Zila (ZILA) 10-Q 2007 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

Form 10-Q

(Mark one)

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

For the quarterly period ended April 30, 2007

OR

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

For the transition period from            to

Commission File Number 0-17521

ZILA, INC.

(Exact Name of Registrant as Specified in its Charter)

Delaware	86-0619668
(State or Other Jurisdiction of	(I.R.S. Employer
Incorporation)	Identification No.)

5227 North 7th Street, Phoenix, Arizona 85014-2800
(Address of Principal Executive Offices and Zip Code)
(602) 266-6700
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.
Yesþ      Noo

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

Large accelerated filero       Accelerated filerþ      Non-accelerated filero

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso      Noþ

As of May 31, 2007, 62,329,083 of common stock were outstanding.

ZILA, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED APRIL 30, 2007
TABLE OF CONTENTS

	Page
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets as of April 30, 2007 and July 31, 2006		3
Consolidated Statements of Operations for the three and nine month periods ended April 30, 2007 and 2006		4
Consolidated Statements of Cash Flows for the nine month periods ended April 30, 2007 and 2006		5
Consolidated Statements of Shareholders’ Equity for the nine month periods ended April 30, 2007 and 2006		6
Notes to Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3. Quantitative and Qualitative Disclosures about Market Risk		31
Item 4. Controls and Procedures		31
Part II. OTHER INFORMATION
Item 1. Legal Proceedings		32
Item 1A. Risk Factors		33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		38
Item 3. Defaults upon Senior Securities		39
Item 4. Submission of Matters to a Vote of Security Holders		39
Item 5. Other Information		39
Item 6. Exhibits		39
SIGNATURES		41
EX-10.2
EX-10.3
EX-10.5
EX-31.1
EX-31.2
EX-32.1
EX-32.2

2

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited).

ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

Unaudited

	April 30,			July 31,
	2007			2006
ASSETS
Current Assets:
Cash and cash equivalents	$	9,652,256		$	3,958,190
Trade receivables — net of allowances of $130,000 and $9,000		4,078,218			254,786
Inventories — net		3,964,477			1,845,773
Prepaid expenses and other current assets		2,429,767			1,513,462
Current assets of discontinued operations		972,496			15,397,949
Total current assets		21,097,214			22,970,160
Property and equipment — net		6,100,348			1,684,017
Purchased technology — net		10,139,902			2,552,937
Goodwill — net		10,169,969			—
Trademarks and other intangible assets — net		12,238,752			3,842,448
Other assets		1,392,122			2,721,885
Long-term assets of discontinued operations		4,065,690			22,592,498
Total Assets	$	65,203,997		$	56,363,945
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	3,026,680		$	2,088,479
Accrued liabilities		5,029,797			1,791,906
Warrant liability		—			2,369,965
Short-term borrowings		91,698			30,347
Current portion of deferred gain on sale leaseback		152,976			152,976
Current portion of long-term debt and capital lease obligations		77,800			18,067,681
Current liabilities of discontinued operations		421,681			5,322,862
Total current liabilities		8,800,632			29,824,216
Deferred gain on sale leaseback		113,903			228,635
Long-term debt and capital lease obligations — net of current portion		6,701,128			527,874
Long-term liabilities of discontinued operations		—			2,532,137
Total liabilities		15,615,663			33,112,862
Commitments and contingencies (Note 12)
Shareholders’ equity:
Preferred stock — Series B, $.001 par value - 2,500,000 shares authorized, 100,000 shares issued and outstanding, liquidation preference of $650,000		462,500			462,500
Common stock, $.001 par value – 147,500,000 and 65,000,000 shares authorized; 62,329,083 shares and 46,007,593 shares issued and outstanding		62,329			46,008
Capital in excess of par value		123,331,380			85,305,331
Accumulated other comprehensive loss		(119,282	)		(82,678	)
Accumulated deficit		(73,597,522	)		(61,929,007	)
Common stock in treasury, at cost (218,411 shares)		(551,071	)		(551,071	)
Total shareholders’ equity		49,588,334			23,251,083
Total Liabilities and Shareholders’ Equity	$	65,203,997		$	56,363,945

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

3

ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

Unaudited

	Three months ended April 30,						Nine months ended April 30,
	2007			2006			2007			2006
Net revenues	$	10,749,840		$	1,217,797		$	18,146,762		$	2,700,672
Cost of products sold		4,230,900			709,777			7,757,354			1,566,239
Gross profit		6,518,940			508,020			10,389,408			1,134,433
Operating costs and expenses:
Marketing and selling		4,325,998			1,781,784			9,247,708			4,088,107
General and administrative		2,682,130			2,650,452			9,566,765			7,599,896
Research and development		2,388,298			2,451,936			5,740,536			5,738,801
Depreciation and amortization		909,085			369,294			1,997,486			1,025,114
		10,305,511			7,253,466			26,552,495			18,451,918
Loss from operations		(3,786,571	)		(6,745,446	)		(16,163,087	)		(17,317,485	)
Other income (expense):
Interest income		120,067			63,550			396,693			201,552
Interest expense		(877,636	)		(622,149	)		(6,479,659	)		(640,445	)
Derivative income (expense)		—			(97,526	)		1,058,873			(97,526	)
Other expense		(47,412	)		(247,041	)		(29,150	)		(315,098	)
		(804,981	)		(903,166	)		(5,053,243	)		(851,517	)
Loss from continuing operations before income taxes		(4,591,552	)		(7,648,612	)		(21,216,330	)		(18,169,002	)
Income tax (expense) benefit		190,809			—			4,000,948			(3,600	)
Loss from continuing operations		(4,400,743	)		(7,648,612	)		(17,215,382	)		(18,172,602	)
Gain (loss) from disposal of operations		(19,741	)		(1,625	)		10,973,697			(5,727	)
Income (loss) from operations of discontinued operations		303,257			(424,621	)		(407,620	)		(2,144,500	)
Income tax expense		(190,809	)		—			(4,067,809	)		—
Income (loss) from discontinued operations		92,707			(426,246	)		6,498,268			(2,150,227	)
Net loss		(4,308,036	)		(8,074,858	)		(10,717,114	)		(20,322,829	)
Preferred stock dividends		9,750			9,750			29,250			29,250
Net loss attributable to common shareholders	$	(4,317,786	)	$	(8,084,608	)	$	(10,746,364	)	$	(20,352,079	)
Basic and diluted net income (loss) per common share:
Loss from continuing operations	$	(0.07	)	$	(0.17	)	$	(0.32	)	$	(0.40	)
Income (loss) from discontinued operations		0.00			(0.01	)		0.12			(0.05	)
Net loss attributable to common shareholders	$	(0.07	)	$	(0.18	)	$	(0.20	)	$	(0.45	)
Weighted average shares outstanding		62,117,309			45,734,371			54,411,050			45,683,925

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

4

ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

	Nine months ended April 30,
	2007			2006
Operating activities:
Net loss	$	(10,717,114	)	$	(20,322,829	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		2,344,741			2,216,775
Amortization of deferred financing costs		2,378,592			203,604
Amortization of debt discounts		3,046,165			114,064
Non-cash interest on term loan		201,940			76,759
Gain from sale of discontinued operations		(10,972,694	)		—
Non-cash derivative (income) expense		(1,058,873	)		97,526
Non-cash stock-based employee compensation expense		1,424,598			329,041
Non-cash charge for options issued to outside parties		29,141			63,064
Other non-cash items — net		(35,758	)		(282,256	)
Change in assets and liabilities:
Receivables — net		225,490			3,863,702
Inventories		20,789			(1,844,551	)
Prepaid expenses and other assets		844,896			(386,452	)
Accounts payable and accrued liabilities		2,494,993			(521,919	)
Net cash used in operating activities		(9,773,094	)		(16,393,472	)
Investing activities:
Additions to property and equipment		(440,780	)		(942,982	)
Additions to intangible assets		(463,959	)		(956,387	)
Restricted cash returned from (deposited to) collaterized letter of credit		3,610,950			(3,072,023	)
Net proceeds from disposition of discontinued operations		34,705,077			—
Acquisition of business		(35,554,421	)		—
Proceeds from disposition of assets		—			8,463
Net cash provided by (used in) investing activities		1,856,867			(4,962,929	)
Financing activities:
Short-term borrowings (repayments), net		61,351			(62,860	)
Financing costs		(2,528,004	)		(2,273,192	)
Proceeds from issuance of common stock		15,971,481			216,479
Proceeds from convertible notes payable		24,075,000			—
Proceeds from long-term borrowings		—			20,000,000
Dividends paid to preferred stockholders		(29,250	)		(29,250	)
Principal payments on long-term debt		(23,940,285	)		(258,366	)
Net cash provided by financing activities		13,610,293			17,592,811
Net increase (decrease) in cash and cash equivalents		5,694,066			(3,763,590	)
Cash and cash equivalents at beginning of period		3,958,190			12,937,517
Cash and cash equivalents at end of period	$	9,652,256		$	9,173,927

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

5

ZILA, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Unaudited)

																	Accumulated
					Common Stock				Capital in								Other			Total
	Preferred Stock						Par		Excess of		Accumulated			Treasury			Comprehensive			Shareholders’
	Shares		Amount		Shares		Value		Par Value		Deficit			Stock			Income (Loss)			Equity
Nine months Ended April 30, 2006
BALANCE AT JULY 31, 2005		100,000	$	462,500		45,864,050	$	45,864	$	84,372,257	$	(32,543,676	)	$	(551,071	)	$	(63,924	)	$	51,721,950
Dividends on preferred stock												(29,250	)								(29,250	)
Issuance of common stock under employee stock purchase plan						18,557		19		52,312											52,331
Exercise of common stock options and warrants						82,395		82		171,859											171,941
Stock-based compensation expense										321,247											321,247
Options for services										63,064											63,064
Foreign currency translation																		(10,789	)		(10,789	)
Net loss												(20,322,829	)								(20,322,829	)
BALANCE AT APRIL 30, 2006		100,000	$	462,500		45,965,002	$	45,965	$	84,980,740	$	(52,895,755	)	$	(551,071	)	$	(74,713	)	$	31,967,666
Nine months Ended April 30, 2007
BALANCE AT JULY 31, 2006		100,000	$	462,500		46,007,593	$	46,008	$	85,305,331	$	(61,929,007	)	$	(551,071	)	$	(82,678	)	$	23,251,083
Cumulative-effect adjustment of adopting FSP No. EITF 00-19-2										2,460,489		(922,151	)								1,538,338
Dividends on preferred stock												(29,250	)								(29,250	)
Issuance of common stock						9,100,000		9,100		7,674,815											7,683,915
Issuance of stock purchase warrants										16,888,348											16,888,348
Conversion of unsecured debt						6,900,000		6,900		4,445,448											4,452,348
Beneficial conversion feature of secured debt										4,397,050											4,397,050
Issuance of shares in settlement of liability						289,728		290		659,710											660,000
Issuance of common stock under employee stock purchase plan						1,762		1		4,474											4,475
Exercise of common stock options and warrants						30,000		30		42,645											42,675
Stock-based compensation expense										1,423,929											1,423,929
Options for services										29,141											29,141
Foreign currency translation																		(36,604	)		(36,604	)
Net loss												(10,717,114	)								(10,717,114	)
BALANCE AT APRIL 30, 2007		100,000	$	462,500		62,329,083	$	62,329	$	123,331,380	$	(73,597,522	)	$	(551,071	)	$	(119,282	)	$	49,588,334

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

6

ZILA, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

1. Description of Business

     Zila, Inc., a Delaware corporation, and its subsidiaries (“Zila”), is a cancer screening company focused on oral cancer.

     Following the sale of our Nutraceuticals Business Unit on October 2, 2006 and our Peridex^® brand of prescription periodontal rinse on May 31, 2007 (see Note 4) and the acquisition of Professional Dental Technologies, Inc. (“Pro-Dentec”) on November 28, 2006 (see Note 3), we manufacture and market ViziLite^® Plus oral lesion identification kits and Soft Tissue Management (“STM^®”) products, including medical devices such as the Rota-dent^® Professional Powered Brush with MicroAccess Flossing Action and the Pro-Select3^® Piezo-Ultrasonic Scaler System, as well as a suite of pharmaceutical STM^® products for both in-office and home-care use. Our research and development division specializes in pre-cancer/cancer detection through our patented Zila Tolonium Chloride (“ZTC™”) and OraTest^® technologies and is pursuing regulatory approval for the OraTest^® product as an oral cancer diagnostic system.

     Pro-Dentec focuses on STM^® oral care products that it sells directly to dental offices through its dedicated national sales force. Its national marketing program reaches most of the nation’s dental offices and includes continuing education seminars each year that dentists and their staffs pay to attend. These seminars, which are certified by the American Dental Association and the Academy of General Dentistry, are ideally suited to educate a large number of dental professionals on the importance of oral cancer screening. We believe that this acquisition completes our transition into a cancer screening company focused on oral cancer. Leveraging Pro-Dentec’s national sales force and its continuing education seminar series will provide us an opportunity to more fully realize the large market potential of ViziLite^® Plus and potential future oral cancer detection products. Additionally, with the integration of the operations of Pro-Dentec with our former Zila Pharmaceuticals Business Unit and the re-alignment of our Zila Biotechnology Business Unit to serve as our research and development division, we have organized ourselves as one operating segment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS No. 131”).

2. Summary of Significant Accounting Policies

Basis of Presentation and Continuance of Operations

     The accompanying consolidated financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information on a going concern basis, which assumes that the Company will be able to meet its obligations and continue its operations for its next twelve months. Such financial statements do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for annual financial statements. We believe that the accompanying consolidated financial statements reflect all adjustments (which are of a normal recurring nature) that are necessary for a fair presentation of the interim results of operation, financial position and cash flows. The results reported in these interim condensed consolidated financial statements should not be regarded as being necessarily indicative of results that might be expected for the full year.

     The accompanying unaudited quarterly financial statements represent the consolidation of Zila, Inc. and its wholly-owned subsidiaries, Zila Pharmaceuticals, Inc., Zila Biotechnology, Inc., Zila Technical, Inc., Zila Limited, Professional Dental Technologies, Inc. and Ryker Dental of Kentucky, Inc. (inactive). This information should be read in conjunction with the financial statements set forth in the Zila, Inc. Annual Report on Form 10-K for the fiscal year ended July 31, 2006 and our Current Report on Form 8-K filed on December 28, 2006. All significant intercompany balances and transactions have been eliminated in consolidation.

     Based on our currently available funds, we will be required to pursue one or more of the following strategies: (i) delay, scale back or eliminate some or all of our research and product development programs including, but not limited to, OraTest^®; (ii) limit the marketing of our products; (iii) license to third parties the rights to commercialize products or technologies that we would otherwise seek to develop and market ourselves; and/or (iv) raise additional funds. There can be no assurance that we will be successful in executing these strategies. If we are unable to execute these strategies, we may breach the financial covenants of our senior secured debt and be unable to repay the outstanding balance. These factors raise substantial doubt about our ability to continue as a going concern. As a result, realization values may be substantially different from carrying values as shown and these financial statements do not give effect to adjustments that would be necessary to the carrying values and classification of assets and liabilities should we be unable to continue as a going concern.

7

Computation of Net Income per Share

     Basic net income per share is computed using the weighted-average number of common shares outstanding during the period and after preferred stock dividends. The weighted-average number of common shares outstanding during the period included restricted shares and restricted share units that are vested but not yet issued. Diluted net income per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period.

     SFAS No. 128, “Earnings per Share,” requires that our grants of employee equity share options, nonvested shares, and similar equity instruments be treated as potential common shares outstanding in computing diluted earnings per share. Dilutive common shares give effect to securities, such as stock options, warrants, and convertible securities which have the potential to be exercised.

     Dilutive shares outstanding includes the dilutive effect of in-the-money options, which is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that we have not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. Diluted net income per share also assumes that any dilutive convertible debt outstanding at the beginning of the period was converted at that date with related interest and weighted-average common shares adjusted accordingly.

     Since we incurred a loss from continuing operations for the three and nine month periods ended April 30, 2007 and 2006, potentially dilutive shares applicable to convertible preferred stock, senior secured convertible notes, options, and warrants to purchase shares of common stock were not included in the computation of diluted net loss per common share because their effect would be antidilutive. Potentially dilutive common shares for both the three month and nine month periods ended April 30, 2007 were 5,746,000 and 3,253,000, respectively, and for the three month and nine month periods ended April 30, 2006 were 483,000 and 509,000, respectively.

Reclassifications

     For comparative purposes, prior year amounts related to discontinued operations described in Note 4 and certain immaterial amounts were reclassified to conform to current year presentation. As described in Note 4, we divested our Nutraceuticals Business Unit, and on May 31, 2007, we divested our Peridex^® product line. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), we presented the financial position as of July 31, 2006, and results of operation of our Nutraceuticals Business Unit and the Peridex product line for all periods presented as discontinued operations.

Business Concentration

     We extend credit on a non-collateralized basis primarily to dental practices and wholesale distributors in the United States and Canada. We perform periodic credit evaluations of our customers’ financial condition in our decision to provide credit terms. We estimate the level of accounts receivable which will ultimately not be paid. Historically, we have not experienced significant credit losses.

     Our cash and cash equivalents are maintained with financial institutions with high credit standings. However, our balances at these financial institutions exceed federally insured limits.

     Raw materials essential to our business are generally readily available. However, certain raw materials and components used in the manufacture of pharmaceutical and medical device products are available from limited sources, and in some cases, a single source. Any curtailment in the availability of such raw materials could be accompanied by production delays and, in the case of products for which only one raw material supplier exists, could result in a material loss of sales. In addition, because raw material sources for our products must generally be approved by regulatory authorities, changes in raw material suppliers could result in production delays, higher raw material costs and loss of sales and customers. Production delays may also be caused by the lack of secondary suppliers.

Recent Accounting Pronouncements

     In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 159”). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain items at fair value. The objective of this standard is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reporting earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. Entities will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (i) may be applied instrument by instrument, with a few exceptions, such as investments accounted for by the equity method; (ii) is irrevocable (unless a new election date occurs); and (iii) is applied only to entire instruments and not to portions

8

of instruments. SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, which for us would be our fiscal year beginning August 1, 2008. We are currently evaluating whether to adopt SFAS No. 159.

     In December 2006, the FASB issued FSP EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“EITF 00-19-2”), which addresses accounting for registration payment arrangements. EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “Accounting for Contingencies.” EITF 00-19-2 further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable generally accepted accounting principles without regard to the contingent obligation to transfer consideration pursuant to the registration payment. EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to December 21, 2006. For registration payment arrangement and related financial instruments entered into prior to December 21, 2006, EITF 00-19-2 is effective for financial statements issued for fiscal years beginning after December 15, 2006 and interim periods within those financial years. Companies are required to report transition through a cumulative-effect adjustment to the opening balance of retained earnings as of the first interim period for the fiscal year in which EITF 00-19-2 is adopted. As more fully described in Note 8, we elected early adoption of EITF 00-19-2 for our interim period beginning November 1, 2006.

     In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value in accordance with generally accepted accounting principles, clarifies the definition of fair value within that framework, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, which for us would be our fiscal year beginning August 1, 2008. We are currently evaluating the impact that the adoption of SFAS No. 157 will have on our consolidated financial statements.

     In September 2006, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 108 (Topic 1N), “Considering the Effects of Prior Year Misstatement when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 requires SEC registrants (i) to quantify misstatements using a combined approach that considers both the balance-sheet and income-statement approaches, (ii) to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors, and (iii) to adjust their financial statements if the new combined approach results in a conclusion that an error is material. SAB No. 108 is effective for fiscal years ending after November 15, 2006, which for us would be our current fiscal year ending July 31, 2007. Historically, we have evaluated uncorrected differences by considering both the balance-sheet and income-statement approach; however, we are currently evaluating the impact, if any, of SAB No. 108 on our consolidated financial statements.

     In July 2006, the FASB issued FASB Interpretation (FIN) No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006, which for us would be our fiscal year beginning on August 1, 2007. The provisions of FIN 48 will be applied to all tax positions upon initial adoption of FIN 48. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We are currently evaluating the impact of FIN 48 to determine whether its adoption will have a material effect on our consolidated financial statements.

3. Acquisition

     On November 13, 2006, we entered into an agreement and plan of merger (the “Agreement”) with Zila Merger, Inc., a wholly-owned subsidiary of Zila, Inc. (“Merger Sub”), Pro-Dentec and certain of the stockholders of Pro-Dentec. Following approval by Pro-Dentec’s stockholders, Merger Sub merged with and into Pro-Dentec, with Pro-Dentec surviving as a wholly-owned subsidiary of Zila, Inc. The cash purchase price paid for Pro-Dentec was approximately $34,000,000 with each stockholder of Pro-Dentec entitled to receive $26,064.03 per share of common stock, less $1,037.90 per share of common stock, which was held back at closing for the payment of certain transaction expenses. To the extent that the aggregated amount of merger consideration withheld exceeds the amounts required to pay such transaction expenses, the excess will be distributed to the stockholders of Pro-Dentec on a pro rata basis.

     The goodwill amount recognized in the acquisition of Pro-Dentec results from the acquisition of an assembled workforce, including a management team, with a proven track record of success in marketing to dental offices through a national sales force and an established seminar program.

     The financial results of the Pro-Dentec acquired operations are included in these financial statements as of November 28, 2006, the date of acquisition. The preliminary estimated fair values of assets acquired and liabilities assumed at the acquisition date are as

9

follows (in thousands):

Assets acquired:
Current assets	$	6,688
Property, plant and equipment		4,518
Intangibles not subject to amortization:
Trademarks		5,449
Intangibles subject to amortization:
Purchased technology – proprietary know-how		8,173
Covenants not to compete		2,304
Customer lists and relationships		1,187
Other assets		2
Goodwill		10,170
Total assets acquired		38,491
Liabilities assumed		2,930
Net assets acquired	$	35,561

     The acquisition cost has been allocated to the acquired net assets based on preliminary evaluation of the estimated fair values of the date of acquisition and are subject to adjustment as additional information is obtained.

     Acquired intangible assets subject to amortization are expected to be amortized over 2 to 15 years and have a weighted average of approximately 11 years. The acquired trademarks were determined to have indefinite useful lives. Aggregate amortization expense associated with the intangibles set forth above recorded since the acquisition date was $475,000 and the estimated annual amortization expense for the remaining portion of the current fiscal year is $740,000. The estimated annual amortization expense for the next five fiscal years is $1,813,000, $1,032,000, $637,000, $628,000, and $619,000, respectively.

     The unaudited condensed pro forma consolidated statements of income for the three and nine month periods ended April 30, 2007 and 2006, assuming the acquisition of Pro-Dentec as of August 1, 2005 are as follows (in thousands):

	Three months ended						Nine months ended
	April 30,						April 30,
	2007			2006			2007			2006
Net revenues	$	10,750		$	10,243		$	29,574		$	29,095
Loss from continuing operations	$	(4,401	)	$	(7,847	)	$	(17,304	)	$	(17,786	)
Primary and diluted earnings per share from continuing operations	$	(0.07	)	$	(0.17	)	$	(0.39	)	$	(0.39	)

     Pro forma data may not be indicative of the results that would have been obtained had the acquisition occurred at the beginning of the periods presented, nor does it intend to be a projection of future results.

4. Dispositions

     As part of our strategy to focus our business operations on the development and commercialization of products with the highest growth potential, we divested Zila Nutraceuticals, Inc. and two components of our former Pharmaceuticals Business Unit. We presented the results of operations of the Nutraceuticals Business Unit and the components of the Pharmaceuticals Business Unit as discontinued operations, including the related gain on the sale, net of any applicable taxes, for all periods included in the accompanying consolidated statements of operations.

     Nutraceuticals Disposition— On August 13, 2006, we entered into a stock purchase agreement to sell Zila Nutraceuticals, Inc., our former Nutraceuticals Business Unit, to NBTY, Inc. Following approval of our shareholders, we completed the sale on October 2, 2006 for a price of $37,500,000, subject to a working capital adjustment. The transaction resulted in the receipt of $35,800,000 in cash, expenses of $1,400,000, and escrowed funds of $300,000. We are also entitled to receive up to an additional $3,000,000 in cash contingent upon the performance of the divested division during the one-year period after the closing. The sale resulted in a pre-tax gain of $11,000,000.

     Under the stock purchase agreement, we have agreed to indemnify NBTY, Inc. for a number of matters, including the breach of our

10

representations, warranties, and covenants contained in the stock purchase agreement, in some cases until the expiration of the statute of limitations applicable to claims related to such breaches.

     The results of the discontinued operations that were formerly reported as the Nutraceuticals Business Unit are as follows (in thousands):

	Three months ended						Nine months ended
	April 30,						April 30,
	2007			2006			2007			2006
Net revenues	$	—		$	3,612		$	1,629		$	18,266
Gain on disposition		3			—			11,025			—
Income (loss) from operations	$	(179	)	$	(774	)	$	(1,216	)	$	(2,676	)

     At July 31, 2006, the significant classes of assets and liabilities of the divested Nutraceuticals Business Unit presented as discontinued operations were as follows (in thousands):

Current assets :
Accounts receivable	$	2,633
Inventory		7,679
Restricted cash collateral		3,611
Other current assents		223
Total current assets		14,146
Property, plant and equipment		6,707
Goodwill		2,897
Patents, trademarks and other intangibles		8,675
Other assets		224
Total assets	$	32,649
Current liabilities	$	4,856
Bonds and capital lease obligations—long term		2,532
Total liabilities	$	7,388

     On September 28, 2006, we redeemed Industrial Development Revenue Bonds in the amount of $2,800,000 plus accrued interest. Funds in a restricted cash collateral account were utilized for this repayment. The balance of the restricted cash collateral was returned to Zila, Inc. Upon the retirement of the bonds, we recognized a loss of approximately $216,000 for the write-off of the unamortized deferred financing costs.

Pharmaceuticals Dispositions— On May 31, 2007 we sold the inventory and technology related to our Peridex^® brand of products for $9,500,000. Estimated expenses of the sale are $300,000. This transaction will have an estimated gain of $4,900,000, which will be reported at closing of the sale. As a result of this agreement, all assets and liabilities related to the Peridex^® brand have been reclassified to assets and liabilities of discontinued operations and all revenue and expenses are reclassified to Income (loss) from discontinued operations for all periods presented.

     On July 21, 2006, our subsidiary Zila Swab Technologies, Inc. sold substantially all of the assets and certain defined liabilities of its IST swab operations to Great Midwest Packaging, LLC, an Illinois limited liability company for approximately $642,000 in cash and retained liabilities of $95,000. The sale resulted in a pre-tax loss of $654,000.

     On June 27, 2005, our subsidiary, Zila Pharmaceuticals, Inc., sold substantially all of the assets of its Zilactin^® brand of over-the-counter lip and oral care products to Blairex Laboratories, Inc., an Indiana corporation (“Blairex”), for $10,300,000. As disclosed in Note 12, at October 31, 2006, we were engaged in an arbitration proceeding regarding this disposition, which was settled on November 3, 2006. The settlement required the payment of $650,000 to Blairex. The settlement cost was included as loss from discontinued operations for the period ended October 31, 2006.

     The results of the Pharmaceutical discontinued operations are as follows (in thousands):

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	Three months ended					Nine months ended
	April 30,					April 30,
	2007			2006		2007			2006
Net revenues, net of intercompany eliminations	$	1,114		$	1,920	$	3,540		$	5,046
Loss on disposition		(23	)		—		(51	)		—
Income (loss) from operations	$	483		$	348	$	808		$	526

5. Balance Sheet Information

     The following tables provide details of selected balance sheet items (in thousands):

	April 30,			July 31,
	2007			2006
Inventories
Finished goods	$	1,511		$	1,088
Work in process		471			281
Raw materials		2,281			533
Inventory reserves		(299	)		(56	)
Total inventories — net	$	3,964		$	1,846
Property, Plant and Equipment
Land	$	529		$	—
Building and improvements		2,525			—
Furniture and equipment		3,258			1,789
Leasehold improvements and other assets		1,184			2,533
Production and warehouse equipment		7,247			894
Total property and equipment		14,743			5,216
Less accumulated deprecation and amortization		(8,643	)		(3,532	)
Property and equipment — net	$	6,100		$	1,684
Accrued Liabilities
Accrued professional and consulting fees	$	3,148		$	1,201
Accrued employee compensation and related taxes		1,026			347
Other		856			244
Total accrued liabilities	$	5,030		$	1,792

6. Intangible Assets

     Intangible assets consist of the following (in thousands):

	April 30, 2007						July 31, 2006
	Gross				Net		Gross				Net
	Carrying		Accumulated		Carrying		Carrying		Accumulated		Carrying
	Amount		Amortization		Amount		Amount		Amortization		Amount
Amortizable intangibles:
Purchased technology rights	$	15,592	$	5,452	$	10,140	$	7,419	$	4,866	$	2,553
Trademarks and other intangibles:
Trademarks		128		10		118		104		7		97
Patents		2,820		375		2,445		2,483		209		2,274
Licensing costs		2,685		1,417		1,268		2,737		1,266		1,471
Other intangibles		3,492		533		2,959		—		—		—
Total trademarks and other intangible assets		9,125		2,335		6,790		5,324		1,482		3,842

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	April 30, 2007						July 31, 2006
	Gross				Net		Gross				Net
	Carrying		Accumulated		Carrying		Carrying		Accumulated		Carrying
	Amount		Amortization		Amount		Amount		Amortization		Amount
Total amortizable intangibles		24,717		7,787		16,930		12,743		6,348		6,395
Unamortizable intangible:
Trademarks		5,449		—		5,449		—		—		—
Goodwill		10,170		—		10,170		—		—		—
Total unamortizable intangibles		15,619		—		15,619		—		—		—
Total intangibles assets	$	40,336	$	7,787	$	32,549	$	12,743	$	6,348	$	6,395

     The change in the carrying amount of goodwill for the nine months ended April 30, 2007 resulted from the addition of $10,170,000 in goodwill from the acquisition of Pro-Dentec and the reclassification of $4,033,000 of Peridex^® goodwill to long-term assets of discontinued operations as a result of its disposition on May 31, 2007.

     Amortization of purchased technology rights, trademarks and other intangibles is calculated using the following useful lives (in years):

	Range of		Weighted average remaining useful lives
	Useful lives		April 30, 2007		July 31, 2006
Purchased technology rights		15		15		5.3
Trademarks		7-10		7.6		9.2
Patents		4-17		6.2		6.4
Licensing costs		7-10		4.4		5.4
Other		2-10		2.1		—

     Intangible asset amortization expense for the three month and nine month periods ended April 30, 2007 was $220,000 and $506,000, respectively, and for the three month and nine month periods ended April 30, 2006 was $196,000 and $392,000, respectively. For fiscal years 2008 through 2012, the amortization of intangibles is estimated to be $2,621,000 each year.

7. Debt

     Debt consisted of the following (in thousands):

	April 30,			July 31,
	2007			2006
Short-term borrowings:
Installment note payable on insurance policies	$	92		$	30
Current portion of long-term debt:
Secured term loan, net of discount	$	—		$	18,044
Capital lease obligations, current portion		78			24
Total current portion of long-term debt	$	78		$	18,068
Long-term debt:
6% Senior Secured Convertible Notes	$	12,000		$	—
Less — unamortized discount		(5,924	)		—
Secured term loan		—			19,884
Less — unamortized discount on term loan		—			(1,840	)
PharmaBio		500			500
Capital lease obligations		203			52
Total long-term debt		6,779			18,596
Less current portion		78			18,068
Long-term portion	$	6,701		$	528

     Short-term Borrowing— On April 30, 2007 and July 31, 2006, we had short-term borrowings for installments due on certain insurance policies with interest rates from 7.5% to 7.8%.

     Private Placement— On November 13, 2006, we entered into two separate purchase agreements that, in the aggregate, provided for

13

the sale of common stock, warrants and convertible notes for an aggregate gross purchase price of approximately $40,000,000 (collectively, the “Private Placement”). The Private Placement closed and funded on November 28 and 29, 2006. We used the net proceeds of the Private Placement to fund the Pro-Dentec acquisition described in Note 3 and for working capital and general corporate purposes.

     Pursuant to the first purchase agreement, we issued and sold:

a.	9,100,000 shares of our common stock for $1.75 per share (the “Shares”);
b.	$12,075,000 in aggregate principal amount of 12% Unsecured Convertible Notes, which converted into 6,900,000 shares of our common stock at a conversion price of $1.75 per share on December 14, 2006 following approval by our shareholders (the “Unsecured Notes”);
c.	Warrants to purchase approximately 5,403,000 shares of our common stock, which are exercisable starting in May 2007 for five years at an exercise price of $2.21 per share (the “Initial Warrants”); and
d.	Warrants to purchase approximately 3,105,000 shares of our common stock, which are exercisable for five years at an exercise price of $2.21 per share following approval by our shareholders on December 14, 2006 (the “Additional Warrants”).

     Pursuant to the second purchase agreement, we issued and sold:

a.	$12,000,000 in aggregate principal amount of 6% Senior Secured Convertible Notes (the “Secured Notes”), which became convertible into 5,454,546 shares of our common stock at a conversion price of $2.20 following approval by our shareholders on December 14, 2006; and
b.	Warrants to purchase approximately 1,909,091 shares of our common stock, which are exercisable for five years at an exercise price of $2.21 per share following approval by our shareholders on December 14, 2006 (the “Secured Note Warrants”).

     Roth Capital Partners, LLC (“Roth”) served as placement agent in the transaction and received warrants to acquire 1,218,701 shares of common stock at an exercise price of $2.21 per share (the “Roth Warrants”). Additionally, we paid Roth cash fees of $1,700,000 at the closing of the Private Placement and on February 20, 2007, after negotiation, we issued 289,728 shares of our common stock to Roth, as well as the Roth Warrants, in final settlement of the fees.

     The Additional Warrants and some of the Initial Warrants were issued in connection with the Unsecured Notes, and the fair values of these Additional Warrants and Initial Warrants were allocated as discounts to the Unsecured Notes. The remaining Initial Warrants were issued in connection with the Shares, and these Initial Warrants were allocated as a reduction of proceeds from the issuance of the Shares. The Secured Note Warrants were allocated as discounts to the Secured Notes. The fair value of the Roth Warrants was allocated between deferred financing cost and the proceeds from the issuance of the Shares. The net proceeds from the issuance of the Shares were $7,684,000, net of the effect of the fair value of the Initial Warrants of $6,253,000 and transaction costs of $1,988,000.

     The conversion price of the Secured Notes ($2.20) at its commitment date, the date of shareholder approval on December 14, 2006, was below the market price of $2.58. In accordance with Emerging Issues Task Force Issue No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios” (“EITF 98-5”) and Issue No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments,” we recorded an amount that represented the difference between the conversion price and the fair value of our common stock multiplied by the number of shares into which the Secured Notes are convertible ($4,400,000) as a discount to the Secured Notes with an offsetting entry to Additional Paid-In Capital. This amount will be amortized to interest expense over the period to the Secured Notes over the contractual maturity of the debt. Should the Secured Notes be converted prior to their contractual maturity the unamortized balance will be charged to interest expense.

     Upon conversion of the Unsecured Notes on December 14, 2006 unamortized discount of $1,202,000 and deferred financing costs of $1,464,000 were recorded as Additional Paid-In Capital.

     The Secured Notes bear interest, payable quarterly, at 6% per annum and are due in November 2009. Following approval of our shareholders on December 14, 2006, the Secured Notes can convert into shares of common stock at a conversion price of $2.20 per share at the option of the holders of the Secured Notes. The Secured Notes are secured by certain of our existing and future property, as well as the existing and future property of each of our wholly-owned subsidiaries. Notwithstanding, we can, under the terms of the Secured Notes, enter into one or more working capital line of credit facilities secured by our accounts receivable and inventory up to $7,000,000.

     So long as any amount due under the Secured Notes is outstanding and until the earlier of (i) the indefeasible payment in full of all

14

amounts payable and (ii) the conversion of Secured Notes, we are required to maintain certain financial covenants, including that we maintain:

a.	at the end of each fiscal quarter commencing with the fiscal quarter ending April 30, 2007, an unrestricted balance of cash (including cash equivalents and excluding cash from any working capital line of credit) of not less than $4,500,000, or $10,500,000 in the event our Peridex® product line is divested;
b.	for each of the fiscal quarters ending January 31, 2008 and April 30, 2008, EBITDA of at least $1, excluding certain costs associated with the development and marketing of OraTest®; provided, however, that if our Peridex® product line is divested the EBITDA target will be reduced by $1,500,000 on an annualized basis;
c.	for the fiscal quarter ended July 31, 2008, GAAP net income of at least $1, excluding certain costs associated with the development and marketing of OraTest; provided, however, that if our Peridex® product line is divested the net income target will be reduced by $1,500,000 on an annualized basis; and
d.	for each fiscal quarter commencing with the fiscal quarter ending October 31, 2008, net income of at least $1.

     Failure to satisfy these financial tests, or to maintain compliance with the negative covenants described in our definitive proxy statement filed with the SEC on November 24, 2006, could, at the option of the Secured Note holders, result in an event of default under the Secured Notes. Upon the occurrence of the first specified event of default, the holders of the Secured Notes could accelerate and demand repayment of one-third of the outstanding principal balance and all accrued but unpaid interest on the Secured Notes. Upon the occurrence of the second specified event of default, the holders of the Secured Notes could accelerate and demand repayment of one-half of the outstanding principal balance and all accrued but unpaid interest on the Secured Notes. Upon the occurrence of the third specified event of default, the entire principal balance and all accrued but unpaid interest may become due and payable.

     The Secured Notes also contain various non-financial covenants, including a requirement that Zila separate the offices of Chairman of the Board and Chief Executive Officer, which occurred on May 21, 2007, and, on or prior to August 1, 2007, increase the size of the Board of Directors from seven to nine directors and, in addition to filling any directorships that become vacant prior to such time, use commercially reasonable efforts to appoint two additional directors to Zila’s Board of Directors. As of the date of this Quarterly Report on Form 10-Q, Zila has not yet increased the size of the Board of Directors nor identified directors to fill the two vacancies that would occur upon such increase in size. Zila’s Board of Directors currently has five members. If these requirements are not satisfied, it could also result in an event of default that could result in the acceleration of the entire principal amount outstanding, together with accrued but unpaid interest.

     The Private Placement was made only to accredited investors in transactions that are exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”) pursuant to Regulation D promulgated thereunder.

     Secured Term Loan— On March 24, 2006, we, certain of our domestic subsidiaries, and Black Diamond Commercial Finance, L.L.C. (“BDCF”), as the initial lender and administrative agent, entered into a $40,000,000 credit facility (the “Credit Facility”). On October 2, 2006, debt outstanding under the Credit Facility in the amount of approximately $20,000,000 plus accrued interest was repaid from the proceeds of the disposition of the Nutraceuticals Business Unit and the Credit Facility was terminated. Upon termination of the Credit Facility, we recognized a loss of $3,600,000 for the write-off of unamortized debt financing costs and debt discount. These costs were recorded as interest expense.

     PharmaBio Development— In December 2002, we entered into an agreement with PharmaBio Development, Inc. (“PharmaBio”), the strategic investment group of Quintiles Transnational Corp., our contract research organization. Under this agreement, PharmaBio invested $500,000 in us. In return for the investment, we agreed to pay PharmaBio an amount equal to 5.0% of all net sales of the OraTest^® product in the European Union and the United States. The aggregated amount of the royalty cannot exceed $1,250,000 and the royalty is payable quarterly. The investment was recorded as long-term debt and will be amortized using the effective interest method.

     Capital Leases— We lease facilities and equipment, some of which are required to be capitalized in accordance with SFAS No. 13, “Accounting for Leases” (“SFAS No. 13”). SFAS No. 13 requires the capitalization of leases meeting certain criteria, with the related asset being recorded in property and equipment and an offsetting amount recorded as a liability.

     Aggregate annual maturities of long-term debt and minimum payments under capital leases for the fiscal years ending July 31 are as follows (in thousands):

15

	Long-term		Capital		Total
	Debt		Leases		Debt
Remaining 2007	$	—	$	20	$	20
2008		347		78		425
2009		12.153		71		12,22434
2010		—		34		34
2011 and thereafter		—		—		—
Total		12,500		203		12,703
Less discount		5,924		—		5,924
Less current portion		—		78		78
Long-term portion	$	6,576	$	125	$	6,701

8. Stock Options and Warrants

Stock Options and Awards

     We have one active share-based stock award plan that provides for the grant of stock options and stock awards, such as restricted stock and restricted stock units (“RSUs”), to our employees, members of our Board of Directors and non-employee consultants as approved by our Board of Directors. RSUs represent a contingent right to receive shares of our stock at a future date provided certain performance targets are met and can be forfeited or accelerated under certain conditions. We grant stock awards to our employees and to members of our Board of Directors at prices equal to the market value of our stock on the date of grant. These awards vest over a period determined at the time of the grant and generally range from one to three years of continuous service, with maximum terms ranging from five to ten years. Certain awards granted to our employees provide for accelerated vesting if there is a “change in control” of Zila (as defined in the plan).

     A summary of stock options activity within our share-based compensation plans for the nine months ended April 30, 2007 follows (shares and aggregate intrinsic values in thousands):

						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
	Number			Exercise		Contractual		Intrinsic
	of Shares			Price		Term		Value
Balance outstanding at July 31, 2006		3,235		$	3.54		7.0	$	878
Granted		1,299			2.47
Exercised		(30	)		1.43
Forfeited/expired		(549	)		4.03
Balance outstanding at April 30, 2007		3,955		$	3.13		6.4	$	331
Options exercisable at April 30, 2007		2,359		$	3.28		5.3	$	331

     The weighted-average grant-date fair value of options granted to our employees and directors during the nine months ended April 30, 2007 and 2006 was $1.49 and $2.05, respectively. The total intrinsic value of options exercised (the amount by which the stock price exceeded the exercise price of the option on the date of exercise) for the nine months ended April 30, 2007 and 2006 was $36,000 and $123,000, respectively. Cash received from option exercises during the nine months ended April 30, 2007 and 2006 was $43,000 and $172,000, respectively, and was reflected as a financing activity in the accompanying unaudited Consolidated Statements of Cash flows under the caption, “proceeds from issuance of common stock.”

     During the nine months ended April 30, 2007, we awarded 275,000 shares of unvested common stock to certain key executives. The unvested shares contain restrictions requiring continued employment. The awards are expensed on a straight-line basis over the vesting period. Within 60 days of the lapse of the restrictions, we are required to issue a stock certificate for the vested shares. The stock awards provide full shareholder rights from the date of grant. Unvested shares under stock awards are not included in our common shares issued and outstanding until the vested shares are issued.

     A summary of unvested common stock award activity within our share-based compensation plan for the nine months ended April 30, 2007 follows (shares in thousands):

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						Weighted
				Weighted		Average
				Average		Remaining		Aggregate
	Number			Grant		Contractual		Intrinsic
	of Shares			Value		Term		Value
Unvested balance outstanding at July 31, 2006		—		$	—			$	—
Granted		275			2.50
Vested		(75	)		2.58
Forfeited		—
Unvested balance outstanding at April 30, 2007		200		$	2.30		2.5	$	398

     A summary of RSU activity within our share-based compensation plan for the nine months ended April 30, 2007 follows (shares in thousands):

					Weighted
			Weighted		Average
			Average		Remaining		Aggregate
	Number		Purchase		Contractual		Intrinsic
	of Shares		Price		Term		Value
Unvested balance outstanding at July 31, 2006		—	$	—			$	—
Granted		100		0.00
Vested		—
Forfeited		—
Unvested balance outstanding at April 30, 2007		100	$	0.00		2.5	$	100

     The share-based compensation cost for continuing operations recognized for the nine months ended April 30, 2007 and 2006 was as follows (in thousands):

	Nine months ended April 30,
	2007		2006
Selling and marketing	$	119	$	19
General and administrative		1,287		344
Research and development		8		6
Cost of products sold		15		4
	$	1,429	$	373

     As of April 30, 2007, total unrecognized compensation cost related to employee stock-based compensation for stock options was $2,887,000. That cost is expected to be recognized over a weighted average period of 1.8 years for stock options, 1.9 years for restricted stock awards, and 3.0 years for restricted stock units. During the nine months ended April 30, 2007, we revised the estimated forfeiture rate for stock options. The resulting adjustment was not material and is included in the above captions in the unaudited Consolidated Statements of Operations.

     The fair value of each stock option award is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

	Nine months ended April 30,
	2007			2006
Expected stock price volatility		62	%		66	%
Expected life of options	5.8 years			4.7 years
Risk-free interest rate		4.8	%		3.7	%
Dividend yield		0.0	%		0.0	%

     We determined that a blend of implied volatility and historical volatility is more reflective of market conditions and a better indicator of expected volatility than using purely historical volatility. The expected lives of options are based on our historical data. The risk-free interest rate is based on the U.S. treasury security rate estimated for the expected life of the options at the date of grant. Our ability to pay dividends is restricted and therefore we have assumed no dividend yield.

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Warrants

     As of April 30, 2007, we have warrants outstanding for approximately 12,938,000 shares of our common stock. We issued these warrants in connection with financing arrangements and in connection with services provided by medical and financial advisors.

     Activity related to warrants, which expire at various dates through March 2011, is summarized as follows (shares and aggregate intrinsic value in thousands):

					Weighted
			Weighted		Average
			Average		Remaining		Aggregate
			Exercise		Contractual		Intrinsic
	Shares		Price		Term		Value
Outstanding at July 31, 2006		1,302	$	2.16		4.4	$	383
Granted		11,636	$	2.21
Exercised		—
Forfeited/expired		—
Outstanding at April 30, 2007		12,938	$	2.20		4.5	$	89
Warrants exercisable at April 30, 2007		7,535	$	2.20		4.5	$	89

     On March 24, 2006, in connection with the Credit Facility described and defined in Note 7, we issued a warrant to BCDF to purchase 1,200,000 shares of our common stock at $3.79 per share. In connection with the amendments to the Credit Facility, the exercise price of such warrant was reduced to $3.14 and $2.22 per share, respectively. The warrant has a term of five years and expires March 24, 2011.

     On November 27 and 28, 2006, in connection with the Private Placement described and defined in Note 7, we issued the following warrants, which have a term of five years, to investors in the Private Placement to purchase approximately 11,636,000 shares of our common stock at $2.21 per share. The following table summarizes the warrants that were issued (shares in thousands):

Warrants	Exercisable	Common Shares
Initial Warrants	May 28, 2007		5,403
Additional Warrants	December 14, 2006		3,105
Secured Notes Warrants	December 14, 2006		1,909
Roth Warrants (1)	February 20, 2007		1,219
			11,636

(1) The Roth Warrants were issued on February 20, 2007.

     In March 2006, concurrent with entering into the Credit Facility with BDCF, we entered into a registration rights agreement with BDCF pursuant to which the Company agreed to register the shares of common stock underlying a warrant issued to BDCF. We were obligated to have the registration statement declared effective at the later of July 15, 2006 and the date upon which at least twenty-five percent (25%) of the shares underlying the warrant have been acquired upon exercise of the warrant. The registration statement was declared effective on June 26, 2006.

     We are obligated to maintain the effectiveness of the registration statement until the earlier to occur of the date upon which all shares registered thereunder have been sold and, in general, the date on which the shares registered thereunder can be sold pursuant to Rule 144(k) under the Securities Act of 1933, as amended (the “Securities Act”). If we fail to maintain the effectiveness of the registration statement for this period of time, we are obligated to pay to BDCF at the end of each thirty (30) day period, in cash, an amount equal to $40,000 for the first 30 days such registration is not effective, pro-rated on a daily basis, and $40,000 per each 30-day period thereafter, pro-rated on a daily basis.

     In November 2006, concurrent with the closing of the Private Placement, we entered into two registration rights agreements (the “Private Placement Registration Rights Agreements”) to register the Shares and shares of common stock issuable upon the conversion of the Unsecured Notes and Secured Notes and upon the exercise of the Initial Warrants, Additional Warrants, and Secured Note Warrants. Under the terms of the Private Placement Registration Rights Agreements, we agreed to file an initial registration statement registering the Shares and shares of common stock underlying the Initial Warrants (the “Initial Registration Statement”). We also agreed to file a subsequent registration statement registering shares of common stock underlying the Additional

18

Warrants, Secured Note Warrants, Unsecured Notes and Secured Notes (the “Subsequent Registration Statement”).

     Under the Private Placement Registration Rights Agreements, if the Initial Registration Statement or Subsequent Registration Statement is not filed, or declared effective, by certain predetermined deadlines, then, in addition to any other rights the investors may have, we will be required to pay the investors whose shares are being registered liquidated damages, in cash, equal to one percent per month (pro rata for each day beyond each deadline) of the aggregate purchase price paid by such investors for the securities being registered on either the Initial Registration Statement or Subsequent Registration Statement, as applicable, up to a maximum of 24% of each such investors’ investment.

     We are obligated to maintain the effectiveness of the Initial Registration Statement and the Subsequent Registration Statement until the earlier of the date on which all securities registered thereby have been sold and the date on which all securities registered thereby may be sold pursuant to Rule 144(k) under the Securities Act. If we do not maintain the effectiveness of the Initial Registration Statement and the Subsequent Registration Statement, as required, then we are subject to the above described liquidated damages.

     Investors participating in the Private Placement invested an aggregate of approximately $40,000,000. Had we been unable to satisfy our obligations under the Private Placement Registration Rights Agreements, our maximum exposure under such agreements would have been 24% of the amount invested, or approximately $9,600,000.

     We did not incur any liquidated damages in connection with the Initial Registration Statement because we filed it on December 28, 2006, and it was declared effective on March 23, 2007, both of which were within the time periods prescribed by the Private Placement Registration Rights Agreements.

     We filed the Subsequent Registration Statement on January 12, 2007, which was within the time period prescribed by the Private Placement Registration Rights Agreements. However, the Subsequent Registration Statement was not declared effective until May 4, 2007, which was after the April 13, 2007 effectiveness deadline. Several of the investors waived their rights to liquidated damages, but we incurred liquidated damages of $123,900 for the period from April 13, 2007 to May 4, 2007 as a result of the delay.

     Although Zila has not received notice of any claim filed against it or a request or demand for alternative dispute resolution, it is possible that a dispute may arise between Zila and some of the investors that were supposed to be listed as selling security holders in the Subsequent Registration Statement. The SEC reviewed and provided extensive comments on the Subsequent Registration Statement and, as a condition precedent to declaring the Subsequent Registration Statement effective, the SEC required Zila to either remove three groups of investors or to identify the same as “underwriters” in the Subsequent Registration Statement. Rather than be designated as underwriters, the three investor groups preferred to have the shares that were issued to them, and the shares that were issuable to them upon conversion of the Secured Notes and exercise of Additional Warrants and Secured Note Warrants, as applicable, removed from the Subsequent Registration Statement. As a result, Zila believes its obligation to pay liquidated damages to these three investors groups for the period after May 4, 2007 was extinguished. However, Zila is aware that at least two of the three investor groups may take the position that Zila’s obligation to pay liquidated damages is ongoing and will continue until their securities are registered, subject to the contractually agreed limitation of 24% of the amount of each investor group’s investment in Zila.

     The dispute would likely be contractual in nature, but Zila cannot predict whether it will prevail. Zila will vigorously defend its position and if Zila’s position prevails, Zila will not be obligated to pay additional liquidated damages, although it will incur costs and expenses associated with participating in alternative dispute resolution. Assuming all three investor groups pursue a claim for liquidated damages of up to 24% of each investor group’s investment, and that this position prevails, in addition to costs and expenses incurred, Zila could be obligated to pay an aggregate of $4,386,600 in additional liquidated damages.

     We account for our warrant arrangements in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”), as well as related interpretations of these standards, evaluating whether these arrangements should be accounted for as equity or a derivative liability and value these arrangements at fair value based on available market date using a Black-Scholes valuation model. For warrant arrangements determined to be a derivative liability, any gains or losses resulting from the changes in fair value of the warrant liability from period to period are included as non-cash credits or charges to earnings.

     In accordance with EITF 00-19, we previously accounted for the warrant issued to BCDF as a derivative liability measured at fair value as a result of the registration rights agreement associated with this warrant. As such, we determined the fair value of the warrant based on available market data using a Black-Scholes valuation model and any gains or losses resulting from the changes in fair value of the warrant liability from period to period were included as non-cash credits or charges to earnings.

     On December 21, 2006, the FASB issued EITF 00-19-2.As permitted under EITF 00-19-2, we elected early adoption as of the beginning of our current interim quarter beginning November 1, 2006. EITF-00-19-2 provides guidance on accounting for registration payment arrangements and how to account for related financial instruments. It clarifies that financial instruments, such as warrants,

19

subject to a registration payment arrangement should be accounted for in accordance with applicable generally accepted accounting principles without regard to the contingent obligation. If, upon adoption, a warrant previously classified as a liability under EITF 00-19 is determined under applicable generally accepted accounting principles to be equity without regard to the registration payment arrangement, then it should be reclassified.

     We recorded the effect of applying EITF 00-19-2 to our derivative liability for the BCDF warrant using the cumulative-effect transition method, which resulted in a decrease in derivative liability of $1,538,000 and an increase to the carrying amount of additional paid-in capital of $2,460,000, representing the original value assigned to the warrants with an offsetting cumulative-effect entry to accumulated deficit of $922,000, as set forth in our Consolidated Statements of Changes in Equity. The cumulative adjustment is not recorded in the consolidated statements of operations and prior periods are not adjusted.

     Based on our evaluation of the warrants issued under the Private Placement under the provisions of EITF 00-19 and EITF 00-19-2, we recorded the Initial Warrants as equity. The Additional Warrants, the Secured Notes Warrants, and the Roth Warrants were recorded as derivative liabilities since insufficient authorized shares existed for their issuance for the period from issuance to approval by our shareholders on December 14, 2006 of additional authorized shares.

9. Income Taxes

     Income tax benefit of $4,001,000 for the nine months ended April 30, 2007 resulted from the utilization of net operating loss carry forwards of $4,068,000 to offset the income tax expense on the taxable gain on the sale of our Nutraceuticals Business Unit and income from the Peridex^® product line, which are presented in discontinued operations.

     At April 30, 2007, we have recorded a valuation allowance for our net deferred tax assets of $15,084,000 due to our lack of earnings history, and we had federal net operating loss carry forwards of approximately $50,045,000, which expire in years 2009 through 2027.

10. Supplemental Cash Flow Information

     Supplemental cash flow information for the nine months ended April 30 follows (in thousands):

	Nine months ended April 30,
	2007		2006
Interest paid	$	957	$	393
Income taxes paid	$	164	$	102
Capital lease obligations for new equipment	$	181	$	65
Conversion of Unsecured Notes	$	4,452	$	—
Value of warrant issued with debt	$	—	$	2,331

11. Comprehensive Income (Loss)

     The components of comprehensive income are as follows (in thousands):

	Three months ended April 30,						Nine months ended April 30,
	2007			2006			2007			2006
Net loss	$	(4,308	)	$	(8,075	)	$	(10,717	)	$	(20,323	)
Foreign currency translation adjustments		(10	)		(12	)		(37	)		(11	)
Comprehensive loss	$	(4,318	)	$	(8,087	)	$	(10,754	)	$	(20,334	)

     The other comprehensive loss in the three and nine month periods ended April 30, 2007 and 2006 reflect no income tax effect due to the recording of valuation allowances.

12. Commitments and Contingencies

FDA approval of the OraTest^®product

     We are pursuing approval by the Federal Drug Administration (“FDA”) of a New Drug Application (“NDA”) for our OraTest^® product. We are in the process of conducting a clinical trial to gather additional data to demonstrate the product’s safety and effectiveness. The clinical data would constitute one part of the yet to be filed resubmission of the NDA. Factors that affect the cost and

20

timing of completion of the regulatory program include but are not limited to: (i) patient enrollment rates; (ii) lesion formation rate within the study population; (iii) compliance with the study protocol and related monitoring; (iv) level of funding throughout the study; (v) completion of testing within the non-clinical and chemistry, manufacturing, and controls area; and (vi) program modifications or requirements for additional testing. No assurances can be made that the regulatory objectives will be achieved for OraTest^®, nor can there be any assurances that even if the study were to be completed that the FDA would view the study data or other submissions, including the chemistry, manufacturing and controls as sufficient to support the approval of the NDA.

     At April 30, 2007, we had approximately $237,000 of OraTest^® rinse and swab inventory and ZTC™ drug substance, the active ingredient in the OraTest^® product, and its related components. The drug substance currently has shelf lives with varying expiration dates. We intend to realize the value of this inventory and drug substance through its consumption during the conduct of the clinical trials, process development, toxicology studies and validation and testing of our manufacturing process. However, no assurance can be given in this regard.

     At April 30, 2007, we have (i) $2,194,000 net purchased technology rights, (ii) patents and pending patent applications of $1,961,000, and (iii) fixed assets of approximately $1,000,000 (primarily related to our manufacturing facility). Should we be unable to obtain FDA approval and generate sufficient revenues from future sales of the OraTest^® products, we may have to reduce the carrying value of these assets.

Litigation

     Except as described below, as of April 30, 2007, we were not a party to any pending legal proceedings other than claims that arise in the conduct of our business. While we currently believe that the ultimate outcome of these proceedings will not have a material adverse effect on our consolidated financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our net income in the period in which a ruling occurs. Our estimate of the potential impact of the following legal proceedings on our financial position and our results of operation could change in the future.

     In connection with the acquisition of patent rights in 1980, we agreed to pay to Dr. James E. Tinnell (“Tinnell”), the inventor of one of our former treatment compositions, a royalty of 5% of gross sales of the invention disclosed in his then pending patent application. In September 2000, we notified Tinnell that we would no longer pay such royalties because the obligations ceased in August 1998 when the related product patents expired and we requested reimbursement of royalties paid since August 1998. We then filed suit on November 8, 2000, in the United States District Court for the District of Nevada requesting a declaratory judgment that we had no royalty obligations to Tinnell and requested judgment for the overpaid royalties. On April 22, 2004, the Court, in part, ruled in our favor, stating that our royalty obligations to Tinnell ceased in August 1998, however, our request for reimbursement of overpaid royalties was dismissed. Tinnell filed a notice of appeal and we have filed a notice of cross-appeal. Briefs have been filed by both parties with the Ninth Circuit Court of Appeals and oral argument took place on December 8, 2006.

     On June 27, 2005 we sold our Zilactin^® brand of products to Blairex. We received a demand for arbitration from Blairex dated February 8, 2006, claiming that it had suffered post-closing economic loss as a result of losing distribution of certain products and requirements by the Consumer Product Safety Commission. Pursuant to the Agreement of Purchase and Sale that documented the Zilactin^® sale, the dispute was subject to arbitration. Both of the events alleged occurred after the sale closed on June 27, 2005 and were not covered by any representations or warranties that were given to Blairex by the Company. The parties were unsuccessful in an attempt to resolve the dispute through formal mediation. However, on November 3, 2006, we entered into a Settlement Agreement and Mutual Release (“Settlement Agreement”) with Blairex. The Settlement Agreement provided for the dismissal of the arbitration matter and the payment of $650,000 to Blairex, the cost of which was recorded in discontinued operations for the quarter ended October 31, 2006.

     On September 15, 2006, Alacer Corporation (“Alacer”) filed suit against Zila Nutraceuticals, Inc. (“ZNI”) and Bernie Landes (“Landes”) in Superior Court in Orange County, California. Alacer alleges misappropriation of trade secrets, unfair competition, conversion, unjust enrichment, and accounting against ZNI and Landes, as well as breach of duty of loyalty claims against Landes. As a part of the sale of ZNI to NBTY, Inc. on October 3, 2006, the Company agreed to indemnify and hold NBTY harmless with respect to the Alacer litigation. By its Complaint, Alacer alleged that Landes, a former Alacer employee, had taken certain documents containing trade secrets with him when he left Alacer. Alacer further alleged that Landes and ZNI had used these documents to unfairly compete with Alacer. In particular, Alacer alleges that copies of the documents were provided to Alacer’s competitor in order to assist the competitor in creating an effervescent vitamin C product similar to Alacer’s Emergen-C product line. ZNI and Landes have denied Alacer’s claims. In particular, ZNI and Landes deny that the information contained in the documents at issue here constitutes trade secrets. The parties are presently engaging in the discovery process, and both parties have served and responded to initial sets of discovery requests. A non-binding mediation was held on March 29, 2007. The parties have agreed to a settlement, pending documentation, which will require the payment of $100,000 to Alacer.

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     An antitrust case was filed in 2000 in the U.S. District Court in Delaware by several dental laboratories as class representatives for all dental labs which had purchased Dentsply artificial teeth. The suit alleges that Dentsply, the major supplier of artificial teeth, required each of its distributors to agree not to supply the teeth of its competitors as a condition of Dentsply’s supplying its artificial teeth to a distributor. According to the complaint this requirement resulted in a lack of choices for the laboratories and increased costs for the Dentsply teeth because it permitted Dentsply to limit the supply of its competitors’ teeth so as to give it a monopoly and the power to set prices. Plaintiffs also alleged that each of the distributors agreed with Dentsply to this condition in violation of Sections 1 and 2 of the Sherman Act and Section 6 of the Clayton Act. At the same time the U.S. Department of Justice was criminally prosecuting Dentsply for the same activities. Ultimately Dentsply was found guilty of the charges.

     The civil lawsuit, in which Ryker Dental of Kentucky, Inc., our inactive wholly-owned subsidiary, is one of about 15 defendants, was stayed for years because of appeals taken by the plaintiffs from orders by the trial court that since the plaintiffs had not purchased artificial teeth directly from Dentsply, it could not, as a matter of law, have any liability to the plaintiffs or class members. The 3rd Circuit Court of Appeals largely agreed with Dentsply, except that it permitted a claim to proceed that Dentsply and the distributors had conspired to monopolize the artificial teeth market. The case is now in the trial court and discovery against the largest distributors has been permitted by the trial judge. There are motions pending before the trial judge to dismiss Ryker for lack of personal jurisdiction and to dismiss one of the Counts on substantive grounds.

     See also Note 8 for a discussion of a possible dispute between Zila and three groups of investors in the Private Placement.

13. Subsequent Events

Peridex^®Disposition

     On May 31, 2007, our subsidiary, Zila Pharmaceuticals, Inc., sold substantially all of the assets of its Peridex^® brand of prescription mouth rinse products to 3M Company and 3M Innovative Properties Company for $9,500,000. We retained trade accounts receivable of $831,000 and accounts payable and accrued liabilities of $311,000. The sale resulted in a pre-tax gain of $4,900,000. The sale of Peridex^® was made as part of our strategy to divest non-core assets to fund ongoing business operations.

     As disclosed in Note 7, under the covenants of the Secured Notes, upon the disposition of Peridex our required minimum unrestricted cash balance increased from $4,500,000 to $10,500,000 and our EBITDA and net income targets were reduced by $1,500,000 on an annualized basis for the quarters ended January 31, 2008, April 30, 2008 and July 31, 2008.

     The Peridex^® product line meets the definition of a “component of an entity” and has been accounted for as a discontinued operation under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The financial position and results of operations for Peridex^® have been classified as discontinued operations in all periods presented.

Resignation of President and Chief Executive Officer

     On June 13, 2007, we accepted the resignation of Douglas D. Burkett, Ph.D., from his positions as President and Chief Executive Officer and as a member of our Board of Directors. We also entered into an agreement with Dr. Burkett on June 13, 2007 that governs the terms of his departure and that provides, in exchange for a general release by Dr. Burkett and his resignation from our Board of Directors, for the following:

     • we will pay to Dr. Burkett a $90,000 severance payment and pay for COBRA coverage for Dr. Burkett for six months following resignation;

     • all vested and unvested options to purchase shares of Zila’s common stock terminated upon resignation; provided, however, that 200,000 options that vested prior to the resignation and that are exercisable at $0.76 per share will survive resignation and remain exercisable for two years; and

     • Dr. Burkett will retain 100,000 shares of restricted stock previously awarded to him, of which 66,666 shares were unvested.

     The agreement also contained other customary provisions, including mutual non-disparagement and cooperation covenants and a limited release by Zila of claims it may have against Dr. Burkett. Because of the modification of the terms of Dr. Burkett’s options and restricted stock, in our quarter ended July 31, 2007, we will recognize non-cash expense of approximately $237,000.

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

Forward-Looking Statements

     This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “may,” and variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated growth and trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified below, under Item 1A. “Risk Factors,” and elsewhere herein. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation and disclaim any duty to revise or update any forward-looking statements for any reason.

Company Overview

     Zila, Inc. is a cancer screening company focused on oral cancer. In this report, “Zila,” the “Company,” “we,” “us,” or “our” refer to Zila, Inc. and its wholly-owned subsidiaries.

     We manufacture and market the chemiluminescent disposable light product and Zila Tolonium Chloride (“ZTC™”), ViziLite^® Plus with T-Blue ⁶³⁰™, for the illumination and marking of oral mucosal abnormalities in patients at increased risk for oral cancer, Soft Tissue Management (“STM^®”) products, including medical devices such as the Rota-dent^® Professional Powered Brush with MicroAccess Flossing Action and the Pro-Select3^® Piezo-Ultrasonic Scaler System, as well as a suite of pharmaceutical STM^® products for both in-office and home-care use. Our research and development division holds expertise in pre-cancer/cancer detection through our patented ZTC™ and OraTest^® technologies and is pursuing regulatory approval for the OraTest^® product, an oral cancer diagnostic system.

Acquisition of Pro-Dentec

     On November 28, 2006, we completed the merger with Pro-Dentec, a privately-held, professional dental products company headquartered in Batesville, Arkansas. Through its national sales and marketing organization, Pro-Dentec offers directly to dental professionals a small suite of proprietary dental products that complement our cancer screening products. The merger consideration was approximately $34,000,000.

     Pro-Dentec focuses on STM^® oral care products that it sells directly to dental offices through its dedicated national sales force. Its national marketing program reaches most of the nation’s dental offices and includes over 100 continuing education seminars each year that dentists and their staffs pay to attend. These seminars, which are certified by the American Dental Association and the Academy of General Dentistry, are ideally suited to educate a large number of dental professionals on the importance of oral cancer screening.

     We believe that this acquisition completes our transition into a cancer screening company focused on oral cancer. Leveraging Pro-Dentec’s national sales force and its continuing education seminar series will provide us an opportunity to more fully realize the large market potential of ViziLite^® Plus and potential future oral cancer detection products.

Disposition of Peridex^®

     In May 2007, we sold the Peridex^® brand of prescription mouth rinse products to a third party for $9,500,000 and recognized a pre-tax gain of approximately $4,900,000. The financial statements included herein reflect the treatment of the financial results of the Peridex^® line as discontinued operations.

Private Placement

     On November 28 and 29, 2006, we completed a private placement of $40,000,000 in common stock, convertible debt instruments and warrants to selected accredited investors (collectively, the “Private Placement”). Shareholders at the closing of the Private Placement and their related funds made up more than 80% of the Private Placement, the proceeds for which were used to complete the Pro-Dentec acquisition and to augment existing working capital. Additional information concerning the Private Placement can be

23

found elsewhere in this Quarterly Report on Form 10-Q and also in our Definitive Proxy Statement on Schedule 14A, which was filed with the Securities and Exchange Commission (“SEC”) on November 24, 2006.

Product Development

     In December 2005, we reached agreement with the Food and Drug Administration (“FDA”) on the design and size of a phase III clinical trial under the FDA’s special protocol assessment (“SPA”) process and commenced patient enrollment. The clinical trial is expected to provide support for safety and efficacy in the OraTest^® new drug application (“NDA”) completed submissions. A meta analysis will also be submitted in the NDA to support the product’s safety and efficacy. The regulatory program is designed to assess the efficacy of OraTest^® in staining cancerous and pre-cancerous oral lesions in a population of tobacco users and alcohol drinkers. The endpoint of the clinical trial is based upon the achievement of a predetermined number of differences in diagnoses between the standard visual exam and OraTest. When the endpoint is achieved, study enrollment will be concluded and the results obtained. We can provide no estimate of when the trial might complete. We continue to respond to various critical issues raised by the FDA, and we can give no assurance that these issues can be addressed to the satisfaction of the FDA. No assurances can be made that the regulatory objectives will be achieved for OraTest^®, nor can there be any assurances that even if the study were to be completed that the FDA would view the study data or other submissions, including the chemistry, manufacturing and controls as sufficient to support the approval of the NDA. Additionally, if available funds are insufficient to complete the study or inadequate to support future regulatory program costs, we may not complete the study or achieve our regulatory objectives for OraTest^®.

Results of Operations

     The following tables summarizes our results of consolidated continuing operations and related statistical information for the three month periods ended April 30, 2007 and 2006 (dollars in thousands):

	Three months ended April 30,
				Percent of						Percent of
				Net						Net
	2007			Revenues			2006			Revenues			Change
Net revenues	$	10,750			100	%	$	1,218			100	%		783	%
Cost of products sold		4,231			39			710			58			496
Gross profit		6,519			61			508			42			1,183
Operating Costs and Expenses:
Marketing & selling		4,326			40			1,782			146			142
General & administrative		2,682			25			2,651			218			1
Research & development		2,389			22			2,452			201			(3	)
Depreciation & amortization		909			9			369			30			146
		10,306			96			7,254			595			42
Loss from operations		(3,787	)		(35	)		(6,746	)		(553	)		(44	)
Other income (expense), net		(805	)		(8	)		(903	)		(74	)		(11	)
Loss before income taxes		(4,592	)		(43	)		(7,649	)		(627	)		(40	)
Income tax benefit (expense)		191			2			—			—			—
Net loss from continuing operations	$	(4,401	)		(41	)	$	(7,649	)		(627	)		(43	)

     The following table summarizes our results of consolidated continuing operations and related statistical information for the nine month periods ended April 30, 2007 and 2006 (dollars in thousands):

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	Nine months ended April 30,
				Percent of						Percent of
				Net						Net
	2007			Revenues			2006			Revenues			Change
Net revenues	$	18,147			100	%	$	2,701			100	%		572	%
Cost of products sold		7,758			43			1,566			58			395
Gross profit		10,389			57			1,135			42			815
Operating Costs and Expenses:
Marketing & selling		9,248			51			4,088			151			126
General & administrative		9,567			53			7,600			281			26
Research & development		5,741			31			5,739			213			—
Depreciation & amortization		1,997			11			1,025			38			95
		26,553			146			18,452			682			44
Loss from operations		(16,164	)		(89	)		(17,317	)		(640	)		(7	)
Other income (expense), net		(5,053	)		(28	)		(852	)		(32	)		(493	)
Loss before income taxes		(21,217	)		(117	)		(18,169	)		(672	)		17
Income tax benefit (expense)		4,001			22			(4	)		—			—
Net loss from continuing operations	$	(17,216	)		(95	)	$	(18,173	)		(672	)		(5	)

     Net revenues increased 783% to $10,750,000 for the three months ended April 30, 2007, compared to revenues of $1,218,000 for the comparable prior year period. Net revenues increased 572% to $18,147,000 for the nine months ended April 30, 2007, compared to revenues of $2,701,000 for the comparable prior year period. The growth in net revenues for the three and nine month periods ended April 30, 2007 is largely driven by our acquisition of Pro-Dentec on November 28, 2006, as well as its effect on ViziLite^® Plus net revenues. For the three month and nine month periods ended April 30, 2007, ViziLite^® Plus net revenues increased 112% and 48%, respectively, over the prior year periods as a result of selling direct to dental offices through Pro-Dentec’s national sales organization beginning in December 2006. ViziLite Plus^® Plus net revenues for the nine months ended April 30, 2007 were affected by our deliberate reductions in sales to our existing distribution channel in the first quarter of fiscal 2007 as we prepared to modify our means of distribution upon the completion of the Pro-Dentec acquisition.

     Gross profit as a percentage of net revenues was 61% for the three months ended April 30, 2007 compared to 42% for the prior year period, and 57% for the nine months ended April 30, 2007 compared to 42% for the prior year period. Prior year’s gross profit reflect the distributor-only business model and the impact of discounts and incentives offered in support of the launch of ViziLite^® Plus.

     Marketing and selling expenses as a percentage of net revenues were 40% and 51%, respectively, for the three and nine month periods ended April 30, 2007, compared to 146% and 151% for the comparable prior year period. Marketing and selling expenses as a percentage of net revenues decreased for the current periods as a result of the increased revenue base from the Pro-Dentec acquisition. Marketing and selling expenses for this quarter were $4,326,000 compared to $1,782,000 in the prior year quarter. Marketing and selling expenses were $9,248,000 year-to-date compared to $4,088,000 for the prior year period. Pro-Dentec represented the majority of these increases as we integrated its dedicated national sales force that sells directly to dental offices. Increased expenditures for ViziLite^® Plus represent the balance of the increase as we continue our efforts to establish ViziLite^® Plus as the standard of care for dental offices in the detection of oral abnormalities.

     General and administrative expenses were $2,682,000, or 25% of net revenues, for the three months ended April 30, 2007, compared to $2,651,000, or 218% of net revenue, for the prior year period. General and administrative expenses were $9,567,000, or 53% of net revenues, for nine months ended April 30, 2007, compared to $7,600,000, or 281% of net revenues, for the prior year period. The increased expenses for these periods are related primarily to the acquisition of and integration activities for Pro-Dentec, stock compensation costs, and additional support costs for ViziLite and our OraTest^® regulatory program. For the nine months ended April 30, 2007 and for the prior year periods, the reclassification of revenues for discontinued operations significantly impacted general and administrative expenses expressed as a percent of net revenues. General and administrative expenses for continuing operations include significant public-company related costs which do not vary in relation to net revenues.

     Research and development expenses decreased $63,000 or 3%, to $2,389,000 for the three months ended April 30, 2007 from $2,452,000 in the three months ended April 30, 2006, and remained relatively flat at $5,741,000 for the nine months ended April 30, 2007 compared to $5,739,000 in the prior year period. Research and development expenses are comprised primarily of costs for the OraTest^® regulatory program. We incurred higher expense levels in the prior year quarter with the commencement of our OraTest^® regulatory program in the second quarter and with the re-commissioning of our manufacturing facility.

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     Depreciation and amortization expenses increased $540,000, or 146%, to $909,000 for the three months ended April 30, 2007 from $369,000 for the three months ended April 30, 2006. Depreciation and amortization expenses increased $972,000, or 95%, to $1,997,000 for the nine months ended April 30, 2007 from $1,025,000 for the nine months ended April 30, 2006. The increased level of depreciation and amortization expense in the current year periods results primarily from the acquisition of Pro-Dentec and its related property, plant and equipment, and intangibles, as more fully described in Note 3 of the unaudited consolidated financial statements.

     Other expense was $805,000 for the three months ended April 30, 2007 compared to other expense of $903,000 in the prior year period. Other expense was $5,053,000 for the nine months ended April 30, 2007 compared to other expense of $852,000 in the prior year period. Other expense decreased for the three month period ended April 30, 2007 primarily as a result of termination fees incurred in the prior year period related to the Wells Fargo credit facility, which was repaid in March 2006. For the nine months ended April 30, 2007, interest expense arising from the Private Placement and the recently retired credit facility (“Credit Facility”) with Black Diamond Commercial Finance (“BDCF”) was the primary cause of the increase from the prior year period, most of which results from non-cash charges. The increase in other expense for the nine month period includes interest expense for the non-cash loss of $3,800,000 for the write-off of unamortized debt financing costs and debt discount upon the repayments of the BDCF Credit Facility and the Industrial Revenue Bonds. These costs were offset by derivative income recognized on the Black Diamond warrant liability in the first quarter.

     Income tax benefit of $4,001,000 for the nine months ended April 30, 2007 resulted primarily from the utilization of net operating loss carryforwards to offset the income tax expense on the taxable gain on the Nutraceuticals disposition Unit and income from the Peridex^® product line, which are presented in discontinued operations.

Inflation and Seasonality

     We do not believe that inflation has a material effect on the operations or financial condition of our businesses. Our consolidated operations are not considered seasonal in nature.

Liquidity and Capital Resources

     Historically, our liquidity needs arise from working capital requirements, the funding of our OraTest^® regulatory program and the launch of our new products, and debt service, and we have met these cash requirements through our cash and cash equivalents, borrowings under debt facilities, cash from operations and working capital management, the sale of non-core assets, proceeds from the issuance of common stock under our employee stock option and stock purchase programs and, recently, proceeds from the Private Placement.

     The development of our products may require the commitment of substantial resources to conduct the time-consuming research and development, clinical studies and regulatory activities necessary to bring any potential product to market and to establish production, marketing and sales capabilities.

     Based upon our current available funds, we will be required to pursue one or more of the following strategies: (i) delay, scale back or eliminate some or all of our research and product development programs, including, but not limited to, OraTest^®; (ii) limit the marketing of our products; (iii) license to third parties the rights to commercialize products or technologies that we would otherwise seek to develop and market ourselves; and/or (iv) raise additional funds. There can be no assurance that we will be successful in executing these strategies. If we are unable to execute these strategies, we may breach the financial covenants of our senior secured debt and be unable to repay the outstanding balance. These factors raise substantial doubt about our ability to continue as a going concern. As a result, realization values may be substantially different from carrying values as shown and these financial statements do not give effect to adjustments that would be necessary to the carrying values and classification of assets and liabilities should we be unable to continue as a going concern.

     Selected cash flow and working capital information is set forth in the table below (dollars in thousands):

	Nine months ended April 30,
	2007			2006
Net cash used in operating activities	$	(9,773	)	$	(16,393	)
Net provided by (used in) investing activities		1,857			(4,963	)
Net cash provided by (used in) by financing activities		13,610			17,593

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	April 30, 2007		July 31, 2006
Cash and cash equivalents	$	9,652	$	3,958
Working capital		12,297		(6,854	)
Current ratio		2.4		0.8

     At April 30, 2007, our primary sources of liquidity included cash and cash equivalents $9,652,000 compared to $3,958,000 at July 31, 2006. Our working capital was $12,297,000 at April 30, 2007 compared to $(6,854,000) at July 31, 2006. The improvement in cash and cash equivalents and in working capital at April 30, 2007 resulted primarily from net proceeds received from the Private Placement of debt and equity and the sale of the Nutraceuticals Business Unit. Also, at July 31, 2006, working capital was negatively affected by the classification of debt of $18,044,000 (net of discount) as a current obligation.

Operating Activities

     Net cash used in operating activities was $9,773,000 during the nine months ended April 30, 2007 compared to $16,393,000 during the same period last year. The decrease for the current period resulted from the reduced cash loss from continuing operations as a result of the Pro-Dentec acquisition and a reduced cash loss from discontinued operations as a result of the disposition of the Nutraceuticals Business Unit. Additionally, reduced levels of inventory and accounts receivable through the disposition of the Nutraceuticals Business Unit and increased accounts payable and accrued liabilities resulting from the Pro-Dentec acquisition provided working capital improvements over the prior year period.

Investing Activities

     Net cash provided by investing activities during the nine months ended April 30, 2007 was $1,857,000 compared to net cash used in investing activities of $4,963,000 during the comparable period of fiscal 2006. Net cash of $38,316,000 was provided by the Nutraceuticals disposition and cash collateral returned upon the retirement of the Industrial Revenue Bonds and $35,554,000 was used for the acquisition of Pro-Dentec. In the prior year period, cash of $3,072,000 was used to increase the restricted cash collateral for the letter of credit supporting the Industrial Revenue Bonds.

Financing Activities

     Net cash provided by financing activities for the nine months ended April 30, 2007 was $13,610,000 compared to net cash provided by financing activities of $17,593,000 during the comparable period of fiscal 2006. The decrease in cash provided by financing activities in the current year arose from the repayment of the balances due under the Credit Facility, the Industrial Development Revenue Bonds, and equipment and mortgage notes of Pro-Dentec which offset the proceeds from the Private Placement.

Private Placement

     On November 13, 2006, we entered into two separate purchase agreements that, in the aggregate, provided for the sale of common stock, warrants and convertible notes for an aggregate gross purchase price of approximately $40,000,000 (collectively, the “Private Placement”). The Private Placement closed and funded on November 28 and 29, 2006. We used the net proceeds of the Private Placement to fund the Pro-Dentec acquisition described in Note 3 and for working capital and general corporate purposes.

     Pursuant to the first purchase agreement, we issued and sold:

a.	9,100,000 shares of our common stock for $1.75 per share (the “Shares”);
b.	$12,075,000 in aggregate principal amount of 12% Unsecured Convertible Notes, which converted into 6,900,000 shares of our common stock at a conversion price of $1.75 per share on December 14, 2006 following approval by our shareholders (the “Unsecured Notes”);
c.	Warrants to purchase approximately 5,403,000 shares of our common stock, which are exercisable starting in May 2007 for five years at an exercise price of $2.21 per share (the “Initial Warrants”); and
d.	Warrants to purchase approximately 3,105,000 shares of our common stock, which are exercisable for five years at an exercise price of $2.21 per share following approval by our shareholders on December 14, 2006 (the “Additional Warrants”).

     Pursuant to the second purchase agreement, we issued and sold:

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a.	$12,000,000 in aggregate principal amount of 6% Senior Secured Convertible Notes (the “Secured Notes”), which became convertible into 5,454,546 shares of our common stock at a conversion price of $2.20 following approval by our shareholders on December 14, 2006; and
b.	Warrants to purchase approximately 1,909,091 shares of our common stock, which are exercisable for five years at an exercise price of $2.21 per share following approval by our shareholders on December 14, 2006 (the “Secured Note Warrants”).

     Roth Capital Partners, LLC (“Roth”) served as placement agent in the transaction and received warrants to acquire 1,218,701 shares of common stock at an exercise price of $2.21 per share (the “Roth Warrants”). Additionally, we paid Roth cash fees of $1,700,000 at the closing of the Private Placement and on February 20, 2007, after negotiation, we issued 289,728 shares of our common stock to Roth, as well as the Roth Warrants, in final settlement of the fees.

     The Additional Warrants and some of the Initial Warrants were issued in connection with the Unsecured Notes, and the fair values of these Additional Warrants and Initial Warrants were allocated as discounts to the Unsecured Notes. The remaining Initial Warrants were issued in connection with the Shares, and these Initial Warrants were allocated as a reduction of proceeds from the issuance of the Shares. The Secured Note Warrants were allocated as discounts to the Secured Notes. The fair value of the Roth Warrants was allocated between deferred financing cost and the proceeds from the issuance of the Shares. The net proceeds from the issuance of the Shares were $7,684,000, net of the effect of the fair value of the Initial Warrants of $6,253,000 and transaction costs of $1,988,000.

     The conversion price of the Secured Notes ($2.20) at its commitment date, the date of shareholder approval on December 14, 2006, was below the market price of $2.58. In accordance with Emerging Issues Task Force Issue No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios” (“EITF 98-5”) and Issue No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments,” we recorded an amount that represented the difference between the conversion price and the fair value of our common stock multiplied by the number of shares into which the Secured Notes are convertible ($4,400,000) as a discount to the Secured Notes with an offsetting entry to Additional Paid-In Capital. This amount will be amortized to interest expense over the period to the Secured Notes over the contractual maturity of the debt. Should the Secured Notes be converted prior to their contractual maturity the unamortized balance will be charged to interest expense.

     Upon conversion of the Unsecured Notes on December 14, 2006 unamortized discount of $1,202,000 and deferred financing costs of $1,464,000 were recorded as Additional Paid-In Capital.

     The Secured Notes bear interest, payable quarterly, at 6% per annum and are due in November 2009. Following approval of our shareholders on December 14, 2006, the Secured Notes can convert into shares of common stock at a conversion price of $2.20 per share at the option of the holders of the Secured Notes. The Secured Notes are secured by certain of our existing and future property, as well as the existing and future property of each of our wholly-owned subsidiaries. Notwithstanding, we can, under the terms of the Secured Notes, enter into one or more working capital line of credit facilities secured by our accounts receivable and inventory up to $7,000,000.

     So long as any amount due under the Secured Notes is outstanding and until the earlier of (i) the indefeasible payment in full of all amounts payable and (ii) the conversion of Secured Notes, we are required to maintain certain financial covenants, including that we maintain:

a.	at the end of each fiscal quarter commencing with the fiscal quarter ending April 30, 2007, an unrestricted balance of cash (including cash equivalents and excluding cash from any working capital line of credit) of not less than $4,500,000, or $10,500,000 in the event our Peridex® product line is divested;
b.	for each of the fiscal quarters ending January 31, 2008 and April 30, 2008, EBITDA of at least $1, excluding certain costs associated with the development and marketing of OraTest®; provided, however, that if our Peridex® product line is divested the EBITDA target will be reduced by $1,500,000 on an annualized basis;
c.	for the fiscal quarter ended July 31, 2008, GAAP net income of at least $1, excluding certain costs associated with the development and marketing of OraTest®; provided, however, that if our Peridex® product line is divested the net income target will be reduced by $1,500,000 on an annualized basis; and
d.	for each fiscal quarter commencing with the fiscal quarter ending October 31, 2008, net income of at least $1.

     Failure to satisfy these financial tests, or to maintain compliance with the negative covenants described in our definitive proxy statement filed with the SEC on November 24, 2006, could, at the option of the Secured Note holders, result in an event of default under the Secured Notes. Upon the occurrence of the first specified event of default, the holders of the Secured Notes could accelerate and demand repayment of one-third of the outstanding principal balance and all accrued but unpaid interest on the Secured Notes. Upon the occurrence of the second specified event of default, the holders of the Secured Notes could accelerate and demand

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repayment of one-half of the outstanding principal balance and all accrued but unpaid interest on the Secured Notes. Upon the occurrence of the third specified event of default, the entire principal balance and all accrued but unpaid interest may become due and payable.

     The Secured Notes also contain various non-financial covenants, including a requirement that Zila separate the offices of Chairman of the Board and Chief Executive Officer, which occurred on May 21, 2007, and, on or prior to August 1, 2007, increase the size of the Board of Directors from seven to nine directors and, in addition to filling any directorships that become vacant prior to such time, use commercially reasonable efforts to appoint two additional directors to Zila’s Board of Directors. As of the date of this Quarterly Report on Form 10-Q, Zila has not yet increased the size of the Board of Directors nor identified directors to fill the two vacancies that would occur upon such increase in size. Zila’s Board of Directors currently has five members. If these requirements are not satisfied, it could also result in an event of default that could result in the acceleration of the entire principal amount outstanding, together with accrued but unpaid interest.

     The Private Placement was made only to accredited investors in transactions that are exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”) pursuant to Regulation D promulgated thereunder.

Credit Facility

     On March 24, 2006, we, certain of our domestic subsidiaries and BDCF, as the initial lender and administrative agent, entered into the Credit Facility. On October 2, 2006, debt outstanding under the Credit Facility in the amount of approximately $20,000,000 plus accrued interest was repaid from the proceeds of the disposition of the Nutraceuticals Business Unit and the Credit Facility was terminated. Upon termination of the Credit Facility, we recognized a non-cash loss of $3,600,000 for the write-off of unamortized debt financing costs and debt discount. These costs were recorded as interest expense.

Industrial Development Revenue Bonds

     On September 28, 2006, we redeemed Bonds in the amount of $2,800,000 plus accrued interest. Funds in the restricted cash collateral account were utilized for this repayment. Upon the retirement of the Bonds, we recognized a loss of approximately $216,000 for the write-off of the unamortized deferred financing costs. These Bonds were included in long-term assets of discontinued operations at July 31, 2006.

PharmaBio Investment

     In December 2002, we entered into an agreement with PharmaBio Development, Inc. (“PharmaBio”), the strategic investment group of Quintiles Transnational Corp., our contract research organization. Under this agreement, PharmaBio invested $500,000 in us. In return for the investment, we agreed to pay PharmaBio an amount equal to 5.0% of all net sales of the OraTest^® product in the European Union and the United States. The aggregated amount of the royalty payments cannot exceed $1,250,000 and the royalty is payable quarterly. The investment was recorded as long-term debt and will be amortized using the effective interest method.

Off-Balance Sheet Financing Arrangements

     We do not have any off-balance sheet financing arrangements.

Disclosures about Contractual Obligations and Commercial Commitments

     The table below summarizes our future cash contractual obligations at April 30, 2007, and the effect that such obligations are expected to have on our liquidity and cash flows for fiscal years ending July 31 (in thousands).

	Remaining
	2007		2008 & 2009		2010 & 2011		Thereafter		Total
Long-term debt	$	—	$	12,500	$	—	$	—	$	12,500
Operating leases		169		613		243		—		1,025
Capital lease obligations		20		149		34		—		203
Purchase obligations		90		1,970		—		—		2,060
Total	$	279	$	15,232	$	277	$	—	$	15,788

     Purchase obligations include contractual arrangements that are legally binding and enforceable. These contractual arrangements specify all significant terms, including fixed or minimum quantities to be purchased, pricing provisions and the approximate timing of the transaction. The timing of payments for our purchase obligations is estimated based upon current information. The actual timing and amount of payment may differ from this estimate.

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     Purchase orders for raw materials and other goods and services are not included in the above table. Our purchase orders may represent authorizations to purchase rather than definitive binding contractual obligations. Contractual arrangements for goods and services that contain clauses allowing for cancellation without significant penalty are not included in the above table.

Summary of Critical Accounting Policies and Estimates

     The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the balance sheet date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Our significant accounting policies and critical estimates are disclosed in our Annual Report on Form 10-K for the year ended July 31, 2006. No significant changes to our significant accounting policies and critical estimates have occurred subsequent to July 31, 2006, except for the adoption of EITF-00-19-2, described in Note 8 of the notes to our unaudited consolidated financial statements.

Accounting for Income Taxes

     For the nine months ended April 30, 2007, we recognized an income tax benefit of $4,001,000 from the utilization of net operating loss carryforwards to offset the income tax expense on the taxable gain from the sale of our Nutraceuticals Business Unit that is presented in discontinued operations.

     At April 30, 2007, we have recorded a valuation allowance for our net deferred tax assets of $15,084,000, due to a lack of earnings history, and we had federal net operating loss carry forwards of approximately $50,045,000, which expire in years 2009 through 2027.

     We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets, liabilities, and net operating loss and credit carryforwards. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on historical income, projected future income, the expected timing of the reversals of existing temporary differences, and the implementation of tax-planning strategies.

     As we have incurred cumulative losses in the United States, we have not recognized tax benefits for these operating losses as we are precluded from considering the impact of future forecasted income pursuant to the provisions of SFAS No. 109 in assessing whether it is more likely than not that all or a portion of our deferred tax assets may be recoverable. We compute cumulative losses for these purposes by adjusting pre-tax results (excluding the cumulative effects of accounting method changes and including discontinued operations and other “non-recurring” items such as restructuring or impairment charges) for permanent items.

     Should we determine that we will be able to realize all or a portion of our deferred tax assets in the United State in the foreseeable future, an adjustment to the valuation allowance related to our deferred tax assets would cause a material increase to net earnings in the period in which such determination was made. Significant management judgment is required in determining the period in which the reversal of a valuation allowance should occur. We consider all available evidence, both positive and negative, in making this determination, including historical income, projected future income, the expected timing of the reversals of existing temporary differences and the implementation of tax-planning strategies.

EBITDA

     We utilize EBITDA (defined as earnings (loss) before interest, taxes (income), depreciation, and amortization) to monitor compliance with the covenants contained in our Secured Notes, some of which are based on EBITDA. Although we use EBITDA as a financial measure to monitor compliance with debt covenants, it does not include certain material costs, expenses, and other items necessary to operate our business. Because EBITDA does not include these items, a stockholder, potential investor or other user of our financial information should not consider this non-GAAP financial measure as a substitute for Net Cash Used in Operating Activities or as the sole indicator of our financial performance since Net Cash Used in Operating Activities provides a more complete measure of our performance.

Reconciliation of Non-GAAP Measures to GAAP Measures
Unaudited
(in thousands)

	Nine months ended April 30,
	2007			2006
EBITDA	$	(1,998	)	$	(17,435	)
Interest income		426			231
Interest expense		(6,733	)		(898	)

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	Nine months ended April 30,
	2007			2006
Income tax expense		(67	)		(4	)
Amortization of deferred financing costs		2,379			204
Amortization of debt discounts		3,046			114
Non-cash interest on term loan		202			77
Gain from sale of discontinued operations		(10,973	)		—
Non-cash derivative (income) expense		(1,059	)		97
Non-cash stock-based employee compensation expense		1,425			329
Non-cash charge for options issued to outside parties		29			63
Other non-cash items — net		(36	)		(282	)
Change in assets and liabilities:
Receivables		225			3,864
Inventories		21			(1,845	)
Prepaid expenses and other assets		846			(386	)
Accounts payable and accrued liabilities		2,494			(522	)
Net cash used in operating activities	$	(9,773	)	$	(16,393	)

Recent Accounting Pronouncements

     The new pronouncements that have been issued for future implementation are discussed in the footnotes to our interim consolidated financial statements (see Note 2).

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

     Our exposure to market risk for a change in interest rates relates primarily to our investments, which consist of cash and cash equivalents. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. We maintain our portfolio in high credit quality money market funds and the carrying value at April 30, 2007 approximates market value. Because our investments consist of cash equivalents, a hypothetical 100 basis point change in interest rates is not likely to have a material effect on our consolidated financial statements.

     We also have market risk arising from changes in foreign currency exchange rates through our subsidiaries that conduct business in Canada and Europe and through a subsidiary that uses the British pound as its functional currency. We believe that such exposure does not present a significant risk due to the limited number of transactions and/or accounts denominated in foreign currency and that a hypothetical 100 basis point change in foreign current exchange rates is not likely to have a material effect on our consolidated financial statement.

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures.

     Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting.

     On November 28, 2006, we acquired Pro-Dentec^® and, as a result of the acquisition, our internal controls over financial reporting with respect to the consolidation of our financial statements have changed. Management expects that ongoing processes and controls related to consolidation will continue to be modified during fiscal year 2007. Since this acquisition, we have started to analyze the systems of disclosure controls and procedures and internal control over financial reporting of the acquired company and integrate them within our broader framework of controls. We plan to continue this evaluation and integration in the next quarter. Although we have not yet identified any material weaknesses in our disclosure controls and procedures or internal control over financial reporting as a result of this acquisition, there can be no assurance that a material weakness will not be identified in the course of this review. There are no other changes in internal control over financial reporting that occurred during the period that have materially affected or are

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reasonably likely to materially affect our internal control over financial reporting.

Part II — Other Information

Item 1. Legal Proceedings.

     Except as described below, as of April 30, 2007, we were not a party to any pending legal proceedings other than claims that arise in the conduct of our business. While we currently believe that the ultimate outcome of these proceedings will not have a material adverse effect on our consolidated financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our net income in the period in which a ruling occurs. Our estimate of the potential impact of the following legal proceedings on our financial position and our results of operation could change in the future.

     In connection with the acquisition of patent rights in 1980, we agreed to pay to Dr. James E. Tinnell (“Tinnell”), the inventor of one of our former treatment compositions, a royalty of 5% of gross sales of the invention disclosed in his then pending patent application. In September 2000, we notified Tinnell that we would no longer pay such royalties because the obligations ceased in August 1998 when the related product patents expired and we requested reimbursement of royalties paid since August 1998. We then filed suit on November 8, 2000, in the United States District Court for the District of Nevada requesting a declaratory judgment that we had no royalty obligations to Tinnell and requested judgment for the overpaid royalties. On April 22, 2004, the Court, in part, ruled in our favor, stating that our royalty obligations to Tinnell ceased in August 1998, however, our request for reimbursement of overpaid royalties was dismissed. Tinnell filed a notice of appeal and we have filed a notice of cross-appeal. Briefs have been filed by both parties with the Ninth Circuit Court of Appeals and oral argument took place on December 8, 2006.

     On June 27, 2005 we sold our Zilactin^® brand of products to Blairex. We received a demand for arbitration from Blairex dated February 8, 2006, claiming that it had suffered post-closing economic loss as a result of losing distribution of certain products and requirements by the Consumer Product Safety Commission. Pursuant to the Agreement of Purchase and Sale that documented the Zilactin^® sale, the dispute was subject to arbitration. Both of the events alleged occurred after the sale closed on June 27, 2005 and were not covered by any representations or warranties that were given to Blairex by the Company. The parties were unsuccessful in an attempt to resolve the dispute through formal mediation. However, on November 3, 2006, we entered into a Settlement Agreement and Mutual Release (“Settlement Agreement”) with Blairex. The Settlement Agreement provided for the dismissal of the arbitration matter and the payment of $650,000 to Blairex, the cost of which was recorded in discontinued operations for the quarter ended October 31, 2006.

     On September 15, 2006, Alacer Corporation (“Alacer”) filed suit against Zila Nutraceuticals, Inc. (“ZNI”) and Bernie Landes (“Landes”) in Superior Court in Orange County, California. Alacer alleges misappropriation of trade secrets, unfair competition, conversion, unjust enrichment, and accounting against ZNI and Landes, as well as breach of duty of loyalty claims against Landes. As a part of the sale of ZNI to NBTY, Inc. on October 3, 2006, the Company agreed to indemnify and hold NBTY harmless with respect to the Alacer litigation. By its Complaint, Alacer alleged that Landes, a former Alacer employee, had taken certain documents containing trade secrets with him when he left Alacer. Alacer further alleged that Landes and ZNI had used these documents to unfairly compete with Alacer. In particular, Alacer alleges that copies of the documents were provided to Alacer’s competitor in order to assist the competitor in creating an effervescent vitamin C product similar to Alacer’s Emergen-C product line. ZNI and Landes have denied Alacer’s claims. In particular, ZNI and Landes deny that the information contained in the documents at issue here constitutes trade secrets. The parties are presently engaging in the discovery process, and both parties have served and responded to initial sets of discovery requests. A non-binding mediation was held on March 29, 2007. The parties have agreed to a settlement, pending documentation, which will require the payment of $100,000 to Alacer.

     An antitrust case was filed in 2000 in the U.S. District Court in Delaware by several dental laboratories as class representatives for all dental labs which had purchased Dentsply artificial teeth. The suit alleges that Dentsply, the major supplier of artificial teeth, required each of its distributors to agree not to supply the teeth of its competitors as a condition of Dentsply’s supplying its artificial teeth to a distributor. According to the complaint this requirement resulted in a lack of choices for the laboratories and increased costs for the Dentsply teeth because it permitted Dentsply to limit the supply of its competitors’ teeth so as to give it a monopoly and the power to set prices. Plaintiffs also alleged that each of the distributors agreed with Dentsply to this condition in violation of Sections 1 and 2 of the Sherman Act and Section 6 of the Clayton Act. At the same time the U.S. Department of Justice was criminally prosecuting Dentsply for the same activities. Ultimately Dentsply was found guilty of the charges.

     The civil lawsuit, in which Ryker Dental of Kentucky, Inc., our inactive wholly-owned subsidiary, is one of about 15 defendants, was stayed for years because of appeals taken by the plaintiffs from orders by the trial court that since the plaintiffs had not purchased artificial teeth directly from Dentsply, it could not, as a matter of law, have any liability to the plaintiffs or class members. The 3rd Circuit Court of Appeals largely agreed with Dentsply, except that it permitted a claim to proceed that Dentsply and the distributors had conspired to monopolize the artificial teeth market. The case is now in the trial court and discovery against the largest distributors has been permitted by the trial judge. There are motions pending

32

before the trial judge to dismiss Ryker for lack of personal jurisdiction and to dismiss one of the Counts on substantive grounds.

     As discussed in greater detail in Note 8 to the financial statements included with this Quarterly Report on Form 10-Q, in November 2006, concurrent with the closing of the Private Placement, we entered into two registration rights agreements (the “Private Placement Registration Rights Agreements”) to register the Shares and shares of common stock issuable upon the conversion of the Unsecured Notes and Secured Notes and upon the exercise of the Initial Warrants, Additional Warrants, and Secured Note Warrants. Under the terms of the Private Placement Registration Rights Agreements, we agreed to file an initial registration statement registering the Shares and shares of common stock underlying the Initial Warrants (the “Initial Registration Statement”). We also agreed to file a subsequent registration statement registration statement registering shares of common stock underlying the Additional Warrants, Secured Note Warrants, Unsecured Notes and Secured Notes (the “Subsequent Registration Statement”).

     Under the Private Placement Registration Rights Agreements, if the Initial Registration Statement or Subsequent Registration Statement are not filed, or declared effective, by certain predetermined deadlines, then, in addition to any other rights the investor may have, we will be required to pay the investor whose shares are being registered liquidated damages, in cash, equal to one percent per month (pro rata for each day beyond each deadline) of the aggregate purchase price paid by such investor for the securities being registered on either the Initial Registration Statement or Subsequent Registration Statement, as applicable, up to a maximum of 24% of each such investor’s investment.

     We are obligated to maintain the effectiveness of the Initial Registration Statement and the Subsequent Registration Statement until the earlier of the date on which all securities registered thereby have been sold and the date on which all securities registered thereby may be sold pursuant to Rule 144(k) under the Securities Act. If we do not maintain the effectiveness of the Initial Registration Statement and the Subsequent Registration Statement, as required, then we are subject to the above described liquidated damages.

     We did not incur any liquidated damages in connection with the Initial Registration Statement because we filed it on December 28, 2006, and it was declared effective on March 23, 2007, both of which were within the time periods prescribed by the Private Placement Registration Rights Agreements.

     We filed the Subsequent Registration Statement on January 12, 2007, which was within the time period prescribed by the Private Placement Registration Rights Agreements. However, the Subsequent Registration Statement was not declared effective until May 4, 2007, which was after the April 13, 2007 effectiveness deadline. Several of the investors waiver their rights to liquidated damages, but we incurred liquidated damages of $99,100 at April 30, 2007 as a result of the delay.

     Although Zila has not received notice of any claim filed against it or a request or demand for alternative dispute resolution, it is possible that a dispute may exist between Zila and some of the investors that were supposed to be listed as selling security holders in the Subsequent Registration Statement. The SEC reviewed and provided extensive comments on the Subsequent Registration Statement and, as a condition precedent to declaring the Subsequent Registration Statement effective, the SEC required Zila to either remove three groups of investors or to identify the same as “underwriters” in the Subsequent Registration Statement. Rather than be designated as underwriters, the three investor groups preferred to have the shares that were issued to them, and the shares that were issuable to them upon conversion of the Secured Notes and exercise of Additional Warrants and Secured Note Warrants, as applicable, removed from the Subsequent Registration Statement. As a result, Zila believes its obligation to pay liquidated damages to these three investors groups for the period after May 4, 2007 was extinguished. However, Zila is aware that at least two of the three investor groups may take the position that Zila’s obligation to pay liquidated damages is ongoing and will continue until their securities are registered, subject to the contractually agreed limitation of 24% of the amount of each investor group’s investment in Zila.

     The dispute would likely be contractual in nature, but Zila cannot predict whether it will prevail. Zila will vigorously defend its position and if Zila’s position prevails, Zila will not be obligated to pay additional liquidated damages, although it will incur costs and expenses associated with participating in alternative dispute resolution. Assuming all three investor groups pursue a claim for liquidated damages of up to 24% of each investor group’s investment, and that this position prevails, in addition to costs and expenses incurred, Zila could be obligated to pay an aggregate of $4,386,600 in additional liquidated damages.

Item 1A. Risk Factors.

     The statements in this section describe the major risks to our business and should be considered carefully. If any of the following risks actually occur, they may materially harm our business, financial condition, operating results or cash flow. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. Additional risks and uncertainties that are not yet identified or that we think are immaterial may also materially harm our business, operating results or financial condition.

33

Trends, Risks and Uncertainties Related to Our Business

We may be unable to obtain FDA approval, or to establish a market, for OraTest^®in the United States and obtaining regulatory approval for OraTest^®and other products is costly and uncertain.

     We are seeking FDA approval for OraTest^® and are conducting a phase III clinical trial to include in an amended New Drug Application. The rigorous clinical testing and extensive regulatory approval process mandated by the FDA and equivalent foreign authorities before we can market for OraTest^® or any new drug, device or product can take a number of years and require the expenditure of substantial resources, and approval may not ultimately be obtained.

     We have made a significant financial investment to obtain FDA approval of the OraTest^® product, to build our manufacturing facility, and to prepare for the introduction of OraTest^® in the United States market. There can be no assurance that our regulatory program will meet the FDA’s requirements or that the FDA will issue a final approval of the OraTest^® product, and the failure of the FDA to approve OraTest^® would make it impossible for us to recoup our investment through sales of the OraTest^® product in the United States and we may have to reduce the carrying value of the OraTest^® assets.

     It is doubtful that funds will be available to conduct the program at the optimal pace or be adequate to support the future regulatory program costs. Factors that affect the cost and timing of completion of the regulatory program include but are not limited to: (i) patient enrollment rates; (ii) lesion formation rate within the study population; (iii) compliance with the study protocol and related monitoring; (iv) level of funding throughout the study; (v) completion of testing within the non-clinical and chemistry, manufacturing, and controls areas; and (vi) program modifications or requirements for additional testing. No assurances can be made that the regulatory objectives will be achieved for OraTest^®.

     If FDA approval of the OraTest^® product is received, such approval may entail limitations on the indicated uses for which the product may be marketed and there is no assurance that we will be successful in gaining market acceptance of the OraTest^® product. Moreover, a marketed product, its manufacturer, its manufacturing facilities, and its suppliers are also subject to continual review and periodic inspections, and later discovery of previously unknown problems, or the exacerbation of problems previously deemed acceptable, with a product, manufacturer, or facility may result in restrictions on such product or manufacturer, potentially including withdrawal of the product from the market, which would adversely affect our operations and financial condition. The length of the FDA regulatory process and review period varies considerably, as does the amount of data required to demonstrate the safety and efficacy of a specific product. If the compounds in testing are modified or optimized or if certain results are obtained, it may extend the testing process. Additional testing, delays or rejections may be encountered based upon changes in FDA policy, personal or prior understandings during the period of product development and FDA regulatory review of each investigational new drug application, new drug application, or product license application. Similar delays may also be encountered in other countries. There can be no assurance that even after such time and expenditures we will obtain regulatory approval for any products we develop.

Our lack of earnings history could adversely affect our financial health and prevent us from fulfilling our payment obligations, and if we are unable to generate funds or obtain funds on acceptable terms, we may not be able to develop and market our present and potential products.

     Our liquidity needs arise from the funding of our OraTest^®regulatory program and the launch of our new products, such as ViziLite^® Plus, working capital and debt service requirements, and future strategic initiatives. In the past, we have met these cash requirements through our cash and cash equivalents, borrowings under our credit facility, cash from operations and working capital management, the sale of non-core assets, proceeds from the issuance of common stock under our employee stock option and stock purchase programs, and, recently, proceeds from the Private Placement.

     However, the development of our products, including OraTest^®, will require the commitment of substantial resources to conduct the time-consuming research and development, clinical studies and regulatory activities necessary to bring any potential product to market and to establish production, marketing and sales capabilities.

     Our ability to develop our products, to service our debt obligations, to fund working capital and capital expenditures, and for other purposes that cannot at this time be quantified will depend on (i) our future operating performance, which will be affected by factors discussed elsewhere in the reports we file with the SEC, including, without limitation, receipt of regulatory approvals, economic conditions and financial, business, and other factors, many of which are beyond our control, and (ii) our ability to obtain additional financing, through indebtedness or otherwise, on acceptable terms, or at all.

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     Based on our currently available funds, we will be required to pursue one or more of the following strategies: (i) delay, scale back or eliminate some or all of our research and product development programs, (ii) limit the marketing of our products, (iii) license to third parties the rights to commercialize products or technologies that we would otherwise seek to develop and market ourselves; and/or (iv) raise additional funds. There can be no assurance that we will be successful in executing these strategies. If we are unable to execute these strategies, we may breach the financial covenants of our senior secured debt and be unable to repay the outstanding balance. These factors raise substantial doubt about our ability to continue as a going concern.

     In addition, our lack of earnings history and our level of debt could have important consequences, such as:

• making it more difficult for us to satisfy our obligations with respect to the Secured Notes;

• increasing our vulnerability to general adverse economic and industry conditions;

• limiting our flexibility in planning for, or reacting to, changes in our business and our industry;

• restricting us from making strategic acquisitions, introducing new products or exploiting business opportunities;

• requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, which will reduce the amount of our cash flow available for other purposes, including capital expenditures and other general corporate purposes;

• requiring us to sell debt securities or to sell some of our core assets, possibly on unfavorable terms;

• limiting our ability to obtain additional financing; and

• placing us at a possible competitive disadvantage compared to our competitors that may have greater financial resources.

Our debt instruments contain restrictive covenants that could adversely affect our business by limiting our flexibility.

     Our Secured Notes impose restrictions that affect, among other things, our ability to incur debt, pay dividends, sell assets, create liens, make capital expenditures and investments, merge or consolidate, enter into transactions with affiliates, and otherwise enter into certain transactions outside the ordinary course of business. Our Secured Notes also require us to maintain defined levels of cash and EBITDA, defined as earnings (loss) before interest, taxes (income), depreciation, and amortization. Our ability to comply with these covenants and restrictions may be affected by events beyond our control. If we are unable to comply with the terms of our Secured Notes, or if we fail to generate sufficient cash flow from operations to service our debt, we may be required to refinance all or a portion of our indebtedness or to obtain additional financing. If cash flow is insufficient and refinancing or additional financing is unavailable because of our high levels of debt and the debt incurrence restrictions under our debt instruments, we may default on our debt instruments. In the event of a default under the terms of any of our indebtedness, the debt holders may, under certain circumstances, accelerate the maturity of our obligations and proceed against their collateral.

We may fail to realize the anticipated cost savings, revenue enhancements, product focus, or other benefits expected from our recent acquisition of Pro-Dentec.

     Our future growth will depend on our ability to implement our business strategy. We believe that our recent acquisition of Pro-Dentec, a privately-held dental products company, could strengthen our business, including the development and commercialization of oral cancer screening products. Further, we believe that this acquisition could increase our ability to deliver our oral cancer screening products into the dental marketplace and could result in synergies that enhance our sales capability, potentially reduce our costs and increase our profits. However, successful acquisitions in our industry are difficult to accomplish because they require, among other things, efficient integration and aligning of product offerings and manufacturing operations and coordination of sales and marketing and research and development efforts. The difficulties of integration and alignment may be increased by the necessity of coordinating geographically separated organizations, the complexity of the technologies being integrated and aligned and the necessity of integrating personnel with disparate business backgrounds and combining different corporate cultures. The integration and alignment of operations following an acquisition or alliance requires the dedication of management resources that may distract attention from the day-to-day business, and may disrupt key research and development, marketing or sales efforts. In addition, there is no guarantee that such acquisition will result in the synergies we anticipate. Furthermore, uncertainties associated with such acquisition combined with the recent disposition of our Nutraceuticals Business Unit may cause loss of employees. Ultimately, the success of such acquisition depends in part on the retention of key personnel. There can be no assurance that we will be able to retain the acquired company’s key management, technical, sales and customer support personnel. If we fail to retain such key employees, we may not realize the anticipated benefits of such acquisition.

Historically we have been dependent on a few key products and our future growth is dependent on the development of new products.

     Nearly all of our revenues for the past fiscal year were derived from sales of Ester-C^®, Peridex^®, and ViziLite^® Plus. As disclosed above, we disposed of our Nutraceuticals Business Unit and the Ester-C^® products on October 2, 2006. With the acquisition of Pro-

35

Dentec and the change in our distribution method for ViziLite^® Plus and the addition of the STM^® products of Pro-Dentec, we now sell direct to thousands of dental offices nationally and we believe we have reduced our dependency on key customers.

     If any of our major products were to become subject to a problem such as loss of patent protection, unexpected side effects, regulatory proceedings, publicity affecting user confidence, or pressure from competing products, or if a new, more effective treatment should be introduced, the impact on our revenues could be significant. Additionally, we are reliant on third party manufacturers and single suppliers for our ViziLite^® Plus product, and any supply problems resulting from regulatory issues applicable to such parties or failures to comply with current Good Manufacturing Practices could have a material adverse impact on our financial condition.

     Our future growth is dependent on new product development. New product initiatives may not be successfully implemented because of many factors, including, but not limited to, difficulty in assimilation, development costs, and diversion of management time. There can be no assurance that we will successfully develop and integrate new products into our business that will result in growth and a positive impact on our business, financial condition, and results of operation.

     A number of factors could impact our plans to commercialize our new products, including, but not limited to, difficulties in the production process, controlling the costs to produce, market and distribute the product on a commercial scale, and our ability to do so with favorable gross margins and otherwise on a profitable basis; the inherent difficulty of gaining market acceptance for a new product; competition from larger, more established companies with greater resources; changes in raw material supplies that could result in production delays and higher raw material costs; difficulties in promoting consumer awareness for the new product; adverse publicity regarding the industries in which we market our products; and the cost, timing, and ultimate results of regulatory program studies that we undertake.

Our proprietary rights may prove difficult to enforce.

     Our current and future success depends on a combination of patent, trademark, and trade secret protection and nondisclosure and licensing agreements to establish and protect our proprietary rights. We own and have exclusive licenses to a number of United States and foreign patents and patent applications and intend to seek additional patent applications as we deem necessary and appropriate to operate our business. We can offer no assurances regarding the strength of the patent portfolio underlying any existing or new product and/or technology or whether patents will issue from any pending patent applications related to a new product and/or technology, or if the patents do issue, that any claims allowed will be sufficiently broad to cover the product, technology or production process. Although we intend to defend our proprietary rights, policing unauthorized use of intellectual property is difficult or may prove materially costly and any patents that may be issued relating to new products and technology may be challenged, invalidated or circumvented.

We are dependent on our senior management and other key personnel.

     Our ability to operate successfully depends in significant part upon the experience, efforts, and abilities of our senior management and other key scientific, technical, and managerial personnel. Competition for talented personnel is intense. On June 13, 2007, Douglas D. Burkett, PhD., resigned as our President and Chief Executive Officer and as a Director. Frank J. Bellizzi, DMD,our Executive Vice President of Zila, Inc. and President of Zila Pharmaceuticals, Inc., assumed, on an interim basis, the role of Principal Executive Officer. The future loss of services of one or more of our key executives could adversely impact our financial performance and our ability to execute our strategies. Additionally, if we are unable to attract, train, motivate, and retain key personnel, our business could be harmed.

     Also, in connection with the Private Placement, the Company agreed to appoint a Chair other than its Chief Executive Officer to its Board of Directors, which occurred on May 21, 2007, and to use its commercially reasonable efforts to fill two vacancies on its Board of Directors resulting from an increase in the size of the Board of Directors that has yet to occur, on or before August 1, 2007. Additionally, we have two vacancies to fill on our Board of Directors as currently constituted. We cannot provide assurance that we will be able to attract qualified candidates to fill such positions. If we are unable to do so, an event of default could occur on our Secured Notes, which would require us to repay the entire outstanding principal balance, plus accrued but unpaid interest, on such Secured Notes, regardless if we have sufficient funds to repay such indebtedness.

We and our products are subject to regulatory oversight that could substantially interfere with our ability to do business.

     We and our present and future products are subject to risks associated with new federal, state, local, or foreign legislation or regulation or adverse determinations by regulators under existing regulations, including the interpretation of and compliance with existing, proposed, and future regulatory requirements imposed by the FDA. We are also subject to other governmental authorities such as the Department of Health and Human Services, the Consumer Products Safety Commission, the Department of Justice, and the United States Federal Trade Commission with its regulatory authority over, among other items, product safety and efficacy claims

36

made in product labeling and advertising. Individual states, acting through their attorneys general, have become active as well, seeking to regulate the marketing of prescription drugs under state consumer protection and false advertising laws. A regulatory determination or development that affects our ability to market or produce one or more of our products could have a material adverse impact on our business, results of operation, and financial condition and may include product recalls, denial of approvals, and other civil and criminal sanctions.

We are at risk with respect to product liability claims.

     We could be exposed to possible claims for personal injury resulting from allegedly defective products manufactured by third parties with whom we have entered into manufacturing agreements or by us. We maintain $6,000,000 in product liability insurance coverage for claims arising from the use of our products, with limits we believe are commercially reasonable under the circumstances, and, in most instances, require our manufacturers to carry product liability insurance. While we believe our insurance coverage is adequate, we could be subject to product liability claims in excess of our insurance coverage. In addition, we may be unable to retain our existing coverage in the future. Any significant product liability claims not within the scope of our insurance coverage could have a material adverse effect on us.

We face significant competition that could adversely affect our results of operation and financial condition.

     The pharmaceutical, medical device, and related industries are highly competitive. A number of companies, many of which have financial resources, marketing capabilities, established relationships, superior experience and operating history, and research and development capacities greater than ours, are actively engaged in the development of products similar to the products we produce and market. The pharmaceutical industry is characterized by extensive and ongoing research efforts. Other companies may succeed in developing products superior to those we market. It may be difficult for us to maintain or increase sales volume and market share due to such competition which would adversely affect our results of operations and financial condition. The loss of any of our products’ patent protection could lead to a significant loss in sales of our products in the United States market.

If the use of our technology is determined to infringe on the intellectual property rights of others, our business could be harmed.

     Litigation may result from our use of registered trademarks or common law marks and, if litigation against us were successful, a resulting loss of the right to use a trademark could reduce sales of our products and could result in a significant damage award. International operations may be affected by changes in intellectual property legal protections and remedies in foreign countries in which we do business.

     Furthermore, if it were ultimately determined that our intellectual property rights are unenforceable, or that our use of our technology infringes on the intellectual property rights of others, we may be required or may desire to obtain licenses to patents and other intellectual property held by third parties to develop, manufacture, and market products using our technology. We may not be able to obtain these licenses on commercially reasonable terms, if at all, and any licensed patents or intellectual property that we may obtain may not be valid or enforceable. In addition, the scope of intellectual property protection is subject to scrutiny and challenge by courts and other governmental bodies. Litigation and other proceedings concerning patents and proprietary technologies can be protracted, expensive, and distracting to management and companies may sue competitors as a way of delaying the introduction of competitors’ products. Any litigation, including any interference proceedings to determine priority of inventions, oppositions to patents in foreign countries or litigation against our partners, may be costly and time-consuming and could significantly harm our business.

     Because of the large number of patent filings in our industry, our competitors may have filed applications or been issued patents and may obtain additional patents and proprietary intellectual property rights relating to products or processes competitive with or similar to ours. We cannot be certain that United States or foreign patents do not exist or will not be issued that would harm our ability to commercialize our products and product candidates. In addition, our exposure to risks associated with the use of intellectual property may be increased as a result of an acquisition as we have lower visibility into any potential target’s safeguards and infringement risks. In addition, third party claims may be asserted after we have acquired technology that had not been asserted prior to such acquisition.

We require certain raw materials for our manufacturing processes that may only be acquired through limited sources.

     Raw materials essential to our business are generally readily available. However, certain raw materials and components used in the manufacture of pharmaceutical and medical device products are available from limited sources, and in some cases, a single source. Any curtailment in the availability of such raw materials could be accompanied by production delays, and in the case of products, for which only one raw material supplier exists, could result in a material loss of sales. In addition, because raw material sources for products must generally be approved by regulatory authorities, changes in raw material suppliers could result in production delays, higher raw material costs and loss of sales and customers. Production delays may also be caused by the lack of secondary suppliers.

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We have, in the past, received minor deficiencies from regulatory agencies related to our manufacturing facilities.

     The FDA, OSHA, and other regulatory agencies periodically inspect our manufacturing facilities and certain facilities of our suppliers. In the past, such inspections resulted in the identification of certain minor deficiencies in the standards we are required to maintain by such regulatory agencies. We developed and implemented action plans to remedy the deficiencies, however, there can be no assurance that such deficiencies will be remedied to the satisfaction of the applicable regulatory body. In the event that we are unable to remedy such deficiencies, our product supply could be affected as a result of plant shutdown, product recall or other similar regulatory actions, which would likely have an adverse affect on our business, financial condition, and results of operation.

Trends, Risks and Uncertainties Related to Our Capital Stock

The Private Placement and other financing arrangements or corporate events could significantly dilute existing ownership.

     Assuming the exercise of all Initial Warrants, Additional Warrants, all Secured Note Warrants, all Roth Warrants, and the conversion of all the Secured Notes, an additional 17,000,000 shares of our common stock will be issued, which will not only dilute a shareholder’s current ownership percentage, but will also dilute voting power. If we choose to raise additional funds through the issuance of shares of our common stock, or securities convertible into our common stock, significant dilution of ownership in our company may occur, and holders of such securities may have rights senior to those of the holders of our common stock. If we obtain additional financing by issuing debt securities, the terms of these securities could restrict or prevent us from paying dividends and could limit our flexibility in making business decisions. Moreover, other corporate events such as the exercise of outstanding options would result in further dilution of our ownership.

In the past, we have experienced volatility in the market price of our common stock and we may experience such volatility in the future.

     The market price of our common stock has fluctuated significantly in the past. We believe that announcements of new products, quarterly fluctuations in the results of operations, and other factors, including changes in conditions in general in the industries in which we operate, and developments in regulatory arenas may have caused such fluctuations. Stock markets have experienced extreme price volatility in recent years. This volatility has had a substantial effect on the market prices of securities we issued and other pharmaceutical and health care companies, often for reasons unrelated to the operating performance of the specific companies.

     In the past, stockholders of other companies have initiated securities class action litigation against such companies following periods of volatility in the market price of the applicable common stock. We anticipate that the market price of our common stock may continue to be volatile. If the market price of our common stock continues to fluctuate and our stockholders initiate this type of litigation, we could incur substantial costs and expenses and such litigation which could divert our management’s attention and resources, regardless of the outcome, thereby adversely affecting our business, financial condition, and results of operation.

We may take actions which could dilute current equity ownership or prevent or delay a change in our control.

     Our Board of Directors and stockholders recently approved an increase in our authorized capital stock from 67,500,000 to 150,000,000 and an increase in authorized common stock from 60,000,000 to 147,500,000. Some of these newly authorized shares will be reserved for issuance upon the exercise of the Initial Warrants, Additional Warrants, Secured Note Warrants and Roth Warrants, as well as the conversion of the Secured Notes, that were issued in the Private Placement. Subject to the rules and regulations promulgated by Nasdaq and the SEC, our Board of Directors could authorize the sale and issuance of additional shares of common stock, which would have the effect of diluting the ownership interests of our stockholders.

     In addition, our Board of Directors has the authority, without any further vote by our stockholders, to issue up to 2,500,000 shares of Preferred Stock in one or more series and to determine the designations, powers, preferences and relative, participating, optional or other rights thereof, including without limitation, the dividend rate (and whether dividends are cumulative), conversion rights, voting rights, rights and terms of redemption, redemption price and liquidation preference. On February 1, 2001, we issued 100,000 shares of our Series B Convertible Preferred Stock in connection with an acquisition. As of April 30, 2007, all of these shares remained outstanding. If the Board of Directors authorizes the issuance of additional shares of Preferred Stock, such an issuance could have the effect of diluting the ownership interests of our stockholders.

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

     Not applicable.

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Item 3. Defaults upon Senior Securities.

     Not applicable.

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

     Not applicable.

Item 5. Other Information.

     As further described in a Current Report on Form 8-K that Zila filed with the SEC on December 20, 2006, the Compensation Committee previously approved, among other things, 2007 annual base salaries for, changes to the severance and change of control provisions of the employment or letter agreements with, and an annual bonus plan under which performance awards can be made to, each of Douglas D. Burkett, Frank J. Bellizzi, Gary V. Klinefelter, and Diane E. Klein.

     At the time the Compensation Committee approved the aforementioned changes, Zila did not amend the employment or letter agreements with any of the officers listed above. On March 30, 2007, each of Gary V. Klinefelter and Diane E. Klein entered into an employment agreement with Zila to memorialize the terms of their respective employment with Zila, copies of which agreements are included as exhibits to this Quarterly Report on Form 10-Q. As of the date of this Quarterly Report on Form 10-Q, Zila had not entered into new employment agreements with either Frank J. Bellizzi or Douglas D. Burkett.

     In the same Current Report on Form 8-K, Zila also disclosed grants of restricted stock awards to each of Douglas D. Burkett, Frank J. Bellizzi, and Gary V. Klinefelter and a copy of the form of the restricted stock award agreement is also attached as an exhibit to this Quarterly Report on Form 10-Q.

Item 6. Exhibits.

     The following documents are filed as Exhibits to this report:

Exhibit
Number	Description
3.1	Certificate of Correction and Certificate of Incorporation (incorporated by reference to Exhibit 3-A filed with the Company’s Form 10-K for the year ended July 31, 1999)
3.2	Certificate of Amendment to Certificate of Incorporation (incorporated by reference to Exhibit 3-B filed with the Company’s Form 10-K for the year ended July 31, 2005)
3.3	Certificate of Amendment to Certificate of Incorporation (incorporated by reference to Exhibit 4.3 filed with the Company’s Form S-3 Registration Statement No. 333-139698 on December 28, 2006)
3.4	Amended and Restated Bylaws (incorporated by reference to Exhibit 3-B filed with the Company’s Form 10-K for the year ended July 31, 2002)
4.1	Certificate of Designations, Preferences and Rights of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3-D filed with the Company’s Form 10-K for the year ended July 31, 2001)
4.2	Warrant, dated February 20, 2007, issued to Roth Capital Partners, LLC (incorporated by reference to Exhibit 4.1 of Form 8-K filed February 23, 2007)
10.1	Asset Purchase Agreement, dated September May 31, 2007, by and between Zila, Inc., Zila Pharmaceuticals, Inc., 3M and 3M Innovative Properties Company (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed June 6, 2007)
10.2*	Employment Agreement between Zila, Inc. and Gary V. Klinefelter, dated as of March 31, 2007 (1)
10.3*	Employment Agreement between Zila, Inc. and Diane E. Klein, dated as of March 31, 2007 (1)
10.4	Offer letter between Zila, Inc. and Lawrence A. Gyenes (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed March 13, 2007) (1)

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Exhibit
Number	Description
10.5*	Form of Restricted Stock Award Agreement (1)
31.1*	Certification of the Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*	Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1**	Certification of the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**	Certification of the Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)	Management contract or compensatory plan or arrangement
*	Filed herewith
**	Furnished herewith

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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.

	Zila, Inc.
Date: June 18, 2007	By:	/s/ Lawrence A. Gyenes
		Lawrence A. Gyenes
		Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer)

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INDEX TO EXHIBITS

Exhibit
Number	Description
3.1	Certificate of Correction and Certificate of Incorporation (incorporated by reference to Exhibit 3-A filed with the Company’s Form 10-K for the year ended July 31, 1999)
3.2	Certificate of Amendment to Certificate of Incorporation (incorporated by reference to Exhibit 3-B filed with the Company’s Form 10-K for the year ended July 31, 2005)
3.3	Certificate of Amendment to Certificate of Incorporation (incorporated by reference to Exhibit 4.3 filed with the Company’s Form S-3 Registration Statement No. 333-139698 on December 28, 2006)
3.4	Amended and Restated Bylaws (incorporated by reference to Exhibit 3-B filed with the Company’s Form 10-K for the year ended July 31, 2002)
4.1	Certificate of Designations, Preferences and Rights of Series B Convertible Preferred Stock (incorporated by reference to Exhibit 3-D filed with the Company’s Form 10-K for the year ended July 31, 2001)
4.2	Warrant, dated February 20, 2007, issued to Roth Capital Partners, LLC (incorporated by reference to Exhibit 4.1 of Form 8-K filed February 23, 2007)
10.1	Asset Purchase Agreement, dated September May 31, 2007, by and between Zila, Inc., Zila Pharmaceuticals, Inc., 3M and 3M Innovative Properties Company (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed June 6, 2007)
10.2*	Employment Agreement between Zila, Inc. and Gary V. Klinefelter, dated as of March 31, 2007 (1)
10.3*	Employment Agreement between Zila, Inc. and Diane E. Klein, dated as of March 31, 2007 (1)
10.4	Offer letter between Zila, Inc. and Lawrence A. Gyenes (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K filed March 13, 2007) (1)
10.5*	Form of Restricted Stock Award Agreement (1)
31.1*	Certification of the Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2*	Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1**	Certification of the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2**	Certification of the Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)	Management contract or compensatory plan or arrangement
*	Filed herewith
**	Furnished herewith

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