The provisions of SFAS 141R are effective for fiscal years beginning after December 15, 2008, with earlier application prohibited.  Accordingly, we will apply the provisions of SFAS 141R prospectively to business combinations consummated beginning in the first quarter of fiscal 2010.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”).  SFAS 161 requires enhanced disclosures about derivative and hedging activities.  SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged, and we are currently evaluating the impact.

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4.  STOCK-BASED COMPENSATION

We currently provide stock-based compensation under five stock incentive plans that have been approved by our shareholders.  Our 1998 Non-Statutory Stock Option Plan provides for the issuance of up to 1,400 shares of common stock to key employees while the 1999 Non-Statutory Stock Option Plan for Non-Employee Directors allows for the issuance of up to 200 shares of common stock.  The 2000 Non-Statutory Stock Option Plan provides for the issuance of up to 1,500 shares of common stock.  The 2003 and 2005 Stock Incentive Plans both provide for the issuance of up to 1,500 shares of common stock.  Stock options granted under all of these plans generally vest over four years from the date of grant as specified in the plans or by the compensation committee of our board of directors and are exercisable for a period of up to ten years from the date of grant.

Effective December 1, 2005, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), using the modified prospective method.  SFAS 123R requires the recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award.  SFAS 123R also requires the stock option compensation expense to be recognized over the period during which an employee is required to provide service in exchange for the award (the vesting period).

In the first quarter of fiscal 2008 and 2007, we recorded compensation expense related to stock options that reduced income from operations by $1,339 and $1,204, provision for income taxes by $477 and $415, net income by $862 and $789, basic net income per share by $.05 and $.04, and diluted net income per share by $.04 and $.04, respectively.  The stock option compensation expense was included partly in cost of sales, advertising and promotion expenses and selling, general and administrative expenses in the accompanying consolidated statements of income.  We capitalized $193 and $174 of stock option compensation cost as a component of the carrying cost of inventory on-hand as of February 29, 2008 and February 28, 2007, respectively.

The weighted average fair value of stock options at the date of grant during the three months ended February 29, 2008 was $28.55.  The fair value of each stock option grant was estimated on the date of grant using a Flex Lattice Model.  The following assumptions were used to determine the fair value of stock option grants during the three months ended February 29, 2008:

	Three Months Ended February 29, 2008
Expected life	6 years
Volatility	34%
Risk-free interest rate	4.47%
Dividend yield	0%
Forfeitures	1.2%

The expected life of stock options represents the period of time that the stock options granted are expected to be outstanding based on historical exercise trends.  The expected volatility is based on the historical price volatility of our common stock.  The risk-free interest rate represents the U.S. Treasury bill rate for the expected life of the related stock options.  The dividend yield represents our anticipated cash dividend over the expected life of the stock options.  In connection with using the Flex Lattice Model to determine the fair value of stock option grants, the forfeiture rate was determined by analyzing post vesting stock option activity for three separate groups (non-employee directors, officers and other employees).

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A summary of stock option activity for the three-months ended February 29, 2008 is presented below:

	Shares Under  Option			Weighted Average Exercise  Price		Weighted Average Remaining Contractual  Life		Aggregate Intrinsic Value
Outstanding at December 1, 2007		1,458		$	40.43
Granted		3			69.65
Exercised		(87	)		23.76
Cancelled		–			–
Outstanding at February 29, 2008		1,374		$	41.53	4.8 years	$	52,586
Exercisable at February 29, 2008		675		$	33.30	4.5 years	$	31,422

The total fair value of stock options that vested during the three months ended February 29, 2008 and February 28, 2007 was $1,356 and $1,215, respectively.  The total intrinsic value of stock options exercised during the three months ended February 29, 2008 and February 28, 2007 was $4,540 and $11,472, respectively.

As of February 29, 2008, we had $11,417 of unrecognized compensation cost related to stock options that will be recorded over a weighted average period of approximately 2.4 years.

We are also authorized to grant restricted shares of common stock to employees under our stock incentive plans that have been approved by shareholders.  The restricted shares under these plans meet the definition of “nonvested shares” in SFAS 123R.  The restricted shares generally vest over a four year service period commencing upon the date of grant.  The total fair market value of restricted shares on the date of grant is amortized to expense on a straight line basis over the four-year vesting period.  The amortization expense related to restricted shares during the three months ended February 29, 2008 and February 28, 2007 was $93 and $184, respectively.

Restricted share under the plans activity is summarized as follows:

	Number of Shares		Weighted Average Grant Date Fair Value
Nonvested at December 1, 2007		9	$	33.11
Granted		–		–
Vested		3		28.51
Forfeited		–		–
Nonvested at February 29, 2008		6	$	35.37

As of February 29, 2008, we had $235 of unrecognized compensation cost related to restricted shares that will be recorded over a weighted average period of approximately 0.9 years.

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5.  EARNINGS PER SHARE

The following table presents the computation of earnings per share for the three months ended February 29, 2008 and February 28, 2007, respectively:

	2008		2007
NET INCOME	$	14,873	$	13,650
NUMBER OF COMMON SHARES:
Weighted average outstanding		19,106		18,657
Issued upon assumed exercise of       outstanding stock options		195		549
Issued upon assumed exercise of convertible     notes		484		–
Effect of issuance of restricted common     shares		3		18
Weighted average and potential       dilutive outstanding (1)		19,788		19,224
NET INCOME PER COMMON SHARE:
Basic	$	.78	$	.73
Diluted	$	.75	$	.71

(1)  Because their effects are anti-dilutive, excludes shares issuable under stock option plans and restricted stock issuance whose grant price was greater than the average market price of common shares outstanding as follows: 401 and 0 shares for the three months ended February 29, 2008 and February 28, 2007, respectively.

6.  LONG-TERM DEBT

Long-term debt consisted of the following as of February 29, 2008 and November 30, 2007:

	2008		2007
Revolving Credit Facility due 2010 at a   variable rate of 5.70% and 6.19% as of   February 29, 2008 and November 30,   2007, respectively	$	55,750	$	30,000
2.0% Convertible Senior Notes due 2013		125,000		125,000
1.625% Convertible Senior Notes due 2014		100,000		100,000
Term Loan due 2013 at a variable rate of    6.13% and 6.97% as of February 29, 2008   and November 30,2007		109,750		145,500
7.0% Senior Subordinated Notes due 2014		107,500		107,500

Total long-term debt		498,000		508,000
Less:  current maturities		128,000		3,000
Total long-term debt, net of current maturities	$	370,000	$	505,000

In February 2004, we entered into a Senior Secured Revolving Credit Facility with a maturity date of February 2009 (the “Revolving Credit Facility”) with Bank of America, N.A. that provided an initial borrowing capacity of $25,000 and an additional $25,000, subject to successful syndication.  In March 2004, we entered into a commitment agreement with a syndicate of commercial banks led by Bank of America, N.A., as agent, that enabled us to borrow up to a total of $50,000 under the Revolving Credit Facility and an additional $50,000, subject to successful syndication.  In November 2005, we entered into an amendment to our Revolving Credit Facility (the “Amended Revolving Credit Facility”) that, among other things, increased our borrowing capacity under the facility from $50,000 to $100,000, increased our flexibility to repurchase shares of our stock, improved our borrowing rate under the facility and extended the maturity date to November 2010.  Upon successful syndication, we will be able to increase the borrowing capacity under the Amended Revolving Credit Facility by $50,000 to an aggregate of $150,000.  In November 2006, we entered into an amendment to our Amended Revolving Credit Facility that, among other things, permitted the sale of the 2.0% Convertible Senior Notes due 2013 (the “2.0% Convertible Notes”).  In January 2007, we completed an amendment to the Amended Revolving Credit Facility providing for up to a $100,000 revolving credit facility and a

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$300,000 term loan (the “Credit Facility”).  The proceeds from the term loan under the Credit Facility were used to finance in part the acquisition of the five consumer and OTC brands from Johnson & Johnson.  The Credit Facility includes “accordion” features that permit us under certain circumstances to increase our borrowings under the revolving credit facility by $50,000 and to borrow an additional $50,000 as a term loan, subject to successful syndication.  In April 2007, we entered into an amendment to our Credit Facility that, among other things, permitted the sale of the 1.625% Convertible Senior Notes due 2014  (the “1.625% Convertible Notes”) and reduced the applicable interest rates on the revolving credit facility portion of our Credit Facility.

Borrowings under the revolving credit facility portion of our Credit Facility bear interest at LIBOR plus applicable percentages of 0.875% to 1.500% or the higher of the federal funds rate plus 0.5% or the prime rate (the “Base Rate”).  The applicable percentages are calculated based on our leverage ratio.  As of February 29, 2008 and November 30, 2007, we had $55,750 and $30,000, respectively, of borrowings outstanding under the revolving credit facility portion of our Credit Facility.  As of April 1, 2008, we had $50,250 of borrowings outstanding under the revolving credit facility portion of our Credit Facility and our borrowing capacity was $49,750.

The term loan under the Credit Facility bears interest at either LIBOR plus 1.75% or the Base Rate plus 0.75%.  The term loan borrowings are to be repaid in increments of $750 each calendar quarter, with the first principal payment paid June 2007.  The principal outstanding after scheduled repayment and any unscheduled prepayments matures and is payable January 2013.  In April 2007, we utilized the net proceeds from the 1.625% Convertible Notes and borrowings under the revolving credit facility portion of our Credit Facility to repay $128,000 of the term loan under the Credit Facility.   In July 2007, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay an additional $25,000 of the term loan under the Credit Facility.  In connection with the term loan repayments during April 2007 and July 2007, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on early extinguishment of debt of $2,633 in fiscal 2007.  In January 2008, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay an additional $35,000 of the term loan under the Credit Facility.  In connection with the term loan repayment in January, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on early extinguishment of debt of $526 in the first quarter of fiscal 2008.

Borrowings under the Credit Facility are secured by substantially all of our assets, except real property, and shares of capital stock of our domestic subsidiaries held by us and by the assets of the guarantors (our domestic subsidiaries).  The Credit Facility contains covenants, representations, warranties and other agreements by us that are customary in credit agreements and security instruments relating to financings of this type.  The significant financial covenants include fixed charge coverage ratio, leverage ratio, senior secured leverage ratio and brand value calculations.

In February 2004, we issued and sold $125,000 of 7.0% Senior Subordinated Notes due 2014 (the “7.0% Subordinated Notes”).  During fiscal 2005, we repurchased $17,500 of our 7.0% Subordinated Notes in the open market at an average premium of 1.6% over the principal amount of the notes.  The outstanding balance of the remaining 7.0% Subordinated Notes was reduced to $107,500.

Interest payments on the 7.0% Subordinated Notes are due semi-annually in arrears in March and September.  Our domestic subsidiaries are guarantors of the 7.0% Subordinated Notes.  The guarantees of the 7.0% Subordinated Notes are unsecured senior subordinated obligations of the guarantors.  At any time after March 1, 2009, we may redeem any of the 7.0% Subordinated Notes upon not less than 30 nor more than 60 days’ notice at redemption prices (expressed in percentages of principal amount), plus accrued and unpaid interest, if any, and liquidation damages, if any, to the applicable redemption rate, if redeemed during the twelve-month periods beginning March 2009 at 103.500%, March 2010 at 102.333%, March 2011 at 101.167% and March 2012 and thereafter at 100.000%.

The indenture governing the 7.0% Subordinated Notes, among other things, limits our ability and the ability of our restricted subsidiaries to: (i) borrow money or sell preferred stock, (ii) create liens, (iii) pay dividends on or redeem or repurchase stock, (iv) make certain types of investments, (v) sell stock in our restricted subsidiaries, (vi) restrict dividends or other payments from restricted subsidiaries, (vii) enter into transactions with affiliates, (viii) issue guarantees of debt and (ix) sell assets or merge with other companies.  In addition, if we experience specific kinds of changes in control, we must offer to purchase the 7.0% Subordinated Notes at 101.0% of their principal amount plus accrued and unpaid interest.

In July 2006, we successfully completed a consent solicitation from the holders of the 7.0% Subordinated Notes to an amendment to the indenture to increase our capacity to make restricted payments by an additional $85,000, including payments for the repurchase of our common stock, and adjust the fixed charge coverage ratio (as defined in the indenture).

In November 2006, we completed a private offering of $125,000 of the 2.0% Convertible Notes to qualified institutional purchasers pursuant to Section 4(2) of the Securities Act of 1933.  The 2.0% Convertible Notes bear interest at an annual rate of 2.0%, payable semi-annually in May and November of each year.  The 2.0% Convertible Notes are convertible into our common stock at an initial conversion price of $58.92 per share, upon the occurrence of certain events, including the closing price of our

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common stock exceeding 130% of the initial conversion price per share, or $76.59 per share, for 20 of the last 30 consecutive trading days of the preceding fiscal quarter (the “prescribed measurement period”).  Based on the closing price of our common stock for the prescribed measurement period during the quarter ended February 29, 2008, the contingent conversion threshold of $76.59 for the 2.0% Convertible Notes was exceeded.  As a result, the 2.0% Convertible Notes are convertible at the option of the holder as of February 29, 2008 and, accordingly, have been classified as a current liability in our accompanying consolidated balance sheet as of February 29, 2008.  The evaluation of the classification of the 2.0% Convertible Notes will occur each fiscal quarter.  The 2.0% Convertible Notes may be classified as long-term debt in future quarters if the contingent conversion threshold is not met in such quarters.

Upon conversion, a holder will receive, in lieu of common stock, an amount of cash equal to the lesser of (i) the principal amount of the 2.0% Convertible Notes, or (ii) the conversion value, determined in the manner set forth in the indenture governing the 2.0% Convertible Notes, of a number of shares equal to the conversion rate. If the conversion value exceeds the principal amount of the 2.0% Convertible Notes on the conversion date, we will also deliver, at our election, cash or common stock or a combination of cash and common stock with respect to the conversion value upon conversion. If conversion occurs in connection with a change of control, we may be required to deliver additional shares of our common stock by increasing the conversion rate with respect to such notes. The maximum aggregate number of shares that we would be obligated to issue upon conversion of the 2.0% Convertible Notes is 2,673.

Concurrently with the sale of the 2.0% Convertible Notes, we purchased a note hedge from an affiliate of Merrill Lynch (the “Counterparty”), which is designed to mitigate potential dilution from the conversion of the 2.0% Convertible Notes. Under the note hedge, the Counterparty is required to deliver to us the number of shares of our common stock that we are obligated to deliver to the holders of the 2.0% Convertible Notes with respect to the conversion, calculated exclusive of shares deliverable by us by reason of any additional premium relating to the 2.0% Convertible Notes or by reason of any election by us to unilaterally increase the conversion rate pursuant to the indenture governing the 2.0% Convertible Notes. The note hedge expires at the close of trading on November 15, 2013, which is the maturity date of the 2.0% Convertible Notes, although the Counterparty will have ongoing obligations with respect to 2.0% Convertible Notes properly converted on or prior to that date of which the Counterparty has been timely notified.

In addition, we issued warrants to the Counterparty that could require us to issue up to approximately 2,122 shares of our common stock on November 15, 2013 upon notice of exercise by the Counterparty. The exercise price is $74.82 per share, which represented a 60.0% premium over the closing price of our shares of common stock on November 16, 2006. If the Counterparty exercises the warrant, we will have the option to settle in cash or shares the excess of the price of our shares on that date over the initially established exercise price.

The note hedge and warrant are separate and legally distinct instruments that bind us and the Counterparty and have no binding effect on the holders of the 2.0% Convertible Notes.

In November 2006, we entered into an interest rate swap (“swap”) agreement effective January 2007.  The swap has decreasing notional principal amounts beginning October 2007 and a swap rate of 4.98% over the life of the agreement.  As of February 29, 2008, we had $146,250 of LIBOR based borrowings hedged under the provisions of the swap.  During the three months ended February 29, 2008, the decrease in fair value of the swap of $1,614, net of tax, was recorded to other comprehensive income.  The current portion of the fair value of the swap of $2,932 is included in accrued liabilities, and the long-term portion of $2,565 is included in noncurrent liabilities.  As of February 29, 2008, the swap was deemed to be an effective cash flow hedge.  The fair value of the swap agreement is valued by a third party.  The swap agreement terminates in January 2010.

In April 2007, we entered into an interest rate cap agreement.  The cap has decreasing notional principal amounts beginning May 2007 and a cap rate of 5.0% over the life of the agreement.  We paid a $114 premium to enter into the cap agreement.  As of February 29, 2008, the value of the cap, as valued by a third party, is insignificant.  The cap agreement terminates in September 2008.

In April 2007, we completed a private offering of $100,000 of the 1.625% Convertible Notes to qualified institutional investors pursuant to Rule 144A under the Securities Act of 1933.  The 1.625% Convertible Notes bear interest at an annual rate of 1.625%, payable semi-annually in May and November of each year.  The 1.625% Convertible Notes are convertible into our common stock at an initial conversion price of $73.20 per share, upon the occurrence of certain events, including the closing price of our common stock exceeding 130% of the initial conversion price per share, or $95.16 per share, for the prescribed measurement period.  The evaluation of the classification of the 1.625% Convertible Notes will occur each fiscal quarter.

Upon conversion, a holder will receive, in lieu of common stock, an amount of cash equal to the lesser of (i) the principal amount of the 1.625% Convertible Notes, or (ii) the conversion value, determined in the manner set forth in the indenture governing the 1.625%  Convertible Notes, of a number of shares equal to the conversion rate. If the conversion value

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exceeds the principal amount of the 1.625% Convertible Note on the conversion date, we will also deliver, at our election, cash or common stock or a combination of cash and common stock with respect to the conversion value upon conversion. If conversion occurs in connection with a change of control, we may be required to deliver additional shares of our common stock by increasing the conversion rate with respect to such notes. The maximum aggregate number of shares that we would be obligated to issue upon conversion of the 1.625% Convertible Notes is 1,694.

Concurrently with the sale of the 1.625% Convertible Notes, we purchased a note hedge from the Counterparty, which is designed to mitigate potential dilution from the conversion of the 1.625% Convertible Notes. Under the note hedge, the Counterparty is required to deliver to us the number of shares of our common stock that we are obligated to deliver to the holders of the 1.625% Convertible Notes with respect to the conversion, calculated exclusive of shares deliverable by us by reason of any additional premium relating to the 1.625% Convertible Notes or by reason of any election by us to unilaterally increase the conversion rate pursuant to the indenture governing the 1.625% Convertible Notes. The note hedge expires at the close of trading on May 1, 2014, which is the maturity date of the 1.625% Convertible Notes, although the Counterparty will have ongoing obligations with respect to 1.625% Convertible Notes properly converted on or prior to that date of which the Counterparty has been timely notified.

In addition, we issued warrants to the Counterparty that could require us to issue up to approximately 1,366 shares of our common stock on May 1, 2014 upon notice of exercise by the Counterparty. The exercise price is $94.45 per share, which represented a 60% premium over the closing price of our shares of common stock on April 4, 2007. If the Counterparty exercises the warrant, we will have the option to settle in cash or shares the excess of the price of our shares on that date over the initially established exercise price.

Pursuant to EITF 90-19, “Convertible Bonds with Issuer Option to Settle for Cash upon Conversion”, (“EITF 90-19”), EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”  (“EITF 00-19”), and EITF 01-6,  “The Meaning of Indexed to a Company’s Own Stock”  (“EITF 01-6”), the 2.0% Convertible Notes and the 1.625% Convertible Notes are accounted for as convertible debt in the accompanying consolidated balance sheet and the embedded conversion option in the 2.0% Convertible Notes and the 1.625% Convertible Notes has not been accounted for as a separate derivative. Additionally, pursuant to EITF 00-19 and EITF 01-6, the note hedges and warrants are accounted for as equity transactions, and therefore, the payments associated with the issuance of the note hedges and the proceeds received from the issuance of the warrants were recorded as a charge and an increase, respectively, in common shares in shareholders’ equity as separate equity transactions.

For income tax reporting purposes, we have elected to integrate the 2.0% Convertible Notes and the 1.625% Convertible Notes and the respective note hedge transaction. Integration of the respective note hedge with the 2.0% Convertible Notes and the 1.625% Convertible Notes creates an in-substance original issue debt discount for income tax reporting purposes and therefore, the cost of the note hedge transactions will be accounted for as interest expense over the term of the 2.0% Convertible Notes and the 1.625% Convertible Notes, respectively, for income tax reporting purposes. The income tax benefit related to each respective convertible note issuance was recognized as a deferred tax asset.

The scheduled future maturities of long-term debt to be funded for the next five successive fiscal years and those thereafter as of February 29, 2008 are as follows:

2008	$	127,250
2009		3,000
2010		58,750
2011		3,000
2012		3,000
Thereafter		303,000
	$	498,000

7.  ACQUISITION OF BRANDS

In January 2007, we acquired the U.S. rights to five leading consumer and OTC brands from Johnson & Johnson (“J&J Acquisition”).  The acquired brands were: ACT, an anti-cavity mouthwash/mouth rinse; Unisom, an OTC sleep-aid; Cortizone-10, a hydrocortisone anti-itch product; Kaopectate, an anti-diarrhea product; and Balmex, a diaper rash product.  The J&J Acquisition was funded with the proceeds from a $300,000 term loan provided under our Credit Facility, borrowings under the revolving credit facility portion of our Credit Facility and through the use of a portion of the proceeds derived from the 2.0% Convertible Notes.  The purchase price of the J&J Acquisition was $410,000 plus $1,573 of costs directly related to the acquisition.  The purchase price related to $5,916 of inventory, $1,781 of assumed liabilities, $463 of equipment, $403,061 of trademarks, which were assigned an indefinite life, and $3,914 of distribution rights, which was assigned a useful life of five years.  The value assigned each of the acquired brands was as follows:  ACT, $163,167; Unisom, $95,181; Cortizone-10, $124,318; Kaopectate,

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$11,653; and Balmex, $8,742.  Johnson & Johnson will continue to manufacture and supply certain of the products to us for a period of up to 18 months from the close of the acquisition, or such earlier date as we are able to move production to our facilities.  The price we pay Johnson & Johnson for these products is equivalent to the manufacturing cost, which includes all costs associated with the manufacturing and delivery of the product.  Certain of the products are manufactured and supplied under assumed agreements with third party manufacturers.  During fiscal 2007, the manufacturing of certain products was transferred to our facilities.  For a period of up to six months from the close of the acquisition, Johnson & Johnson was to provide transition services consisting of consumer affairs, distribution and collection services (including related financial, accounting and reporting services).  We terminated the distribution and collections services effective April 2, 2007 and the consumer affairs services effective June 21, 2007.  The costs charged for these transition services approximated the actual costs incurred by Johnson & Johnson.  During the year ended November 30, 2007, we incurred $2,057 of expenses related to these transition services.

The following unaudited consolidated pro forma information assumes the J&J Acquisition had occurred at the beginning of the period presented:

PRO FORMA CONSOLIDATED RESULTS OF OPERATIONS (Unaudited)

	Three Months Ended February 28, 2007
Total revenue	$	110,012
Net income		14,432
Earnings per share –  basic		0.77
Earnings per share –  diluted		0.75

The pro forma consolidated results of operations include adjustments to give effect to interest expense on debt to finance the J&J Acquisition, increased advertising expense to raise brand awareness, incremental selling, general and administrative expenses, amortization of certain intangible assets and decreased interest income on cash used in the J&J Acquisition, together with related income tax effects. The pro forma information is for comparative purposes only and does not purport to be indicative of the results that would have occurred had the J&J Acquisition and borrowings occurred at the beginning of the periods presented, or indicative of the results that may occur in the future.

On May 25, 2007, we acquired the worldwide trademark and rights to sell and market ACT in Western Europe from Johnson & Johnson (“ACT Acquisition”) for $4,100 in cash plus certain assumed liabilities.  The ACT Acquisition was funded with existing cash.

8.  FAIR VALUE MEASUREMENTS

We currently measure and record in the accompanying consolidated financial statements securities considered available-for-sale, an interest rate cap and an interest rate swap at fair value.  SFAS 157 establishes a fair value hierarchy for those instruments measured at fair value that distinguishes between assumptions based on market data (observable inputs) and our own assumptions (unobservable inputs).  The hierarchy consists of three levels:

Level 1 - Quoted market prices in active markets for identical assets or liabilities;

Level 2 - Inputs other than Level 1 inputs that are either directly or indirectly observable; and

Level 3 - Unobservable inputs developed using estimates and assumptions developed by us, which reflect those that a market participant would use.

Determining which category an asset or liability falls within the hierarchy requires significant judgment.  We evaluate our hierarchy disclosures each quarter.

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The following table summarizes the financial instruments measured at fair value in the accompanying consolidated balance sheet as of February 29, 2008:

	Fair Value Measurements as of   February 29, 2008
	Level 1		Level 2		Level 3		Total
Assets
Available-for-sale securities (1)	$	508	$	–	$	–	$	508
Interest rate cap (2)		–		–		–		–
Liabilities
Interest rate swap (3)	$	–	$	5,497	$	–	$	5,497

(1)   Our available-for-sale securities are included in the accompanying consolidated balance sheet as an other noncurrent asset using the “market approach” valuation technique. This method uses prices and other relevant information observable in market transactions involving identical or comparable assets or liabilities.

(2)   The interest rate cap is valued at an insignificant amount in the accompanying consolidated balance sheet as of February 29, 2008 and matures September 2008.  We value this financial instrument using the “Income Approach” valuation technique.  This method uses valuation techniques to convert future amounts to a single present amount.  The measurement is based on the value indicated by current market expectations about those future amounts.

(3)   The total fair value of the interest rate swap is partially classified as a current and a noncurrent liability as of February 29, 2008 and matures January 2010.  This financial instrument is valued using the “Income Approach” valuation technique as described above.

SFAS 157 requires separate disclosure of assets and liabilities measured at fair value on a recurring basis, as documented above, from those measured at fair value on a nonrecurring basis.  As of February 29, 2008, no assets or liabilities are measured at fair value on a nonrecurring basis.

9.  ADVERTISING EXPENSES

We incur significant expenditures on television, radio and print advertising to support our nationally branded OTC health care products and toiletries.  Customers purchase products from us with the understanding that the brands will be supported by our extensive media advertising.  This advertising supports the retailers’ sales effort and maintains the important brand franchise with the consuming public.  Accordingly, we consider our advertising program to be clearly implicit in our sales arrangements with our customers.  Therefore, we believe it is appropriate to allocate a percentage of the necessary supporting advertising expenses to each dollar of sales by charging a percentage of sales on an interim basis based upon anticipated annual sales and advertising expenditures (in accordance with APB Opinion No. 28, “Interim Financial Reporting”) and adjusting that accrual to the actual expenses incurred at the end of the year.

10.  SHIPPING AND HANDLING

Shipping and handling costs of $3,997 and $2,401 are included in selling, general and administrative expenses for the three months ended February 29, 2008 and February 28, 2007, respectively.

11.  PATENTS, TRADEMARKS AND OTHER PURCHASED PRODUCT RIGHTS

The carrying value of trademarks, which are not subject to amortization under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), was $613,364 and $613,328 as of February 29, 2008 and November 30, 2007, respectively.  The gross carrying amount of intangible assets subject to amortization at February 29, 2008 and November 30, 2007, which consist primarily of non-compete agreements and distribution rights, was $6,503 and $6,278, respectively.  The related accumulated amortization of intangible assets at February 29, 2008 and November 30, 2007 was $3,002 and $2,797, respectively.  Amortization of our intangible assets subject to amortization under the provisions of SFAS 142 for the three months ended February 29, 2008 and February 28, 2007 was $205 and $190, respectively.  Estimated annual amortization expense for these assets for the years ended November 30, 2009, 2010, 2011, 2012 and 2013 is $913, $893, $873, $873 and $88, respectively.

12.  INVENTORIES

Inventories consisted of the following as of February 29, 2008 and November 30, 2007:

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	2008		2007
Raw materials and work in process	$	16,499	$	17,892
Finished goods		26,039		25,373
Total inventories	$	42,538	$	43,265

13.  ACCRUED LIABILITIES

Accrued liabilities consisted of the following as of February 29, 2008 and November 30, 2007:

	2008		2007
Interest	$	6,289	$	3,510
Salaries, wages and commissions		2,328		6,209
Product advertising and promotion		3,584		3,051
Litigation settlement and legal fees		1,785		2,084
Income taxes payable		997		3,643
Product recall expenses		5,716		–
Interest rate swap		2,932		1,274
Other		1,293		1,766
Total accrued liabilities	$	24,924	$	21,537

14.  COMPREHENSIVE INCOME

Comprehensive income consisted of the following components for the three months ended February 29, 2008 and February 28, 2007, respectively:

	2008			2007
Net income	$	14,873		$	13,650
Other – interest rate hedge adjustment		(1,573	)		334
Other – foreign currency translation adjustment		186			(71	)
Total	$	13,486		$	13,913

15.  STOCK REPURCHASE

In the three months ended February 29, 2008, we repurchased 4 shares of our common stock for $240 at an average price per share of $64.93. The repurchased shares were retired and returned to unissued.  As of April 1, 2008, the current amount available under the authorization from the Board of Directors was $64,306.

16.  POSTRETIREMENT BENEFIT PLANS

DEFINED BENEFIT PENSION PLAN

We have a noncontributory defined benefit pension plan (the “Pension Plan”), which covers substantially all employees as of December 31, 2000.  The Pension Plan provides benefits based upon years of service and employee compensation to employees who had completed one year of service prior to December 31, 2000.  On December 31, 2000, benefits and participation in the Pension Plan were frozen.  Contributions to the Pension Plan are calculated by an independent actuary and have been sufficient to provide benefits to participants and meet the funding requirements of the Employee Retirement Income Security Act (“ERISA”).  Plan assets as of February 29, 2008 and November 30, 2007 were invested primarily in United States government and agency securities and corporate debt and equity securities.

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Net periodic pension cost for the three months ended February 29, 2008 and February 28, 2007 comprised the following components:

	2008			2007
Service cost	$	–		$	–
Interest cost		152			153
Expected return on plan assets		(234	)		(220	)
Recognized net actuarial (gain)/loss		–			–
Net periodic pension cost (benefit)	$	(82	)	$	(67	)

No employer contributions were made for the three months ended February 29, 2008 and February 28, 2007, and no employer contributions are expected to be made for the Pension Plan in fiscal 2008.

DEFINED CONTRIBUTION PLAN

We sponsor a defined contribution plan that covers substantially all employees.  Eligible employees are allowed to contribute up to 15% of their eligible annual compensation.  We make matching contributions of 25% on the first 6% of contributed compensation.  The cost of the matching contribution totaled $88 and $73 for the three months ended February 29, 2008 and February 28, 2007, respectively.  In addition to matching contributions, safe harbor contributions equaling 3% of eligible annual compensation are made on behalf of eligible participants.  Safe harbor contributions totaled $288 and $243 for the three months ended February 29, 2008 and February 28, 2007, respectively.  Total matching and safe harbor contributions for fiscal 2008 are expected to approximate amounts funded in fiscal 2007.  Total matching and safe harbor contributions in fiscal 2007 were $1,061.

POSTRETIREMENT HEALTH CARE BENEFITS PLAN

We maintain a postretirement health care benefits plan (the “Retiree Health Plan”) for certain eligible employees over the age of 65.  On May 31, 2006, Retiree Health Plan eligibility was restricted to current retirees and those active employees that were retirement eligible as of that date (age 55 and 10 years of service or age 65). Contributions to the Retiree Health Plan are limited to approximately $2 per participant per year and are paid monthly on a fully insured basis.  Participants are required to pay any insurance premium amount in excess of the $2 employer contribution.   Employer contributions expected for fiscal 2008 are approximately $78.

Net periodic postretirement health care benefits cost for the three months ended February 29, 2008 and February 28, 2007, included the following components:

	2008			2007
Service cost	$	5		$	14
Interest cost		14			18
Amortization of prior service cost		–			4
Recognized net actuarial(gain)/loss		(24	)		(4	)
Net periodic postretirement benefits cost	$	(5	)	$	32

17.  INCOME TAXES

We account for income taxes using the asset and liability approach as prescribed by SFAS 109, FIN 48 and other applicable FSP’s and FASB Interpretations.  This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements or tax returns.  Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability.  We record income tax expense in our consolidated financial statements based on an estimated annual effective income tax rate.  Our tax rate for the three months ended February 29, 2008 was 35.6%, as compared to 34.5% for the three months ended February 28, 2007.

Undistributed earnings of Chattem Canada, our Canadian subsidiary, are considered to be reinvested indefinitely and, accordingly, no provision for U.S. federal and state income taxes has been provided thereon.  Upon distribution of accumulated earnings in the form of dividends or otherwise, we would be subject to U.S. income taxes (subject to an adjustment for foreign tax credits).  For the three months ended February 29, 2008, Chattem Canada recognized a loss of approximately $147.

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We adopted FIN 48 on December 1, 2007. The difference between the tax benefit recognized in the financial statements for a position in accordance with FIN 48 and the tax benefit claimed in the tax return is referred to as an unrecognized tax benefit.  In connection with the adoption of FIN 48, we recognized an increase in the liability for unrecognized tax benefits of $1,595, which is included in the accompanying consolidated financial statements as a reduction to retained earnings of $711 and an increase to deferred tax assets of $884.  We have a total unrecognized tax benefit of $2,180 as of December 1, 2007, which includes an estimate of related interest and penalties of $312.  The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate is $1,205.  We recognize interest and penalties related to income tax matters as a component of the provision for income taxes.

During the first quarter of fiscal 2008 the total unrecognized tax benefit increased by $2,722, to $4,902 primarily as a result of deductions in amended tax returns related to certain elements of compensation.  It is reasonably possible that the amount of unrecognized tax benefit could increase by approximately $3,130, to approximately $8,032, during the next twelve months if certain elements of compensation are deducted in our 2007 federal and state tax returns.

We file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. We are no longer subject to examinations by tax authorities related to U.S. federal income taxes for fiscal years before 2004, state income taxes for fiscal years before 2003 or non-U.S. income taxes for fiscal years before 2002.

18.  PRODUCT SEGMENT INFORMATION

Net sales within our single healthcare business segment for the three months ended February 29, 2008 and February 28, 2007 are as follows:

	2008		2007
Medicated skin care	$	37,653	$	27,833
Topical pain care		25,315		27,226
Oral care		15,772		8,487
Internal OTC		11,210		8,449
Medicated dandruff shampoos		10,579		10,296
Dietary supplements		5,374		8,030
Other OTC and toiletry products		5,412		4,302
Total domestic net sales		111,315		94,623
International revenues		9,458		6,208
Total revenues	$	120,773	$	100,831

19.  COMMITMENTS AND CONTINGENCIES

GENERAL LITIGATION

We were named as a defendant in a number of lawsuits alleging that the plaintiffs were injured as a result of ingestion of products containing phenylpropanolamine (“PPA”), which was an active ingredient in most of our Dexatrim products until November 2000.  The lawsuits filed in federal court were transferred to the United States District Court for the Western District of Washington before United States District Judge Barbara J. Rothstein (In Re Phenylpropanolamine (“PPA”) Products Liability Litigation, MDL No. 1407).  The remaining lawsuits were filed in state court in a number of different states.

On April 13, 2004, we entered into a class action settlement agreement with representatives of the plaintiffs’ settlement class, which provided for a national class action settlement of all Dexatrim PPA claims.  On November 12, 2004, Judge Barbara J. Rothstein of the United States District Court for the Western District of Washington entered a final order and judgment certifying the class and granting approval of the Dexatrim PPA settlement.  The Dexatrim PPA settlement included claims against us involving alleged injuries by Dexatrim products containing PPA in which the alleged injury occurred after December 21, 1998, the date we acquired the Dexatrim brand.  A total of 14 claimants with alleged injuries that occurred after December 21, 1998 elected to opt-out of the class settlement.  Subsequently, we have settled twelve of the opt-out claims. The other two opt-outs have not filed lawsuits against us, and we believe the applicable statutes of limitation have run against their claims. Consequently, we are not currently defending any PPA products liability claims.

In accordance with the terms of the class action settlement, approximately $70,885 was initially funded into a settlement trust.  All claims in the settlement have been resolved and expenses of the trust have been paid.  On June 14, 2006, we filed a motion to dissolve the settlement trust.  The court granted this motion on July 14, 2006.  Although the court granted our motion to dissolve the settlement trust, we have continued the trust’s existence.  These funds are available in the unlikely event an additional PPA products liability lawsuit is filed against us.

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We were also named as a defendant in approximately 206 lawsuits relating to Dexatrim containing PPA which involved alleged injuries by Dexatrim products containing PPA manufactured and sold prior to our acquisition of Dexatrim on December 21, 1998.  The DELACO Company (“DELACO”), successor by merger to the Thompson Medical Company, Inc., which owned the brand prior to December 21, 1998, owed us an indemnity obligation for any liabilities arising from these lawsuits.  On February 12, 2004, DELACO filed a Chapter 11 bankruptcy petition in the United States Bankruptcy Court for the Southern District of New York.  We filed a claim for indemnification in DELACO’s bankruptcy.  We entered into a settlement agreement with DELACO dated June 30, 2005 that resolved DELACO’s indemnity obligations to us (“the DELACO Agreement”).  The DELACO Agreement was approved by the DELACO bankruptcy court on July 28, 2005.  In accordance with the DELACO bankruptcy plan, a settlement trust established under the plan paid us $8,750 on March 17, 2006, which is included in our consolidated statement of income, net of legal expenses, as litigation settlement for 2006.  The payment to us by the DELACO settlement trust of $8,750 has conclusively compromised and settled our indemnity claim filed in the DELACO bankruptcy. The confirmation of the DELACO bankruptcy plan effectively released us from liability for all PPA products liability cases with injury dates prior to December 21, 1998.

On December 30, 2003, the United States Food and Drug Administration ("FDA") issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products.  The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury.  The final rule became effective on April 11, 2004.  Although we discontinued the manufacturing and shipment of Dexatrim containing ephedrine after September 2002, the FDA's final rule resulted in lawsuits being filed against us alleging damages related to the use or purchase of Dexatrim containing ephedrine.  We have resolved all of the lawsuits against us alleging ingestion of Dexatrim containing ephedrine, including the previously disclosed Gunduz case.

We were named as a defendant in a putative class action lawsuit filed in the United States District Court for the Southern District of California relating to the labeling, advertising, promotion and sale of our Garlique product.  We were served with this lawsuit on July 5, 2007.  The lawsuit seeks class certification of a nationwide class of consumers who purchased this product.  The time period for purchases that would apply to the class is not clear from the complaint.  The lawsuit seeks restitution and/or disgorgement of profits, punitive damages, costs and attorney fees, injunctive relief, and other unspecified damages.  We plan to vigorously defend this case.

On December 20, 2007, Avon Products, Inc. filed a patent infringement lawsuit against us in the U.S. District Court for the Southern District of New York alleging that our Bullfrog Mosquito Coast product infringes an Avon patent.  We dispute this claim and plan to defend this lawsuit vigorously.  As of April 1, 2008, we have not been served with this lawsuit.

On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy products, including consumer “samples” that were included on a limited promotional basis in cartons of our 3 oz. Aspercreme product.  The recall is being conducted to the consumer level.  We recalled these products because we received some consumer reports of first, second and third degree burns, as well as skin irritation resulting from consumer use or possible misuse of the products.  As of April 1, 2008, approximately 155 consumers have pending claims against us alleging some type of personal injury.  We are not aware of any Heat Therapy products liability lawsuits pending against us as of April 1, 2008.  We may receive lawsuits in the future alleging burns and/or skin irritation from use of our Heat Therapy products.  The outcome of any such potential litigation cannot be predicted.

Other claims, suits and complaints arise in the ordinary course of our business involving such matters as patents and trademarks, product liability, environmental matters, employment law issues and other alleged injuries or damage. The outcome of such litigation cannot be predicted, but, in the opinion of management, based in part upon assessments from counsel, all such other pending matters are without merit or are of such kind or involve such other amounts as would not have a material adverse effect on our financial position, results of operations or cash flows if disposed of unfavorably.

We maintain insurance coverage for product liability claims relating to our products under claims-made policies which are subject to annual renewal.   For the current annual policy period beginning June 1, 2007, we maintain product liability insurance coverage in the amount of $30,000 through our captive insurance subsidiary, of which approximately $2,550 has been funded as of April 1, 2008.  We also have $25,000 of excess coverage through a third party reinsurance policy, which excludes coverage for our Dexatrim products containing ephedrine.

19

REGULATORY

We were notified in October 2000 that the FDA denied a citizen petition submitted by Thompson Medical Company, Inc., the previous owner of Sportscreme and Aspercreme.  The petition sought a determination that 10% trolamine salicylate, the active ingredient in Sportscreme and Aspercreme, was clinically proven to be an effective active ingredient in external analgesic OTC drug products and should be included in the FDA's yet-to-be finalized monograph for external analgesics. We have met with the FDA and submitted a proposed protocol study to evaluate the efficacy of 10% trolamine salicylate as an active ingredient in OTC external analgesic drug products. We are working to develop alternate formulations for Sportscreme and Aspercreme in the event that the FDA does not consider the available clinical data to conclusively demonstrate the efficacy of trolamine salicylate when the OTC external analgesic monograph is finalized. If 10% trolamine salicylate is not included in the final monograph, we would likely be required to discontinue these products as currently formulated and remove them from the market after expiration of an anticipated grace period. If this occurred, we believe we could still market these products as homeopathic products or reformulate them using ingredients included in the FDA monograph.  We are uncertain as to when the monograph is likely to become final.

Certain of our topical analgesic products are currently marketed under a FDA tentative final external analgesic monograph. The FDA has proposed that the final monograph exclude external analgesic products in patch, plaster or poultice form, unless the FDA receives additional data supporting the safety and efficacy of these products. On October 14, 2003, we submitted to the FDA information regarding the safety of our Icy Hot patches and arguments to support our product’s inclusion in the final monograph. We have also participated in an industry effort coordinated by Consumer Healthcare Products Association (“CHPA”) to establish with the FDA a protocol of additional research that will allow the patches to be marketed under the final monograph even if the final monograph does not explicitly allow them. The CHPA submission to the FDA was made on October 15, 2003. Thereafter, in April 2004, we launched the Icy Hot Sleeve, a flexible, non-occlusive fabric patch containing 16% menthol.  In February 2006, we launched the Capzasin Back & Body patch containing 0.025% capsaicin.  All of these drug products contain levels of active ingredients consistent with levels permitted in the OTC monograph.  If additional research is required either as a preliminary to final FDA monograph approval and/or as a requirement of future individual product sale, we may need to invest in a considerable amount of costly testing and data analysis. Any preliminary expenditures may be shared with other patch manufacturers. Because the submissions made into the FDA docket have been forwarded from its OTC Division to its Dermatological Division within the Center for Drug Evaluation and Research (“CDER”), we are uncertain as to when this matter is likely to become final.  For example, the FDA could choose to hold in abeyance a final ruling on alternative dose forms even if the monograph is otherwise finalized.  If the final monograph excludes such products, we will have to file a new drug application (“NDA”) for previously marketed drugs in order to continue to market the Icy Hot and Aspercreme Patches, the Icy Hot Sleeve, the Capzasin Back & Body Patch and/or similar delivery systems under our other topical analgesic brands. In such case, we would likely have to remove the existing products from the market one year from the effective date of the final monograph, pending FDA review and approval of an NDA. The preparation of an NDA would likely take us six to 18 months and would be a significant cost. It typically takes the FDA at least twelve months to rule on an NDA once it is submitted.

We have responded to certain questions with respect to efficacy received from the FDA in connection with clinical studies for pyrilamine maleate, one of the active ingredients used in certain of the Pamprin and Prēmsyn PMS products. While we addressed all of the FDA questions in detail, the final monograph for menstrual drug products, which has not yet been issued, will determine if the FDA considers pyrilamine maleate safe and effective for menstrual relief products. If pyrilamine maleate were not included in the final monograph, we would be required to reformulate the products to continue to provide the consumer with multi-symptom relief benefits.  We have been actively monitoring the process and do not believe that either Pamprin or Prēmsyn PMS, as brands, will be materially affected by the FDA review.  We believe that any adverse finding by the FDA would likewise affect our principal competitors in the menstrual product category and that finalization of the menstrual products monograph is not imminent.  Moreover, we have formulated alternative Pamprin products that fully comply with both the internal analgesic and menstrual product monographs.

In early 2005, infrequent, but serious, adverse cardiovascular events were reported to the FDA associated with patients who were prescribed a subclass of COX-2 inhibitor non-steroidal anti-inflammatory drugs (“NSAID’s”) for long periods to relieve pain of chronic diseases such as arthritis.  These products include Vioxx®, Bextra®, and Celebrex®.  In February 2005, the FDA held a joint advisory committee meeting to seek external counsel on the extent to which manufacturers might further warn patients of these cardiovascular risks on prescription product labeling, or prohibit sale of these prescription products.  As part of its response on this issue, the FDA has recommended labeling changes for both the prescription and OTC NSAID’s. Well-known OTC NSAID’s such as ibuprofen and naproxen, which have been sold in vast quantities since the 1970s, were affected by this regulatory action.   Manufacturers of OTC NSAID’s were asked to revise their labeling to provide more specific information about the potential cardiovascular and gastrointestinal risks recognizing the limited dose and duration of treatment of these products.  Our Pamprin All Day product, which contains naproxen sodium, is subject to these new labeling requirements.  Pamprin All Day is manufactured for us by The Perrigo Company (“Perrigo”), holder of an abbreviated NDA for naproxen sodium.  As holder of the abbreviated NDA, Perrigo made the mandated labeling changes within the time frame required by the FDA. Product with revised labeling compliant with new FDA regulations began shipping in February 2006.  We are also aware of the FDA's concern about

20

the potential toxicity due to concomitant use of OTC and prescription products that contain the analgesic ingredient acetaminophen, an ingredient also found in Pamprin and Prēmsyn PMS.  We are also aware that the FDA will revise acetaminophen labeling to reflect the concerns similar to NSAID analgesics such as naproxen.  We are participating in an industry-wide effort to reassure the FDA that the current recommended dosing regimen is safe and effective and that proper labeling and public education by both OTC and prescription drug companies are the best policies to abate the FDA's concern.   The FDA will address both issues in its effort to finalize the monograph on internal analgesic products.  We believe the FDA may issue revised labeling requirements within the next year, perhaps prior to monograph closure that will cause the industry to relabel its analgesic products to better inform consumers.

During the finalization of the monograph on sunscreen products, the FDA chose to hold in abeyance specific requirements relating to the characterization of a product’s ability to reduce UVA radiation.  In September 2007, the FDA published a new proposed rule amending the previously stayed final monograph on sunscreens to include new formulation options, labeling requirements and testing standards for measuring UVA protection and revised testing for UVB protection.  When implemented, the final rule will require all sunscreen manufacturers to conduct new testing and revise the labeling of their products within eighteen months after issuance of the final rule.  We will be required to take such actions for our BullFrog product line.

Our business is also regulated by the California Safe Drinking Water and Toxic Enforcement Act of 1986, known as Proposition 65.  Proposition 65 prohibits businesses from exposing consumers to chemicals that the state has determined cause cancer or reproduction toxicity without first giving fair and reasonable warning unless the level of exposure to the carcinogen or reproductive toxicant falls below prescribed levels.  From time to time, one or more ingredients in our products could become subject to an inquiry under Proposition 65.  If an ingredient is on the state’s list as a carcinogen, it is possible that a claim could be brought in which case we would be required to demonstrate that exposure is below a “no significant risk” level for consumers.  Any such claims may cause us to incur significant expense, and we may face monetary penalties or injunctive relief, or both, or be required to reformulate our product to acceptable levels.  The State of California under Proposition 65 is also considering the inclusion of titanium dioxide on the state’s list of suspected carcinogens.  Titanium dioxide has a long history of widespread use as an excipient in prescription and OTC pharmaceuticals, cosmetics, dietary supplements and skin care products and is an active ingredient in our Bullfrog Superblock products. We have participated in an industry-wide submission to the State of California, facilitated through the CHPA, presenting evidence that titanium dioxide presents “no significant risk” to consumers.

On February 12, 2008, we recalled all lots of the medical device, Icy Hot Heat Therapy Air Activated Heat patch (Back and Arm, Neck and Leg) distributed since December 2006.  The recall was due to adverse events reports which associated the use of the products with temporary or medically reversible health consequences, skin irritation and burns.  The recall was voluntary and conducted with the full knowledge of the Food and Drug Administration.  On February 5-8, 2008, FDA conducted a medical device inspection of our manufacturing plant, manufacturing records, and consumer complaint handling system.  On February 8, 2008, the FDA issued a Form FDA-483 noting three inspectional observations pertaining to MDR reporting, device correction reports, and corrective and preventive action procedures.  We responded to the Form FDA-483 on February 14, 2008 committing to correct the cited observations.

In June 2007, the FDA published a final rule establishing regulations requiring current good manufacturing practices for dietary supplements.  This final rule becomes effective June 2008.

20.  CONSOLIDATING FINANCIAL STATEMENTS

The consolidating financial statements, for the dates or periods indicated, of Chattem, Inc.  (“Chattem”), Signal Investment & Management Co. (“Signal”), SunDex, LLC (“SunDex”) and Chattem (Canada) Holdings, Inc. (“Canada”), the guarantors of the long-term debt of Chattem, and the non-guarantor direct and indirect wholly-owned subsidiaries of Chattem are presented below.  Signal is 89% owned by Chattem and 11% owned by Canada.  SunDex and Canada are wholly-owned subsidiaries of Chattem.  The guarantees of Signal, SunDex and Canada are full and unconditional and joint and several.  The guarantees of Signal, SunDex and Canada as of February 29, 2008 arose in conjunction with our Credit Facility and our issuance of the 7.0% Subordinated Notes (See Note 6).  The maximum amount of future payments the guarantors would be required to make under the guarantees as of February 29, 2008 is $273,000.

21

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATING BALANCE SHEETS

FEBRUARY 29, 2008

(Unaudited and in thousands)

	CHATTEM			GUARANTOR  SUBSIDIARY    COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	332		$	512		$	10,775		$	—		$	11,619
Accounts receivable, less allowances of $15,575		52,120			17,704			6,014			(17,704	)		58,134
Interest receivable		90			650			(73	)		(667	)		—
Inventories		35,928			2,611			3,999			—			42,538
Deferred income taxes		7,421			—			42			—			7,463
Prepaid expenses and other current assets		5,661			—			235			(90	)		5,806
Total current assets		101,552			21,477			20,992			(18,461	)		125,560
PROPERTY, PLANT AND EQUIPMENT, NET		31,050			775			669			—			32,494
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net		3,501			674,057			1,597			(62,290	)		616,865
Debt issuance costs, net		14,223			—			—			—			14,223
Investment in subsidiaries		333,036			33,000			66,860			(432,896	)		—
Note receivable		—			33,000			—			(33,000	)		—
Other		4,292			—			508			—			4,800
Total other noncurrent assets		355,052			740,057			68,965			(528,186	)		635,888
TOTAL ASSETS	$	487,654		$	762,309		$	90,626		$	(546,647	)	$	793,942
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt	$	128,000		$	—		$	—		$	—		$	128,000
Accounts payable and other		18,695			—			1,987			—			20,682
Bank overdraft		2,850			—			—			—			2,850
Accrued liabilities		37,628			857			4,900			(18,461	)		24,924
Total current liabilities		187,173			857			6,887			(18,461	)		176,456
LONG-TERM DEBT, less current maturities		369,400			(1,200	)		34,800			(33,000	)		370,000
DEFERRED INCOME TAXES		(24,709	)		48,966			—			—			24,257
OTHER NONCURRENT LIABILITIES		3,566			—			—			—			3,566
INTERCOMPANY ACCOUNTS		(267,422	)		259,761			7,661			—			—
SHAREHOLDERS’ EQUITY:
Preferred shares, without par value, authorized 1,000, none issued		—			—			—			—			—
Common shares, without par value, authorized 100,000, issued and outstanding 19,177		41,980			—			—			—			41,980
Share capital of subsidiaries		—			329,704			39,804			(369,508	)		—
Dividends		—			(16,688	)		—			16,688			—
Retained earnings		179,817			140,909			(188	)		(140,721	)		179,817
Total		221,797			453,925			39,616			(493,541	)		221,797
Cumulative other comprehensive income, net of taxes:
Interest rate cap adjustment		(3,320	)		—			—			—			(3,320	)
Foreign currency translation adjustment		1,177			—			1,662			(1,645	)		1,194
Unrealized actuarial gains and losses		(8	)		—			—			—			(8	)
Total shareholders’ equity		219,646			453,925			41,278			(495,186	)		219,663
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	487,654		$	762,309		$	90,626		$	(546,647	)	$	793,942

22

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATING BALANCE SHEETS

NOVEMBER 30, 2007

(In thousands)

	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	4,685		$	590		$	10,132		$	—		$	15,407
Accounts receivable, less allowances of $13,810		37,492			16,693			6,261			(16,693	)		43,753
Interest receivable		101			625			(84	)		(642	)		—
Inventories		36,220			3,242			3,803			—			43,265
Deferred income taxes		6,709			—			41			—			6,750
Prepaid expenses and other current assets		1,913			—			302			(150	)		2,065
Total current assets		87,120			21,150			20,455			(17,485	)		111,240
PROPERTY, PLANT AND EQUIPMENT, NET		30,902			775			672			—			32,349
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net		3,482			674,058			1,560			(62,290	)		616,810
Debt issuance costs, net		15,430			—			—			—			15,430
Investment in subsidiaries		336,936			33,000			66,860			(436,796	)		—
Note receivable		—			33,000			—			(33,000	)		—
Other		4,218			—			513			—			4,731
Total other noncurrent assets		360,066			740,058			68,933			(532,086	)		636,971
TOTAL ASSETS	$	478,088		$	761,983		$	90,060		$	(549,571	)	$	780,560
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt	$	3,000		$	—		$	—		$	—		$	3,000
Accounts payable		16,439			—			1,800			—			18,239
Bank overdraft		7,584			—			—						7,584
Accrued liabilities		33,561			691			4,770			(17,485	)		21,537
Total current liabilities		60,584			691			6,570			(17,485	)		50,360
LONG-TERM DEBT, less current maturities		504,400			(1,200	)		34,800			(33,000	)		505,000
DEFERRED INCOME TAXES		(23,976	)		45,032			—			—			21,056
OTHER NONCURRENT LIABILITIES		2,436			—			—			—			2,436
INTERCOMPANY ACCOUNTS		(267,058	)		259,083			7,975			—			—
SHAREHOLDERS’ EQUITY
Preferred shares, without par value, authorized 1,000, none issued		—			—			—			—			—
Common shares, without par value, authorized 100,000, issued 19,092		36,800			—			—			—			36,800
Share capital of subsidiaries		—			329,704			39,804			(369,508	)		—
Dividends		—			(18,046	)		(9,000	)		27,046			—
Retained earnings		165,655			146,719			8,430			(155,149	)		165,655
Total		202,455			458,377			39,234			(497,611	)		202,455
Cumulative other comprehensive income, net of taxes:
Interest rate hedge adjustment		(1,747	)		—			—			—			(1,747	)
Foreign currency translation adjustment		1,002			—			1,481			(1,475	)		1,008
Unrealized actuarial gains and losses		(8	)		—			—			—			(8	)
Total shareholders’ equity		201,702			458,377			40,715			(499,086	)		201,708
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	478,088		$	761,983		$	90,060		$	(549,571	)	$	780,560

23

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATING STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED FEBRUARY 29, 2008

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY  COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
TOTAL REVENUES	$	110,464		$	23,044		$	6,071		$	(18,806	)	$	120,773
COSTS AND EXPENSES:
Cost of sales		31,876			1,431			2,502			(1,076	)		34,733
Advertising and promotion		30,760			1,822			1,914			—			34,496
Selling, general and administrative		14,741			110			615			—			15,466
Product recall expenses		5,555			—			488			—			6,043
Equity in subsidiary income		(11,994	)		—			—			11,994			—
Total costs and expenses		70,938			3,363			5,519			10,918			90,738
INCOME FROM OPERATIONS		39,526			19,681			552			(29,724	)		30,035
OTHER INCOME (EXPENSE):
Interest expense		(6,529	)		—			(642	)		619			(6,552	)
Investment and other income, net		12			646			723			(1,244	)		137
Loss on early extinguishment of debt		(526	)		—			—			—			(526	)
Royalties		(16,873	)		(858	)		—			17,731			—
Corporate allocations		509			(469	)		(40	)		—			—
Total other income (expense)		(23,407	)		(681	)		41			17,106			(6,941	)
INCOME BEFORE INCOME TAXES		16,119			19,000			593			(12,618	)		23,094
PROVISION FOR INCOME TAXES		1,246			6,764			211			—			8,221
NET INCOME	$	14,873		$	12,236		$	382		$	(12,618	)	$	14,873

24

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATING STATEMENTS OF INCOME

FOR THE THREE MONTHS ENDED FEBRUARY 28, 2007

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY  COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
TOTAL REVENUES	$	88,217		$	23,010		$	5,337		$	(15,733	)	$	100,831
COSTS AND EXPENSES:
Cost of sales		26,988			2,315			2,482			(805	)		30,980
Advertising and promotion		24,147			2,880			1,760			—			28,787
Selling, general and administrative		12,211			(42	)		242			—			12,411
Acquisition expenses		1,171			—			—			—			1,171
Equity in subsidiary income		(10,792	)		—			—			10,792			—
Total costs and expenses		53,725			5,153			4,484			9,987			73,349
INCOME FROM OPERATIONS		34,492			17,857			853			(25,720	)		27,482
OTHER INCOME (EXPENSE):
Interest expense		(7,190	)		—			(665	)		619			(7,236	)
Investment and other income, net		403			636			798			(1,244	)		593
Royalties		(13,622	)		(1,306	)		—			14,928			—
Corporate allocations		743			(727	)		(16	)		—			—
Total other income (expense)		(19,666	)		(1,397	)		117			14,303			(6,643	)
INCOME BEFORE INCOME TAXES		14,826			16,460			970			(11,417	)		20,839
PROVISION FOR INCOME TAXES		1,176			5,679			334			—			7,189
NET INCOME	$	13,650		$	10,781		$	636		$	(11,417	)	$	13,650

25

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATING STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED FEBRUARY 29, 2008

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
OPERATING ACTIVITIES:
Net income	$	14,873		$	12,236		$	382		$	(12,618	)	$	14,873
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		2,090			—			29			—			2,119
Deferred income taxes		500			3,934			(1	)		—			4,433
Tax benefit realized from stock options exercised		(1,812	)		—			—			—			(1,812	)
Stock-based compensation expense		1,339			—			—			—			1,339
Loss on early extinguishment of debt		526			—			—			—			526
Other, net		109			—			3			—			112
Equity in subsidiary income		(12,618	)		—			—			12,618			—
Changes in operating assets and liabilities:
Accounts receivable and other		(14,629	)		(1,011	)		248			1,011			(14,381	)
Interest Receivable		10			(25	)		(10	)		25			—
Inventories		302			631			(196	)		—			737
Prepaid expenses and other current assets		(3,752	)		—			66			(60	)		(3,746	)
Accounts payable and accrued liabilities		6,542			166			315			(976	)		6,047
Net cash provided by (used in) operating activities		(6,520	)		15,931			836			—			10,247
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(1,258	)		—			(13	)		—			(1,271	)
Change in other assets, net		(1,792	)		—			136			—			(1,656	)
Net cash provided by (used in) investing activities		(3,050	)		—			123			—			(2,927	)
FINANCING ACTIVITIES:
Repayment of long-term debt		(35,750	)		—			—			—			(35,750	)
Proceeds from borrowings under revolving credit facility		69,500			—			—			—			69,500
Repayment of revolving credit facility		(43,750	)		—			—			—			(43,750	)
Bank overdraft		(4,734	)		—			—			—			(4,734	)
Proceeds from exercise of stock options		2,057			—			—			—			2,057
Repurchase of common shares		(240	)		—			—			—			(240	)
Tax benefit realized from stock options exercised		1,812			—			—			—			1,812
Changes in intercompany accounts		259			679			(938	)		—			—
Dividends paid		16,063			(16,688	)		625			—			—
Net cash (used in) provided by financing activities		5,217			(16,009	)		(313	)		—			( 11,105	)
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS		—			—			(3	)		—			(3	)
CASH AND CASH EQUIVALENTS:
Increase (decrease) for the period		(4,353	)		(78	)		643			—			(3,788	)
At beginning of period		4,685			590			10,132			—			15,407
At end of period	$	332		$	512		$	10,775		$	—		$	11,619

26

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONSOLIDATING STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED FEBRUARY 28, 2007

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY  COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
OPERATING ACTIVITIES:
Net income	$	13,650		$	10,781		$	636		$	(11,417	)	$	13,650
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		2,005			—			24			—			2,029
Deferred income taxes		2,795			—			(1	)		—			2,794
Tax benefit realized from stock options exercised		(3,013	)		—			—			—			(3,013	)
Stock-based compensation expense		1,204			—			—			—			1,204
Other, net		104			—			20			—			124
Equity in subsidiary income		(11,417	)		—			—			11,417			—
Changes in operating assets and liabilities:
Accounts receivable and other		(22,855	)		(5,521	)		(357	)		5,521			(23,212	)
Inventories		43			(48	)		363			—			358
Refundable income taxes		196			—			—			—			196
Prepaid expenses and other current assets		(402	)		—			(109	)		1,191			680
Accounts payable and accrued liabilities		18,635			173			3,031			(6,712	)		15,127
Net cash provided by operating activities		945			5,385			3,607			—			9,937
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(451	)		—			(2	)		—			(453	)
Acquisition of brands		(8,732	)		(403,156	)		—			—			(411,888	)
Change in other assets, net		(405	)		468			(89	)		—			(26	)
Net cash used in investing activities		(9,588	)		(402,688	)		(91	)		—			(412,367	)
FINANCING ACTIVITIES:
Intercompany debt proceeds (payments)		7,000			—			(7,000	)		—			—
Proceeds from long-term debt		300,000			—			—			—			300,000
Proceeds from borrowings under revolving credit facility		39,000			—			—			—			39,000
Repayment of revolving credit facility		(9,000	)		—			—			—			(9,000	)
Bank overdraft		(3,719	)		—			—			—			(3,719	)
Proceeds from exercise of stock options		4,457			—			—			—			4,457
Increase in debt issuance costs		(6,079	)		—			—			—			(6,079	)
Tax benefit realized from stock options exercised		3,013			—			—			—			3,013
Changes in intercompany accounts		(398,503	)		397,809			694			—			—
Dividends paid		—			(625	)		625			—			—
Net cash (used in) provided by financing activities		(63,831	)		397,184			(5,681	)		—			327,672
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS		—			—			(20	)		—			(20	)
CASH AND CASH EQUIVALENTS:
Decrease for the period		(72,474	)		(119	)		(2,185	)		—			(74,778	)
At beginning of period		80,198			1,967			8,362			—			90,527
At end of period	$	7,724		$	1,848		$	6,177		$	—		$	15,749

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).  This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions.  The actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those described in our filings with the SEC.

Overview

Founded in 1879, we are a leading marketer and manufacturer of a broad portfolio of branded over-the-counter (“OTC”) healthcare products, toiletries and dietary supplements including such categories as medicated skin care, topical pain care, oral care, internal OTC, medicated dandruff shampoos, dietary supplements and other OTC and toiletry products. Our portfolio of products includes well-recognized brands such as:

• Gold Bond, Balmex and Cortizone – medicated skin care;

• Icy Hot, Capzasin and Aspercreme – topical pain care;

• ACT and Herpecin-L – oral care;

• Unisom, Pamprin and Kaopectate  – internal OTC;

• Selsun Blue and Selsun Natural – medicated dandruff shampoos;

• Dexatrim, Garlique and New Phase  – dietary supplements; and

• Bullfrog, Ultraswim and Sun-In  – other OTC and toiletry products.

Our products target niche markets that are often outside the focus of larger companies where we believe we can achieve and sustain significant market share through product innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical pain care brands, our Cortizone-10 anti-itch ointment, and our Gold Bond medicated body powders have the leading U.S. market share in these categories. We support our brands through extensive and cost-effective advertising and promotion, the expenditures for which represented approximately 29% of our total revenues in the first quarter of fiscal 2008. We sell our products nationally through mass merchandiser, drug and food channels, principally utilizing our own sales force.

Our experienced management team has grown our business by acquiring brands, developing product line extensions and increasing market penetration of our existing products.

Developments During the First Quarter of Fiscal 2008

Products

In the first quarter of fiscal 2008, we introduced the following product line extensions: Cortizone-10 Intensive Healing, Gold Bond Ultimate Restoring Lotion, Gold Bond Ultimate Foot Cream, Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Relieving Gel, Aspercreme Nighttime Lotion and Dexatrim Max Daytime Control.

Product Recall

On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy product. Icy Hot Heat Therapy is an air-activated, self-heating disposable device for temporary relief of muscular and joint pain.  We recalled these products because we received some consumer reports of first, second and third degree burns and skin irritation resulting from the use or possible misuse of the product.  Based in part on consideration of on-hand factory inventory and retail point of sales data, we estimated approximately $6.0 million of recall expenses related to product returns, inventory obsolescence, destruction costs, consumer refunds, legal fees and other estimated expenses.

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Results of Operations

The following table sets forth, for the periods indicated, certain items from our unaudited Consolidated Statements of Income expressed as a percentage of total revenues:

	For the Three Months Ended
	February 29, 2008			February 28, 2007
TOTAL REVENUES		100.0	%		100.0	%
COSTS AND EXPENSES:
Cost of sales		28.8			30.7
Advertising and promotion		28.6			28.5
Selling, general and administrative		12.8			12.3
Product recall expenses		5.0			—
Acquisition expenses		—			1.2
Total costs and expenses		75.2			72.7
INCOME FROM OPERATIONS		24.8			27.3
OTHER INCOME (EXPENSE):
Interest expense		(5.4	)		(7.2	)
Investment and other income, net		0.1			0.6
Loss on early extinguishment of debt		(0.4	)		—
Total other income (expense)		(5.7	)		(6.6	)
INCOME BEFORE INCOME TAXES		19.1			20.7
PROVISION FOR INCOME TAXES		6.8			7.1
NET INCOME		12.3	%		13.6	%

Critical Accounting Policies

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to use estimates.  Several different estimates or methods can be used by management that might yield different results.  The following are the significant estimates used by management in the preparation of the February 29, 2008 unaudited consolidated financial statements:

Allowance for Doubtful Accounts

As of February 29, 2008, an estimate was made of the collectibility of the outstanding accounts receivable balances.   This estimate requires the utilization of outside credit services, knowledge about the customer and the customer’s industry, new developments in the customer’s industry and operating results of the customer as well as general economic conditions and historical trends.  When all these facts are compiled, a judgment as to the collectibility of the individual account is made.   Many factors can impact this estimate, including those noted in this paragraph.  The adequacy of the estimated allowance may be impacted by the deterioration in the financial condition of a large customer, weakness in the economic environment resulting in a higher level of customer bankruptcy filings or delinquencies and the competitive environment in which the customer operates.  During the first quarter of fiscal 2008, we performed a detailed assessment of the collectibility of trade accounts receivable and did not make any significant adjustments to our estimate of allowance for doubtful accounts.  The balance of allowance for doubtful accounts was $0.4 million at both February 29, 2008 and November 30, 2007.

Revenue Recognition

Revenue is recognized when our products are shipped to our customers.  It is generally our policy across all classes of customers that all sales are final.  As is common in the consumer products industry, customers return products for a variety of reasons including products damaged in transit, discontinuance of a particular size or form of product and shipping errors.  As sales are recorded, we accrue an estimated amount for product returns, as a reduction of these sales, based upon our historical

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experience and consideration of discontinued products, products divestitures, estimated inventory levels held by our customers and retail point of sale data on existing and newly introduced products.  The level of returns may fluctuate from our estimates due to several factors including weather conditions, customer inventory levels and competitive conditions.  We charge the allowance account resulting from this accrual with any authorized deduction from remittance by the customer or product returns upon receipt of the product.

We separate returns into the two categories of seasonal and non-seasonal products.  We use the historical return detail of seasonal and non-seasonal products for at least the most recent three fiscal years on generally all products, which is normalized for any specific occurrence that is not reasonably likely to recur, to determine the amount of product returned as a percentage of sales, and estimate an allowance for potential returns based on product sold in the current period.  To consider product sold in current and prior periods, an estimate of inventory held by our retail customers is calculated based on customer inventory detail.  This estimate of inventory held by our customers, along with historical returns as a percentage of sales, is used to determine an estimate of potential product returns.  This estimate of the allowance for seasonal and non-seasonal returns is further analyzed by considering retail customer point of sale data.  We also consider specific events, such as discontinued product or product divestitures, when determining the adequacy of the allowance.  Based on consideration of the sales of Icy Hot Pro-Therapy performing below expectations, review of retail point of sales data and an estimate of inventory on hand at customers, an allowance for returns of $4.5 million was recorded as of November 30, 2007.  As of February 29, 2008, the allowance for Icy Hot Pro-Therapy returns is $4.0 million.

Our estimate of product returns for seasonal and non-seasonal products as of February 29, 2008 was $1.5 million and $1.2 million, respectively, and $1.2 million and $1.3 million, respectively, as of November 30, 2007.  For the three months ended February 29, 2008, we increased our estimate of returns for seasonal products by $0.3 million, which resulted in a decrease to net sales in our consolidated financial statements.  For the three months ended February 29, 2008, we decreased our estimate of non-seasonal returns by approximately $0.1 million, which resulted in an increase to net sales in our consolidated financial statements.  During the three months ended February 28, 2007, we decreased our estimate of returns for seasonal products and non-seasonal returns by approximately $0.3 million and $0.2 million, respectively, which resulted in a increase to net sales in our consolidated financial statements.  Each percentage point change in the seasonal return rate would impact net sales by approximately $0.1 million.  Each percentage point change in the non-seasonal return rate would impact net sales by approximately $0.6 million.

We routinely enter into agreements with customers to participate in promotional programs.  The cost of these programs is recorded as either advertising and promotion expense or as a reduction of sales as prescribed by Emerging Issues Task Force 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”.  A significant portion of the programs are recorded as a reduction of sales and generally take the form of coupons and vendor allowances, which are normally taken via temporary price reductions, scan downs, display activity and participations in in-store programs provided uniquely by the customer.  We also enter into cooperative advertising programs with certain customers, the cost of which is recorded as advertising and promotion expense.  In order for retailers to receive reimbursement under such programs, the retailer must meet specified advertising guidelines and provide appropriate documentation of the advertisement being run.

We analyze promotional programs in two primary categories -- coupons and vendor allowances.  Customers normally utilize vendor allowances in the form of temporary price reductions, scan downs, display activity and participations in in-store programs provided uniquely by the customer.  We estimate the accrual for outstanding coupons by utilizing a third-party clearinghouse to track coupons issued, coupon value, distribution and expiration dates, quantity distributed and estimated redemption rates that are provided by us.  We estimate the redemption rates based on internal analysis of historical coupon redemption rates and expected future retail sales by considering recent point of sale data.  The estimate for vendor allowances is based on estimated unit sales of a product under a program and amounts committed for such programs in each fiscal year.  Estimated unit sales are determined by considering customer forecasted sales, point of sale data and the nature of the program being offered.  The three most recent years of expected program payments versus actual payments made and current year retail point of sale trends are analyzed to determine future expected payments.  Customer delays in requesting promotional program payments due to their audit of program participation and resulting request for reimbursement is also considered to evaluate the accrual for vendor allowances.  The costs of these programs is often variable based on the number of units actually sold.  As of February 29, 2008, the coupon accrual and reserve for vendor allowances were $2.2 million and $7.3 million, respectively, and $1.9 million and $5.5 million, respectively, as of November 30, 2007.  Each percentage point change in promotional program participation and advertising and promotion expense would impact net sales by an insignificant amount.

Income Taxes

We account for income taxes using the asset and liability approach as prescribed by SFAS 109, FIN 48 and other applicable FSP’s and FASB Interpretations.  This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns.  

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Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability.  We adopted FIN 48 on December 1, 2007.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109.  We record income tax expense in our consolidated financial statements based on an estimated annual effective income tax rate.  Our tax rate for the three months ended February 29, 2008 was 35.6%, as compared to 34.5% for the three months ended February 28, 2007.

Accounting for Acquisitions and Intangible Assets

We account for our acquisitions under the purchase method of accounting for business combinations as prescribed by SFAS No. 141, “Business Combinations” (“SFAS 141”).  Under SFAS 141, the cost, including transaction costs, are allocated to the underlying net assets, based on their respective estimated fair values.

We account for our Intangible Assets in accordance with SFAS 142.  Under SFAS 142, intangible assets with indefinite useful lives are not amortized but are reviewed for impairment at least annually. Intangible assets with finite lives are amortized over their estimated useful lives using the straight-line method.

The judgments made in determining the estimated fair value and expected useful lives assigned to each class of assets and liabilities acquired can significantly affect net income.  For example, the useful life of property, plant, and equipment acquired will differ substantially from the useful life of brand licenses and trademarks.  Consequently, to the extent a longer-lived asset is ascribed greater value under the purchase method than a shorter-lived asset or a value is assigned to an indefinite-lived asset, net income in a given period may be higher.

Determining the fair value of certain assets and liabilities acquired is judgmental in nature and often involves the use of significant estimates and assumptions.  An area that requires significant judgment is the fair value and useful lives of intangible assets.  In this process, we often obtain the assistance of a third party valuation firm for certain intangible assets.

Our intangible assets consist of exclusive brand licenses, trademarks and other intellectual property, customer relationships and non-compete agreements.  We have determined that our trademarks have indefinite useful lives, as cash flows from the use of the trademarks are expected to be generated indefinitely. The useful lives of our intangible assets are reviewed as circumstances dictate using the guidance of applicable accounting literature.

The value of our intangible assets is exposed to future adverse changes if we experience declines in operating results or experience significant negative industry or economic trends.  We review our indefinite-lived intangible assets for impairment at least annually by comparing the carrying value of the intangible assets to its estimated fair value.  The estimate of fair value is determined by discounting the estimate of future cash flows of the intangible assets.  During the quarter ended November 30, 2007, we performed our annual impairment testing of these assets and no impairment or adjustment was required.

Fair Value Measurements

On December 1, 2007, we adopted SFAS No. 157.  SFAS 157 provides guidance for using fair value to measure assets and liabilities. SFAS 157 applies both to items recognized and reported at fair value in the financial statements and to items disclosed at fair value in the notes to the financial statements.  SFAS 157 does not change existing accounting rules governing what can or must be recognized and reported at fair value and clarifies that fair value is defined as the price received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date.  Additionally, SFAS 157 does not eliminate practicability exceptions that exist in accounting pronouncements amended by SFAS 157 when measuring fair value.  As a result, we are not required to recognize any new assets or liabilities at fair value.

SFAS 157 also establishes a framework for measuring fair value.  Fair value is generally determined based on quoted market prices in active markets for identical assets or liabilities.  If quoted market prices are not available, SFAS 157 provides guidance on alternative valuation techniques that place greater reliance on observable inputs and less reliance on unobservable inputs.

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Stock-Based Compensation

We account for stock-based compensation under the provisions of SFAS 123R.  SFAS 123R requires the recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award.  The fair value of each stock option grant is estimated using a Flex Lattice Model.  The input assumptions used in determining fair value are the expected life of the stock options, the expected volatility of our common stock, the risk-free interest rate over the expected life of the option and the expected forfeiture rate of the options granted.  We recognize stock option compensation expense over the period during which an employee provides service in exchange for the award (the vesting period).

Comparison of Three Months Ended February 29, 2008 and February 28, 2007

To facilitate discussion of our operating results for the three months ended February 29, 2008 and February 28, 2007, we have included the following selected data from our unaudited Consolidated Statements of Income:

					Increase (Decrease)
	2008		2007		Amount			Percentage
	(dollars in thousands)
Domestic net sales	$	111,315	$	94,623	$	16,692			17.6	%
International revenues		9,458		6,208		3,250			52.4
Total revenues		120,773		100,831		19,942			19.8
Cost of sales		34,733		30,980		3,753			12.1
Advertising and promotion expense		34,496		28,787		5,709			19.8
Selling, general and administrative expense		15,466		12,411		3,055			24.6
Product recall expenses		6,043		—		6,043			100.0
Acquisition expenses		—		1,171		(1,171	)		(100.0	)
Interest expense		6,552		7,236		(684	)		(9.5	)
Loss on early extinguishment of debt		526		—		526			100.0
Net income		14,873		13,650		1,223			9.0

Domestic Net Sales

Domestic net sales in the first quarter of fiscal 2008 increased $16.7 million, or 17.6%, to $111.3 million from $94.6 million in the prior year quarter.   A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:

					Increase (Decrease)
	2008		2007		Amount			Percentage
	(dollars in thousands)
Medicated skin care	$	37,653	$	27,833	$	9,820			35.3	%
Topical pain care		25,315		27,226		(1,911	)		(7.0	)
Oral care		15,772		8,487		7,285			85.8
Internal OTC		11,210		8,449		2,761			32.7
Medicated dandruff shampoos		10,579		10,296		283			2.7
Dietary supplements		5,374		8,030		(2,656	)		(33.1	)
Other OTC and toiletry products		5,412		4,302		1,110			25.8
Total	$	111,315	$	94,623	$	16,692			17.6

Net sales in the medicated skin care products category increased 35.3% for the first quarter of fiscal 2008 compared to the prior year quarter as a result of our ownership of the Cortizone-10 and Balmex brands for the three month period of the first quarter of fiscal 2008 as compared to two months of ownership in the first quarter of fiscal  2007, and increased net sales of Gold Bond, led by strong sales of Gold Bond Ultimate Softening Lotion and the launch of Gold Bond Restoring Lotion in the first quarter of fiscal 2008.

Net sales in the topical pain care category decreased 7.0% for the first quarter of fiscal 2008 compared to the prior year quarter, as a result of the launch and initial sell-in of Icy Hot Heat Therapyin the first quarter of fiscal 2007 and the discontinuance of shipments of Icy Hot Heat Therapy following the voluntary recall of the product announced on February 8,

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2008.  These factors were offset in part by the launch and initial sell-in of Icy Hot PM Lotion, Icy Hot PM Patch, Aspercreme Heat Pain Gel and Aspercreme Nighttime Lotion in the first quarter of fiscal 2008.

Net sales in the oral care products category increased 85.8% for the first quarter of fiscal 2008 compared to the prior year quarter as a result of our ownership of the ACT brand for the three month period of the first quarter of fiscal 2008 as compared to two months of ownership in the first quarter of fiscal 2007 and continued growth of ACT from additional product distribution and media support.

Net sales in the internal OTC category increased 32.7% for the first quarter of fiscal 2008 compared to the prior year quarter as a result of our ownership of the Unisom and Kaopectate brands for the three month period of the first quarter of fiscal 2008 as compared to two months of ownership in the first quarter of fiscal 2007.

Net sales in the medicated dandruff shampoos category increased 2.7% in the first quarter of fiscal 2008 compared to the prior year quarter resulting from the launch of Selsun Blue Naturals in the second quarter of fiscal 2007, offset by declines in the Selsun Salon line of products.

Net sales in the dietary supplements category decreased 33.1% for the first quarter of fiscal 2008 compared to the prior year quarter as a result of a 46.6% decrease in Dexatrim, resulting from increased competitive pressures in the category and the decline in sales of Dexatrim Max20.

Net sales in the other OTC and toiletry products category increased 25.8% for the first quarter of fiscal 2008 compared to the prior year quarter due primarily to the timing of shipments of Bullfrog.

Domestic sales variances were principally the result of changes in unit sales volumes with the exception of certain selected products for which we implemented a unit sales price increase.

International Revenues

For the first quarter of fiscal 2008, international revenues increased $3.3 million, or 52.4%, compared to the first quarter of fiscal 2007, primarily due to increased sales in the Latin American market and the impact of the brands acquired in the J&J Acquisition on January 2, 2007 and the ACT Acquisition in the second quarter of fiscal 2007.

Cost of Sales

Cost of sales in the first quarter of fiscal 2008 was $34.7 million, a 12.1% increase over the same period of fiscal 2007, or 28.8% as a percentage of total revenues for the first quarter of fiscal 2008 as compared to 30.7% in the prior year quarter.  Gross margin for the first quarter of fiscal 2008 was 71.2% compared to 69.3% in the prior year quarter.  The increase in gross margin was largely attributable to the integration of manufacturing of certain of the acquired brands from the J&J Acquisition in the fourth quarter of fiscal 2007.

Advertising and Promotion Expense

Advertising and promotion expenses in the first quarter of fiscal 2008 increased $5.7 million, or 19.8%, as compared to the same quarter of fiscal 2007 and were 28.6% of total revenues in the first quarter of fiscal 2008 compared to 28.5% for the prior year quarter.  The increase in expense results from an increased planned media spend in fiscal 2008 and ownership of the brands acquired in the J&J Acquisition for the three-month period of the first quarter of fiscal 2008 as compared to two months of  ownership in the first quarter of fiscal 2007.

Selling, General and Administrative Expense

Selling, general and administrative expenses increased $2.9 million, or 22.9%, compared to the prior year quarter.  Selling, general and administrative expenses were 12.8% and 12.3% of total revenues for the first quarter of fiscal 2008 and 2007, respectively.  The $2.9 million increase in expense is largely attributable to the increased freight costs associated with higher revenues.  In the first quarter of fiscal 2008, we absorbed certain transition service costs paid to Johnson & Johnson related to freight and administrative costs that were recorded as acquisition expenses in the first quarter of fiscal 2007.

Product Recall Expenses

The $6.0 million of product recall expenses in the first quarter of fiscal 2008 related to the voluntary recall of our Icy Hot Heat Therapy product initiated in February 2008.  Based in part on consideration of on-hand inventory and retail point of sales

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data, the $6.0 million of product recall expenses relate to product returns, inventory obsolescence, destruction costs, consumer refunds, legal fees and other estimated expenses.

Acquisition Expenses

Acquisition expenses of $1.2 million for the first quarter of fiscal 2007 reflect amounts paid to Johnson & Johnson for transition services, including consumer affairs, distribution and collection services, in connection with the J&J Acquisition.  The distribution and collection services were terminated in April 2007 and the consumer affairs services were terminated in June 2007.

Interest Expense

Interest expense decreased $0.7 million, or 9.5%, in the first quarter of fiscal 2008 as compared to the prior year quarter, reflecting payments made to reduce debt since the first quarter of fiscal 2007.  Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our total revenues.

Loss on Early Extinguishment of Debt

In January 2008, we utilized borrowings under the revolving credit facility portion of our Credit Facility to repay $35.0 million of the term loan under the Credit Facility.  In connection with the term loan repayment, we retired a proportional share of the term loan debt issuance costs and recorded the resulting loss on extinguishment of debt of $0.5 million.

Liquidity and Capital Resources

We have historically financed our operations with a combination of internally generated funds and borrowings.  Our principal uses of cash are for operating expenses, servicing long-term debt, acquisitions, working capital, repurchases of our common stock, payment of income taxes and capital expenditures.

Cash of $10.2 million and $9.9 million was provided by operations in the first quarter of fiscal 2008 and fiscal 2007, respectively.  The increase in cash flows from operations in the first quarter of fiscal 2008 as compared to the same prior year period was primarily attributable to the reduction in the change in accounts receivable offset by a reduction in the change in accounts payable and accrued liabilities.

Investing activities used cash of $2.9 million and $412.4 million in the first quarter of fiscal 2008 and fiscal 2007, respectively.  The reduction in cash used for investing activities in the first quarter of fiscal 2008 relates to the lack of an acquisition similar to the J&J Acquisition in the prior year period.

Financing activities used cash of $11.1 million and provided cash of $327.7 million in the first quarter of fiscal 2008 and 2007, respectively.  The decrease in cash provided was primarily attributable to repayment of debt in the current year period compared to the borrowings under the term loan portion and revolving credit facility of the Credit Facility in the prior year period which were used to fund the J&J Acquisition.

Based upon the closing price of our common stock for the prescribed measurement period during the three months ended February 29, 2008, the contingent conversion threshold of our 2.0% Convertible Notes was exceeded.  As a result, the 2.0% Convertible Notes are convertible at the option of the holder as of February 29, 2008 and, accordingly, have been classified as a current liability in our accompanying consolidated balance sheet as of February 29, 2008.  If holders elect to convert, we would be required to settle the principal amount of the notes in cash and the conversion premium in cash or shares of our common stock.  We would fund the repayment with existing cash and cash equivalents and additional borrowings.

We believe that cash provided by operating activities, our cash and cash equivalents balance and funds available under our Credit Facility will be sufficient to fund our capital expenditures, debt service and working capital requirements for the foreseeable future as our business is currently conducted.  It is likely that any acquisitions we make in the future will require us to obtain additional financing.  If additional financing is required, there are no assurances that it will be available, or, if available, that it can be obtained on terms favorable to us or not dilutive to our shareholders.

As of February 29, 2008, we had $55.8 million of borrowings outstanding under our $100.0 million revolving credit facility portion of our Credit Facility.

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Foreign Operations

Historically, our primary foreign operations have been conducted through our Canadian and United Kingdom (“U.K.”) subsidiaries.  Effective November 1, 2004, we transitioned our European business to Chattem Global Consumer Products Limited, a wholly-owned subsidiary located in Limerick, Ireland.  The functional currencies of these subsidiaries are Canadian dollars and Euros, respectively.  Fluctuations in exchange rates can impact operating results, including total revenues and expenses, when translations of the subsidiary financial statements are made in accordance with SFAS No. 52, “Foreign Currency Translation”.  For the three months ended February 29, 2008 and February 28, 2007, these subsidiaries accounted for 5% and 5% of total revenues, respectively, and 2% and 2% of total assets, respectively.  It has not been our practice to hedge our assets and liabilities in Canada, the U.K. and Ireland or our intercompany transactions due to the inherent risks associated with foreign currency hedging transactions and the timing of payments between us and our foreign subsidiaries.    Historically, gains or losses from foreign currency transactions have not had a material impact on our operating results.  Losses resulting from foreign currency transactions are insignificant for the three months ended February 29, 2008 and February 28, 2007 and are included in selling, general and administrative expenses in the unaudited Consolidated Statements of Income.

Recent Accounting Pronouncements

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“SFAS 109”). FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition.  Additionally, in May 2007, the FASB published FASB Staff Position (“FSP”) No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (“FSP FIN 48-1”).  FSP FIN 48-1 is an amendment to FIN 48.  It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits.  The provisions of FIN 48 and FSP FIN 48-1 are effective for fiscal years beginning after December 15, 2006.  We adopted the provisions of FIN 48 and FSP FIN 48-1 at the beginning of the first quarter of fiscal 2008.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 provides guidance for using fair value to measure assets and liabilities.  SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances.  SFAS 157 also requires expanded disclosure of the effect on earnings for items measured using unobservable data, establishes a fair value hierarchy that prioritizes the information used to develop those assumptions and requires separate disclosure by level within the fair value hierarchy.  We adopted SFAS 157 effective December 1, 2007.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 permits entities to choose to measure certain financial assets and liabilities at fair value.  Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. We adopted SFAS 159 effective December 1, 2007 without choosing to elect to measure certain financial assets or liabilities at fair value that were not previously measured at fair value.  Thus there was no impact to our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”).  SFAS 141R provides guidance to improve the relevance, representational faithfulness and comparability of the information that a reporting entity provides in its financial reports about its business combinations and its effects.  SFAS 141R establishes principles and requirements for how the acquirer recognizes and measures in its financial statements the identifiable assets acquired, liabilities assumed, the intangible assets acquired and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination.  The provisions of SFAS 141R are effective for fiscal years beginning after December 15, 2008, with earlier application prohibited.  Accordingly, we will apply the provisions of SFAS 141R prospectively to business combinations consummated beginning in the first quarter of fiscal 2010.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”).  SFAS 161 requires enhanced disclosures about derivative and hedging activities.  SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged, and we are currently evaluating the impact.

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Forward Looking Statements

We may from time to time make written and oral forward-looking statements. Forward-looking statements may appear in writing in documents filed with the Securities and Exchange Commission, in press releases and in reports to shareholders or be made orally in publicly accessible conferences or conference calls. The Private Securities Litigation Reform Act of 1995 contains a safe harbor for forward-looking statements. We rely on this safe harbor in making such disclosures. These forward-looking statements generally can be identified by use of phrases such as “believe,” “plan,” “expect,” “anticipate,” “intend,” “forecast” or other similar words or phrases.  These forward-looking statements relate to, among other things, our strategic and business initiatives and plans for growth or operating changes; our financial condition and results of operation; future events, developments or performance; and management’s expectations, beliefs, plans, estimates and projections.  The forward-looking statements are based on management’s current beliefs and assumptions about expectations, estimates, strategies and projections. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. We undertake no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Factors that could cause our actual results to differ materially from those anticipated in the forward-looking statements in this Form 10-Q and the documents incorporated herein by reference include the following:

• we face significant competition in the OTC healthcare, toiletries and dietary supplements markets;

• our acquisition strategy is subject to risk and may not be successful;

• our initiation of a voluntary recall of our Icy Hot Heat Therapy products could expose us to product liability claims;

• we rely on a few large customers, particularly Wal-Mart Stores, Inc., for a significant portion of our sales;

• litigation may adversely affect our business, financial condition and results of operations;

• we have a significant amount of debt that could adversely affect our business and growth prospects;

• our product liability insurance coverage may be insufficient to cover existing or future liability claims;

• our business is regulated by numerous federal, state and foreign governmental authorities, which subjects us to elevated compliance costs and risks of non-compliance;

• our success depends on our ability to anticipate and respond in a timely manner to changing consumer preferences;

• we may be adversely affected by fluctuations in buying decisions of mass merchandise, drug and food trade buyers and the trend toward retail trade consolidation;

• we rely on third party manufacturers for a portion of our product portfolio, including products under our Gold Bond, Icy Hot, Selsun, Dexatrim, ACT, Unisom and Kaopectate brands;

• our dietary supplement business could suffer as a result of injuries caused by dietary supplements in general, unfavorable scientific studies or negative press;

• our business could be adversely affected if we are unable to successfully protect our intellectual property;

• because most of our operations are located in Chattanooga, Tennessee, we are subject to regional and local risks;

• we depend on sole or limited source suppliers for ingredients in certain of our products, and our inability to buy these ingredients would prevent us from manufacturing these products;

• we are subject to the risk of doing business internationally;

• the terms of our outstanding debt obligations limit certain of our activities;

• to service our indebtedness, we will require a significant amount of cash;

• our operations are subject to significant environmental laws and regulations;

• we are dependent on certain key executives, the loss of whom could have a material adverse effect on our business;

• our shareholder rights plan and restated charter contain provisions that may delay or prevent a merger, tender offer or other change of control of us;

• the trading price of our common stock may be volatile;

• we have no current intentions of paying dividends to holders of our common stock;

• we can be affected adversely and unexpectedly by the implementation of new, or changes in the interpretation of existing, accounting principles generally accepted in the United States of America (“GAAP”);

• identification of material weakness in internal controls over financial reporting may adversely affect our financial results;

• the convertible note hedge and warrant transactions may affect the value of our common stock and our convertible notes;

• conversion of our convertible notes may dilute the ownership interest of existing shareholders, including holders who had previously converted their convertible notes;

• virtually all of our assets consists of intangibles; and

• other risks described in our Securities and Exchange Commission filings.

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Item 3.   Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk from changes in interest rates and foreign currency exchange rates, which may adversely affect our results of operations and financial condition.  We seek to minimize the risks from these interest rates and foreign currency exchange rate fluctuations through our regular operating and financing activities.

Our exposure to interest rate risk currently relates to amounts outstanding under our Credit Facility.  Loans under the revolving credit facility portion of our Credit Facility bear interest at LIBOR plus applicable percentages of 0.875% to 1.50% or the higher of the federal funds rate plus 0.50% or the prime rate (the “Base Rate”).  The applicable percentages are calculated based on our leverage ratio.  The term loan under our Credit Facility bears interest at either LIBOR plus 1.75% or the Base Rate plus 0.75%.  As of February 29, 2008, $55.8 million was outstanding under the revolving credit facility and $109.8 million was outstanding under the term loan portion of our Credit Facility.  The variable rate for the revolving credit facility was LIBOR plus 1.50%, or 5.70% as of February 29, 2008, and the variable rate for the term loan portion was LIBOR plus 1.75%, or 6.13%, as of February 29, 2008.  The 7.0% Subordinated Notes, the 1.625% Convertible Notes and the 2.0% Convertible Notes are fixed interest rate obligations.

In November 2006, we entered into an interest rate swap (“swap”) agreement effective January 2007.  The swap has decreasing notional principal amounts beginning in October 2007 and a swap rate of 4.98% over the life of the agreement.  As of February 29, 2008, the decrease in fair value of $1.6 million, net of tax, was recorded to other comprehensive income and the swap was deemed to be an effective cash flow hedge.  The swap agreement terminates in January 2010.

In April 2007, we entered into an interest rate cap (“cap”) agreement.  The cap has decreasing notional principal amounts beginning in May 2007 and a rate of 5.0% over the life of the agreement.  As of February 29, 2008, the value of the cap, as valued by a third party, is insignificant.  The cap agreement terminates in September 2008.

The impact on our results of operations of a one-point rate change on the April 1, 2008 outstanding revolving credit facility balance of $50.3 million and $109.0 million term loan balance of our Credit Facility for the next twelve months would be approximately $1.0 million, net of tax.

We are subject to risk from changes in the foreign exchange rates relating to our Canadian, U.K., Irish and Greek subsidiaries. Assets and liabilities of these subsidiaries are translated to U.S. dollars at year-end exchange rates. Income and expense items are translated at average rates of exchange prevailing during the year.  Translation adjustments are accumulated as a separate component of shareholders' equity. Gains and losses, which result from foreign currency transactions, are included as a component of investment and other income in the accompanying consolidated statements of income.  The potential loss resulting from a hypothetical 10.0% adverse change in the quoted foreign currency exchange rate amounts to approximately $1.2 million as of February 29, 2008.

This market risk discussion contains forward-looking statements.  Actual results may differ materially from this discussion based upon general market conditions and changes in financial markets.

Item 4.   Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of February 29, 2008 (the “Evaluation Date”).  Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective in alerting them on a timely basis to material information relating to us (including our consolidated subsidiaries) required to be included in our reports filed or submitted under the Exchange Act.

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PART II.  OTHER INFORMATION

Item 1.   Legal Proceedings

See Note 19 of Notes to Consolidated Financial Statements included in Part 1, Item 1 of this Report.

Item 1A.  Risk Factors

There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended November 30, 2007, other than the addition of the following risk factor.

Our initiation of a voluntary recall of our Icy Hot Heat Therapy products could expose us to additional product liability claims.

On February 8, 2008, we initiated a voluntary nationwide recall of our Icy Hot Heat Therapy products.  The recall is being conducted to the consumer level.  We recalled these products because we received some consumer reports of first, second and third degree burns, as well as skin irritation resulting from consumer use or possible misuse of the products.  We may receive lawsuits in the future alleging skin irritation and/or burns from use of our Heat Therapy products.  See our current Report on Form 8-K, filed on February 14, 2008, for additional information.

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds

A summary of the common stock repurchase activity for our first quarter of fiscal 2008 is as follows:

Period	Total Number of Shares Purchased		Average Price Paid Per Share (1)		Total Number of Shares Purchased as Part of Publicly Announced Plans or  Programs (2)		Approximate Dollar Value that may yet be Purchased under the Plans or  Programs (2)
December 1 – December 31		—	$	—		—		64,546,467
January 1 – January 31		3,700		64.93		3,700		64,306,212
February 1 – February 29		—		—		—		64,306,212
Total First Quarter		3,700	$	64.93		3,700		64,306,212

(1)   Average price paid per share includes broker commissions.

(2)   Effective November 29, 2005 our board of directors increased the total authorization to repurchase our common stock under our stock repurchase program to $30.0 million.  On June 26, 2006, our board of directors authorized the repurchase of up to an additional $100.0 million of our common stock under our existing stock repurchase program. There is no expiration date specified for our stock repurchase program.

Item 3.   Defaults Upon Senior Securities

None.

Item 4.   Submission of Matters to a Vote of Security Holders

None.

Item 5.   Other Information

None.

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Item 6.   Exhibits

Exhibits (numbered in accordance with Item 601 of Regulation S-K):

Exhibit Number	Description
31.1	Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934
31.2	Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934
32	Certification required by Rule 13a-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350

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CHATTEM, INC.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	CHATTEM, INC.
	(Registrant)
Dated:     April 8, 2008	By:	/s/ Zan Guerry
		Zan Guerry
		Chairman and Chief Executive Officer

Dated:     April 8, 2008	By:	/s/ Robert B. Long
		Robert B. Long
		Vice President, Finance
		(Principal Financial Officer)

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Chattem, Inc. and Subsidiaries

Exhibit Index

Exhibit Number	Description of Exhibit
31.1	Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934
31.2	Certification required by Rule 13a-14(a) under the Securities Exchange Act of 1934
32	Certification required by Rule 13a-14(b) under the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350

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