UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT

PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended August 31, 2006

Commission file number 0-5905

CHATTEM, INC. 

A TENNESSEE CORPORATION

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

1715 WEST 38TH STREET

CHATTANOOGA, TENNESSEE 37409

TELEPHONE: 423-821-4571

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

YESþNO࿳

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 filer þ  Accelerated filer o  Non-accelerated filer o 

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

YES࿳      NOþ

As of October 5, 2006, 18,576,096 shares of the Company’s common stock, without par value, were outstanding.

CHATTEM, INC.

INDEX

	PAGE NO.
PART I.    FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of August 31, 2006 and November 30, 2005	3
Condensed Consolidated Statements of Income for the Three and Nine Months Ended August 31, 2006 and August 31, 2005	5
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended August 31, 2006 and August 31, 2005	6
Notes to Condensed Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3. Quantitative and Qualitative Disclosures About Market Risk	39
Item 4. Controls and Procedures	39
PART II.    OTHER INFORMATION
Item 1. Legal Proceedings	40
Item 1A. Risk Factors	40
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	40
Item 3. Defaults Upon Senior Securities	40
Item 4. Submission of Matters to a Vote of Security Holders	40
Item 5. Other Information	40
Item 6. Exhibits	40
SIGNATURES	41

2

PART 1. FINANCIAL INFORMATION

Item 1.    Financial Statements

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

ASSETS	August 31,         2006		NOVEMBER 30,         2005
	(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents	$	26,903	$	47,327
Accounts receivable, less allowances of $4,210 at August 31, 2006 and $2,338 at November 30, 2005		33,727		33,672
Other receivables		249		9,600
Inventories		28,903		23,631
Refundable income taxes		—		1,207
Deferred income taxes		2,010		2,478
Prepaid expenses and other current assets		7,562		5,106
Total current assets		99,354		123,021
PROPERTY, PLANT AND EQUIPMENT, NET		30,229		29,884
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net		206,209		206,387
Debt issuance costs, net		8,225		4,297
Other		4,976		4,704
Total other noncurrent assets		219,410		215,388
TOTAL ASSETS	$	348,993	$	368,293

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

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CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

LIABILITIES AND SHAREHOLDERS’ EQUITY	AUGUST 31,       2006			NOVEMBER 30,         2005
	(Unaudited)
CURRENT LIABILITIES:
Current maturities of long-term debt	$	—		$	37,000
Accounts payable and other		7,634			17,238
Accrued liabilities		17,562			16,327
Total current liabilities		25,196			70,565
LONG-TERM DEBT, less current maturities		161,000			145,500
DEFERRED INCOME TAXES		30,862			27,736
OTHER NONCURRENT LIABILITIES		1,425			1,865
COMMITMENTS AND CONTINGENCIES (Note 18)
SHAREHOLDERS’ EQUITY:
Preferred shares, without par value, authorized 1,000, none issued		—			—
Common shares, without par value, authorized 50,000, issued and outstanding 18,576 at August 31, 2006 and 19,668 at November 30, 2005		30,975			63,876
Retained earnings		101,055			60,853
		132,030			124,729
Unamortized value of restricted common shares issued Cumulative other comprehensive income, net of tax:		(1,161	)		(1,818	)
Interest rate cap adjustment		(18	)		(83	)
Foreign currency translation adjustment		(341	)		(201	)
Total shareholders’ equity		130,510			122,627
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	348,993		$	368,293

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

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CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited and in thousands, except per share amounts)

	FOR THE THREE MONTHS ENDED AUGUST 31,						FOR THE NINE MONTHS ENDED AUGUST 31,
	2006			2005			2006			2005
REVENUES:
Net sales	$	71,947		$	68,185		$	235,276		$	215,305
Royalties		58			30			164			128
Total revenues		72,005			68,215			235,440			215,433
COSTS AND EXPENSES:
Cost of sales		22,238			18,575			73,312			59,951
Advertising and promotion		23,607			17,657			75,575			58,739
Selling, general and administrative		10,855			12,122			33,974			36,341
Executive severance charges		—			2,269			—			2,269
Litigation settlement		(10,800	)		431			(19,305	)		(2,401	)
Total costs and expenses		45,900			51,054			163,556			154,899
INCOME FROM OPERATIONS		26,105			17,161			71,884			60,534
OTHER INCOME (EXPENSE):
Interest expense		(3,018	)		(3,332	)		(8,318	)		(10,285	)
Investment and other income, net		188			274			616			676
Loss on early extinguishment of debt		—			—			(2,805	)		(744	)
Total other income (expense)		(2,830	)		(3,058	)		(10,507	)		(10,353	)
INCOME BEFORE INCOME TAXES		23,275			14,103			61,377			50,181
PROVISION FOR INCOME TAXES		8,046			4,654			21,175			16,560
NET INCOME	$	15,229		$	9,449		$	40,202		$	33,621
NUMBER OF COMMON SHARES:
Weighted average outstanding-basic		18,749			19,762			19,195			19,669
Weighted average and potential dilutive outstanding		18,912			20,487			19,468			20,456
NET INCOME PER COMMON SHARE:
Basic	$	.81		$	.48		$	2.09		$	1.71
Diluted	$	.81		$	.46		$	2.07		$	1.64

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

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CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited and in thousands, except per share amount)

	FOR THE NINE MONTHS ENDED
	AUGUST 31, 2006			AUGUST 31, 2005
OPERATING ACTIVITIES:
Net income	$	40,202		$	33,621
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		4,339			4,372
Deferred income taxes		3,554			7,111
Excess tax benefit from stock-based compensation		(744	)		—
Stock-based compensation		3,322			1,057
Loss on early extinguishment of debt		2,805			744
Restricted stock modification expense		—			1,360
Other, net		255			205
Changes in operating assets and liabilities:
Accounts receivable		9,296			(1,478	)
Inventories		(5,099	)		(1,128	)
Refundable income taxes		1,951			4,285
Prepaid expenses and other current assets		(1,125	)		(3,272	)
Accounts payable and accrued liabilities		(7,057	)		(9,002	)
Net cash provided by operating activities		51,699			37,875
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(3,557	)		(2,353	)
Sales of patents, trademarks and other product rights		—			3,252
Increase in other assets, net		(2,078	)		(507	)
Net cash provided by (used in) investing activities		(5,635	)		392
FINANCING ACTIVITIES:
Repayment of long-term debt		(75,000	)		(17,500	)
Proceeds from borrowings under revolving credit facility		75,500			—
Repayments of revolving credit facility		(22,000	)		—
Repayment of policy loans		—			(1,031	)
Proceeds from exercise of stock options		911			5,286
Repurchase of common shares		(39,332	)		(21,664	)
Increase in debt issuance costs		(5,634	)		—
Debt retirement costs		(1,501	)		(282	)
Excess tax benefit from stock-based compensation		744			—
Net cash used in financing activities		(66,312	)		(35,191	)
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS		(176	)		(131	)
CASH AND CASH EQUIVALENTS:
Increase (decrease) for the period		(20,424	)		2,945
At beginning of period		47,327			40,193
At end of period	$	26,903		$	43,138
SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Issuance of 50 shares of restricted common stock at a value of $35.37 per share for the nine months ended August 31, 2005	$	—		$	1,768
PAYMENTS FOR:
Interest	$	6,452		$	7,797
Taxes	$	14,706		$	5,200

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

6

CHATTEM, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

1.  BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended November 30, 2005. The accompanying unaudited condensed consolidated financial statements, in the opinion of management, include all adjustments necessary for a fair presentation. All such adjustments are of a normal recurring nature.

2.            CASH AND CASH EQUIVALENTS

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

3.  RECLASSIFICATIONS

Certain prior year amounts have been reclassified to conform to the current period’s presentation.

4.  RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and amends SFAS No. 95, “Statement of Cash Flows”. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires all share-based payments to employees, including grants of employee stock options, to be recognized as additional compensation expense in the financial statements based on the calculated fair value of the awards. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation costs to be reported as a financing cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. We adopted SFAS 123R effective for our fiscal year beginning December 1, 2005. We have described the impact of adopting SFAS 123R in our condensed consolidated financial statements in Note 5, Stock-Based Compensation.

The American Jobs Creation Act of 2004 (the “AJCA”) was enacted on October 22, 2004. The AJCA repeals an export incentive, creates a new deduction for qualified domestic manufacturing activities and includes a special one-time deduction of 85% of certain foreign earnings repatriated to the U.S.

In December 2004, the FASB issued FASB Staff Position No. 109-1, “Application of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004” (“FSP 109-1”). FSP 109-1 clarifies that the manufacturer’s deduction provided for under the AJCA should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. In accordance with FSP 109-1, we treat the deduction for qualified domestic manufacturing activities, which became effective beginning December 1, 2005, as a reduction of the income tax provision in future years when realized.

In July 2006, FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, or our fiscal year beginning December 1, 2007. We are evaluating the impact of adopting FIN 48 on our consolidated financial statements.

7

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities and is intended to respond to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. SFAS 157 also requires expanded disclosure of the effect on earnings for items measured using unobservable data, establishes a fair value hierarchy that prioritizes the information used to develop those assumptions and requires separate disclosure by level within the fair value hierarchy. The provisions of SFAS 157 are effective for interim financial statements issued for fiscal years beginning after November 15, 2007, or our fiscal 2008.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans -- An Amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS 158”). SFAS 158 requires an employer to recognize in its balance sheet an asset or liability for a plan’s funded status, measure a plan’s assets and obligations as of the end of the employer’s fiscal year and recognize changes in the funded status in the year in which the changes occur. SFAS 158 also enhances the current disclosure requirements for pension and other postretirement plans to include disclosure related to certain effects on net periodic benefit cost. The requirement to recognize the funded status of a benefit plan and the disclosure requirements are effective as of the end of the fiscal year ending after December 15, 2006, or our fiscal 2007. The requirement to measure plan assets and benefit obligations as of the employer’s fiscal year-end is effective for fiscal years ending after December 15, 2008, or our fiscal 2009.

5. STOCK-BASED COMPENSATION

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

Effective December 1, 2005, we adopted SFAS 123R, using the modified prospective method. SFAS 123R requires the recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements and is measured based on the grant date fair value of the award. SFAS 123R also requires the stock option compensation expense to be recognized over the period during which an employee is required to provide service in exchange for the award (the vesting period). Prior to our adopting SFAS 123R, we accounted for our stock-based compensation plans under APB 25 and adopted the disclosure-only provision of SFAS 123. Under APB 25, generally no compensation expense is recorded when the terms of the award are fixed and the exercise price of the employee stock option equals or exceeds the fair value of the underlying stock on the date of grant.

For the three and nine months ended August 31, 2006, we recorded compensation expense related to stock options that reduced income from operations by $1,130 and $3,322, provision for income taxes by $390 and $1,146, net income by $740 and $2,176 and basic and diluted net income per share by $.04 and $.11, respectively. The stock option compensation expense was included partly in cost of sales, advertising and promotion expenses and selling, general and administrative expenses in the accompanying condensed consolidated statements of income. We capitalized $173 of stock option compensation cost as a component of the carrying cost of inventory on-hand as of August 31, 2006.

8

The weighted average grant-date fair value of stock options granted during the three months ended August 31, 2006 and 2005 was $16.44 and $24.39, respectively, and for the nine months ended August 31, 2006 and 2005 was $16.81 and $21.44, respectively. For options granted subsequent to our SFAS 123R adoption date of December 1, 2005, the fair value of each stock option grant was estimated on the date of grant using a Flex Lattice Model. For options granted prior to our adoption date of SFAS 123R, we used the Black-Scholes option pricing model. The following assumptions were used to determine the fair value of stock option grants during the nine months ended August 31, 2006 and 2005:

	Nine Months Ended August 31,
	2006			2005
Expected life		6.0 years			5.0 years
Volatility		43	%		55	%
Risk-free interest rate		4.48	%		4.02	%
Dividend yield		0	%		0	%
Forfeitures		0.9	%		0	%

The expected life of stock options represents the period of time that the stock options granted are expected to be outstanding based on historical exercise trends. The expected volatility is based on the historical price volatility of our common stock. The risk-free interest rate represents the U.S. Treasury bill rate for the expected life of the related stock options. The dividend yield represents our anticipated cash dividend over the expected life of the stock options. Subsequent to the adoption of SFAS 123R and in connection with using the Flex Lattice Model to determine the fair value of stock option grants, the forfeiture rate was determined by analyzing post vesting stock option activity for three separate groups (non-employee directors, officers and other employees). Prior to the adoption of SFAS 123R, forfeitures were not an input assumption for our fair value calculations of stock options under the Black-Scholes pricing model.

A summary of stock option activity for the nine months ended August 31, 2006 is presented below:

	For the Nine Months Ended
	Shares Under Option			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life		Aggregate Intrinsic Value
Outstanding at December 1, 2005		1,753		$	23.94
Granted		439			37.96
Exercised		(81	)		11.27
Cancelled		(89	)		32.31
Outstanding at August 31, 2006		2,022		$	27.12		6.2 years	$	19,582
Exercisable at August 31, 2006		1,212		$	24.49		6.0 years	$	15,187

The total fair value of stock options that vested during the three and nine months ended August 31, 2006 and 2005 was $1,169 and $2,558 and $3,549 and $6,664, respectively. The total intrinsic value of stock options exercised during the three and nine months ended August 31, 2006 and 2005 was $231 and $14,210 and $2,067 and $18,921, respectively.

As of August 31, 2006, we had $9,861 of unrecognized compensation cost related to stock options that will be recorded over a weighted average period of approximately two years.

We are also authorized to grant restricted shares of common stock to employees under our stock incentive plans that have been approved by shareholders. The restricted shares under these plans meet the definition of “nonvested shares” in SFAS 123R. The restricted shares generally vest over a four year service period commencing upon the date of grant. The total fair market value of restricted shares on the date of grant is amortized to expense on a straight line basis over the four-year vesting period. The amortization expense related to restricted shares during the three months ended August 31, 2006 and 2005 was $184 and $284, respectively, and for the nine months ended August 31, 2006 and 2005 was $551 and $986, respectively.

9

Restricted share activity under the plans is summarized as follows:

	Number of Shares			Weighted Average Grant Date Fair Value
Nonvested at December 1, 2005		75		$	24.27
Granted		—			—
Vested		(26	)	$	21.13
Forfeited		(3	)	$	35.37
Nonvested at August 31, 2006		46		$	25.46

Prior to December 1, 2005, we accounted for stock-based compensation plans under APB 25. We adopted the disclosure-only provision of SFAS 123. Had compensation expense for stock option grants been determined based on the fair value at the grant dates consistent with the method prescribed by SFAS 123, our net income and net income per share would have been adjusted to the pro forma amounts for the three and nine months ended August 31, 2005 as indicated below:

	For the Three Months Ended August 31, 2005			For the Nine Months Ended August 31, 2005
Net income :
As reported	$	9,449		$	33,621
Fair value method compensation costs, net		(1,714	)		(4,465	)
Pro forma	$	7,735		$	29,156
Net income per share, basic:
As reported	$	.48		$	1.71
Pro forma	$	.39		$	1.48
Net income per share, diluted:
As reported	$	.46		$	1.64
Pro forma	$	.38		$	1.43

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6.  EARNINGS PER SHARE

The following table presents the computation of per share earnings for the three and nine months ended August 31, 2006 and 2005, respectively:

	For the Three Months Ended August 31,				For the Nine Months Ended August 31,
	2006		2005		2006		2005
NET INCOME	$	15,229	$	9,449	$	40,202	$	33,621
NUMBER OF COMMON SHARES:
Weighted average outstanding		18,749		19,762		19,194		19,669
Issued upon assumed exercise of outstanding stock options		126		691		238		758
Effect of issuance of restricted common shares		37		34		36		29
Weighted average and potential dilutive outstanding (1)		18,912		20,487		19,468		20,456
NET INCOME PER COMMON SHARE:
Basic	$	.81	$	.48	$	2.09	$	1.71
Diluted	$	.81	$	.46	$	2.07	$	1.64

(1)   Because their effects are anti-dilutive, excludes shares issuable under stock option plans and restricted stock issuance whose grant price was greater than the average market price of common shares outstanding as follows: 937 and 10 shares for the three months ended August 31, 2006 and 2005, respectively, and 830 and 227 shares for the nine months ended August 31, 2006 and 2005, respectively.

7. ADVERTISING EXPENSES

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

8.  SHIPPING AND HANDLING

Shipping and handling costs of $2,038  and $1,817 are included in selling expenses for the three months ended August 31, 2006 and 2005, respectively, and $6,623 and $5,878 for the nine months ended August 31, 2006 and 2005, respectively.

9.  PATENT, TRADEMARKS AND OTHER PURCHASED PRODUCT RIGHTS

The carrying value of trademarks, which are not subject to amortization under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), was $205,983 as of August 31, 2006 and November 30, 2005, respectively. The gross carrying amount of intangible assets subject to amortization at August 31, 2006 and November 30, 2005, which consist primarily of non-compete agreements, was $2,139, respectively. The related accumulated amortization of intangible assets at August 31, 2006 and November 30, 2005 was $1,913 and $1,735, respectively. Amortization of our intangible assets subject to amortization under the provisions of SFAS 142 for the three months ended August 31, 2006 and 2005 was $59 and $46, respectively, and for the nine months ended August 31, 2006 and 2005 was $178 and $191, respectively. Estimated annual amortization expense for these assets for the years ending November 30, 2007, 2008 and

11

2009 is $106, $40 and $20, respectively. We expect our intangible assets subject to amortization to be fully amortized during fiscal 2009.

On February 28, 2005, we entered into an agreement to sell the trademark and product rights of our Selsun business in certain countries in Africa and Asia. As a result of the sale, $3,143 of indefinite-lived assets and $108 of intangible assets subject to amortization were retired, which resulted in an insignificant loss.

On November 30, 2005, we sold the pHisoderm line of skin care products to The Mentholatum Company, Inc. for a purchase price of $8,500 plus inventories of approximately $1,100. As a result of this transaction, we recorded a loss on product divestitures of $8,678 in the fourth quarter of fiscal 2005.

10.          INVENTORIES

Inventories consisted of the following as of August 31, 2006 and November 30, 2005:

	2006		2005
Raw materials and work in process	$	13,917	$	12,388
Finished goods		14,986		11,243
Total inventories	$	28,903	$	23,631

11.          ACCRUED LIABILITIES

Accrued liabilities consisted of the following as of August 31, 2006 and November 30, 2005:

	2006		2005
Interest	$	4,363	$	3,201
Salaries, wages and commissions		1,982		5,991
Product advertising and promotion		7,595		2,589
Litigation settlement and legal fees		1,649		2,212
Other		1,973		2,334
Total accrued liabilities	$	17,562	$	16,327

12.          LONG-TERM DEBT

Long-term debt consisted of the following as of August 31, 2006 and November 30, 2005:

	2006		2005
Revolving Credit Facility due 2010 at a variable rate of 6.65% and 7.00% as of August 31, 2006 and November 30, 2005, respectively	$	53,500	$	—
Floating Rate Senior Notes due 2010 at a variable rate of 7.41% and 6.87% as of December 30, 2005 (date redeemed) and November 30, 2005, respectively		—		75,000
7.0% Senior Subordinated Notes due 2014		107,500		107,500

Total long-term debt		161,000		182,500
Less: current maturities		—		37,000
Total long-term debt, net of current maturities	$	161,000	$	145,500

On February 26, 2004, we entered into a new Senior Secured Revolving Credit Facility that matures February 26, 2009 (the “Revolving Credit Facility”) with Bank of America, N.A. that provided an initial borrowing capacity of $25,000 and an additional $25,000, subject to successful syndication. On March 9, 2004, we entered into a new commitment agreement with a syndicate of commercial banks led by Bank of America, N.A., as agent, that enabled us to borrow up to a total of $50,000 under the Revolving Credit Facility and an additional $50,000, subject to successful syndication. On November 29, 2005, we entered into an amendment to our Revolving Credit Facility (the “Amended Revolving Credit Facility”) that, among other things, increased our borrowing capacity under the facility from $50,000 to $100,000, increased our flexibility to

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repurchase shares of our stock, improved our borrowing rate under the facility and extended the maturity date to November 15, 2010. Upon successful syndication, we are able to increase the borrowing capacity under the Amended Revolving Credit Facility by $50,000 to an aggregate of $150,000. Borrowings under our Amended Revolving Credit Facility bear interest at LIBOR plus applicable percentages of 1.0% to 2.0% or a base rate (the higher of the federal funds rate plus 0.5% or the prime rate) plus applicable percentages up to 0.5%. The applicable percentages are calculated based on our leverage ratio. As of August 31, 2006 and November 30, 2005, $53,500 and $0, respectively, were borrowed under the Amended Revolving Credit Facility, and the variable rate was 6.65% and 7.00%, respectively. Borrowings under our Amended Revolving Credit Facility are secured by substantially all of our assets, except real property, and shares of capital stock of our domestic subsidiaries held by us and by the assets of the guarantors (our domestic subsidiaries). The Amended Revolving Credit Facility contains covenants, representations, warranties and other agreements by us that are customary in credit agreements and security instruments relating to financings of this type. The significant financial covenants include fixed charge coverage ratio, leverage ratio, senior secured leverage ratio, net worth and brand value calculations. As of October 5, 2006, we had $38,000 of borrowings outstanding under our Amended Revolving Credit Facility and our borrowing capacity was $62,000.

On February 26, 2004, we issued and sold $75,000 of Floating Rate Senior Notes due March 1, 2010 (the “Floating Rate Senior Notes”) and $125,000 of 7.0% Subordinated Notes due 2014, the proceeds of which were used to purchase the outstanding $204,538 of our 8.875% Senior Subordinated Notes due 2008 on February 26, 2004 and April 1, 2004 and refinance our then existing credit facility.

On March 8, 2004, we entered into an interest rate cap agreement effective June 1, 2004 with decreasing annual notional principal amounts of $15,000 beginning March 1, 2006 and cap rates ranging from 4.0% to 5.0% over the life of the agreement. We paid a $1,375 premium to enter into the interest rate cap agreement, which will be amortized over the life of the agreement. As of August 31, 2006, increases in the variable interest rate of up to $60,000 of LIBOR based borrowings could be hedged under the provisions of the cap. We had $38,000 of LIBOR based borrowings with an interest rate capped at 4.0% as of August 31, 2006. During the nine months ended August 31, 2006, the amortized value of the premium on the interest rate cap was compared to the fair value of the interest rate cap and the change in the market value of the premium of $65, net of tax, was recorded to other comprehensive income. The current portion of the premium on the interest rate cap agreement of $294 is included in prepaid expenses and other current assets, and the long-term portion of $778 is included in other noncurrent assets. As of November 30, 2005, a portion of the interest rate cap was deemed to be an ineffective cash flow hedge due to the reduction of variable rate debt upon the subsequent redemption of the Floating Rate Senior Notes, resulting in a loss of $60, net of tax, reflected in the income statement as interest expense. The balance of the cash flow hedge was deemed to be effective as of November 30, 2005. As of August 31, 2006, a portion of the interest rate cap continued to be deemed an ineffective cash flow hedge due to the reduction of variable rate debt as a result of the redemption of the Floating Rate Senior Notes, resulting in a gain of $32, net of tax, in the condensed consolidated statement of income. The balance of the cash flow hedge was deemed to be effective as of August 31, 2006. The fair value of the interest rate cap agreement is valued by a third party. The interest rate cap agreement terminates on March 1, 2010.

Interest payments on the 7.0% Subordinated Notes are due semi-annually in arrears on March 1 and September 1. Our domestic subsidiaries are guarantors of the 7.0% Subordinated Notes. The guarantees of the 7.0% Subordinated Notes are unsecured senior subordinated obligations of the guarantors. At any time after March 1, 2009, we may redeem any of the 7.0% Subordinated Notes upon not less than 30 nor more than 60 days’ notice at redemption prices (expressed in percentages of principal amount), plus accrued and unpaid interest, if any, and liquidation damages, if any, to the applicable redemption rate, if redeemed during the twelve-month periods beginning March 1, 2009 at 103.500%, March 1, 2010 at 102.333%, March 1, 2011 at 101.167% and March 1, 2012 and thereafter at 100.000%. At any time prior to March 1, 2007, we may redeem up to 35% of the aggregate principal amount of the 7.0% Subordinated Notes (including any additional 7.0% Subordinated Notes) at a redemption price of 107.0% of the principal amount thereof, plus accrued and unpaid interest and liquidated damages, if any, thereon to the applicable redemption rate, with the net cash proceeds of one or more qualified equity offerings; provided, that (i) at least 65.0% of the aggregate principal amount of the 7.0% Subordinated Notes remains outstanding immediately after the occurrence of such redemption (excluding the 7.0% Subordinated Notes held by us and our subsidiaries); and (ii) the redemption must occur within 90 days of the date of the closing of such qualified equity offering.

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

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During the second quarter of fiscal 2005, we repurchased $17,500 of our 7.0% Subordinated Notes in the open market at an average premium of 1.6% over the principal amount of the notes. The repurchases resulted in a loss on early extinguishment of debt, including related expenses of $744. The outstanding balance of the remaining 7.0% Subordinated Notes was reduced to $107,500. On July 25, 2006 the Company successfully completed the consent solicitation from the holders of the 7.0% Subordinated Notes to an amendment to the indenture to increase our capacity to make restricted payments by an additional $85,000, including payments for the repurchase of our common stock, and adjust the fixed charge coverage ratio as defined in the indenture. We paid a consent fee of $5,619 in connection with the successful completion of the consent solicitation, which is being amortized as additional interest expense through 2014, the remaining term of the 7.0% Subordinated Notes.

On November 30, 2005, we called our $75,000 of Floating Rate Senior Notes for full redemption on December 30, 2005. On December 30, 2005, we fully redeemed our $75,000 of Floating Rate Senior Notes at a price of 102% of par plus accrued interest to December 30, 2005. We utilized borrowings of $38,000 under our Amended Revolving Credit Facility and $38,948 of our cash on hand to fund the redemption of the Floating Rate Senior Notes. As a result of the redemption, we paid a 2% premium over par or $1,500, retired associated debt issuance costs of $1,303 and incurred other related call fees, which resulted in a loss on early extinguishment of debt of $2,805 during the first quarter of fiscal 2006.

The future maturities of long-term debt outstanding as of August 31, 2006 are as follows:

2007	$	—
2008		—
2009		—
2010		53,500
2011		—
Thereafter		107,500
	$	161,000

13.          COMPREHENSIVE INCOME

Comprehensive income consisted of the following components for the three and nine months ended August 31, 2006 and 2005, respectively:

	For the Three Months EndedAugust 31,						For the Nine Months EndedAugust 31,
	2006			2005			2006			2005
Net income	$	15,229		$	9,449		$	40,202		$	33,621
Other - interest rate cap adjustment		122			16			65			(183	)
Other - foreign currency translation adjustment		(151	)		(151	)		(140	)		(257	)
Total	$	15,200		$	9,314		$	40,127		$	33,181

14.          STOCK REPURCHASE

In the three and nine months ended August 31, 2006, we repurchased 573 and 1,172 shares of our common stock, respectively, for $18,000 and $39,332, respectively, at an average price per share of $31.42 and $33.57, respectively. All repurchased shares were retired and returned to unissued. We, however, are limited in our ability to repurchase shares due to restrictions under the terms of our Amended Revolving Credit Facility and the indenture pursuant to which the 7.0% Subordinated Notes were issued. We have not repurchased any shares of our common stock subsequent to August 31, 2006.

On July 25, 2006 the Company successfully completed the consent solicitation from the holders of the 7% Subordinated Notes to an amendment to the indenture to increase our capacity to make restricted payments by an additional $85,000, including payments for the repurchase of our common stock, and adjust the fixed charge coverage ratio as defined in the indenture. We paid a consent fee of $5,619 in connection with the successful completion of the consent solicitation, which is being amortized as additional interest expense through 2014, the remaining term of the 7% Subordinated Notes. In connection with the consent solicitation, our Board of Directors authorized the repurchase of up to an additional $100,000 of our common stock under the terms of our existing stock repurchase program. As of October 5, 2006, the current amount available under the authorization from the Board of Directors was $88,147.

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15.          RETIREMENT PLANS AND POSTRETIREMENT HEALTH CARE BENEFITS

RETIREMENT PLANS

We have a noncontributory defined benefit pension plan (“the Plan”), which covers substantially all employees as of December 31, 2000. The Plan provides benefits based upon years of service and the employee’s compensation. Our contributions are based on computations by independent actuaries. Plan assets at August 31, 2006 and November 30, 2005 were invested primarily in United States government and agency securities and corporate debt and equity securities. Effective December 31, 2000, participation and benefits under the Plan were frozen.

Net periodic pension cost for the three and nine months ended August 31, 2006 and 2005 included the following components:

	For the Three Months Ended August 31,						For the Nine Months Ended August 31,
	2006			2005			2006			2005
Service cost	$	—		$	—		$	—		$	—
Interest cost on projected benefit   obligation		156			155			467			465
Actual return on plan assets		(226	)		(214	)		(677	)		(642	)
Net amortization and deferral		—			7			—			21
Net pension benefit	$	(70	)	$	(52	)	$	(210	)	$	(156	)

No employer contributions were made for the nine months ended August 31, 2006 and 2005, and no employer contributions are expected to be made in fiscal 2006.

POSTRETIREMENT HEALTH CARE BENEFITS

We maintain certain postretirement health care benefits for eligible employees. Employees become eligible for these benefits if they meet certain age and service requirements. We pay a portion of the cost of medical benefits for certain retired employees over the age of 65. Effective May 31, 2006, we adopted an amendment to change the eligibility requirements for employee participation and limit the annual benefit to be paid. This action resulted in a curtailment gain of $496 and is included as a component of selling, general and administrative expenses in the accompanying condensed consolidated statements of income. Employer contributions expected for fiscal 2006 are approximately $69.

Net periodic postretirement health care benefits cost for the three and nine months ended August 31, 2006 and 2005 included the following components:

	For the Three Months Ended August 31,						For the Nine Months Ended August 31,
	2006			2005			2006			2005
Service cost	$	20		$	18		$	60		$	54
Interest cost on accumulated   postretirement benefit obligation		22			21			66			63
Amortization of prior service cost		4			4			11			12
Amortization of net gain		(4	)		(4	)		(12	)		(12	)
Curtailment gain		—			—			(496	)		—
Net periodic postretirement benefits cost   (benefit)	$	42		$	39		$	(371	)	$	117

16.          INCOME TAXES

We account for income taxes using the asset and liability approach as prescribed by SFAS No. 109, “Accounting for Income Taxes”. This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an asset or liability. We record income tax expense in our consolidated financial statements based on an estimated annual effective income tax rate. Our

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effective tax rate for the three and nine months ended August 31, 2006 was 34.6% and 34.5%, respectively, as compared to 33.0% in the three and nine months ended August 31, 2005.

Undistributed earnings of Chattem Canada, our Canadian subsidiary, amounted to approximately $103 and $1,032 for the three and nine months ended August 31, 2006, respectively. These earnings are considered to be reinvested indefinitely and, accordingly, no provision for U.S. federal and state income taxes has been provided thereon. Upon distribution of those earnings in the form of dividends or otherwise, those earnings would be subject to U.S. income taxes (subject to an adjustment for foreign tax credits).

During fiscal 2005, pursuant to the provisions of the American Jobs Creation Act of 2004 (the “Act”), we adopted a domestic reinvestment plan for purposes of facilitating the repatriation of dividends from our Canadian affiliates. Upon distribution of fiscal 2004 and 2005 earnings, we were subject to U.S. income taxes of $213. The majority of the cash distribution was treated as an extraordinary dividend and qualified for the 85 percent dividend received deduction allowed under the Act.

17.          PRODUCT SEGMENT INFORMATION

Net sales of our domestic product categories within our single healthcare business segment for the three and nine months ended August 31, 2006 and 2005 are as follows:

	For the Three Months Ended August 31,				For the Nine Months Ended August 31,
	2006		2005		2006		2005
Topical pain care products	$	21,767	$	20,965	$	82,605	$	67,415
Medicated skin care products		17,340		15,775		49,620		49,232
Dietary supplements		9,934		8,521		27,696		27,461
Medicated dandruff shampoos and   conditioner		7,798		7,653		28,075		25,341
Other OTC and toiletry products		9,472		8,873		28,911		26,590
Total	$	66,311	$	61,787	$	216,907	$	196,039

18.          COMMITMENTS AND CONTINGENCIES

GENERAL LITIGATION

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

On April 13, 2004, we entered into a class action settlement agreement with representatives of the plaintiffs’ settlement class, which provided for a national class action settlement of all Dexatrim PPA claims. On November 12, 2004, Judge Barbara J. Rothstein of the United States District Court for the Western District of Washington entered a final order and judgment certifying the class and granting approval of the Dexatrim PPA settlement.

The Dexatrim PPA settlement included claims against us involving alleged injuries by Dexatrim products containing PPA in which the alleged injury occurred after December 21, 1998, the date we acquired the Dexatrim brand. In accordance with the terms of the class action settlement agreement, we previously published notice of the settlement and details as to the manner in which claims could be submitted. The deadline for submission of claims was July 7, 2004. A total of 391 claims were certified by the court as timely submitted. Of these 391 claims, 173 alleged stroke as an injury and 218 alleged other non-stroke injuries. Of the 391 total claims, only 371 claimants actually had alleged injuries that occurred after December 21, 1998 and continued to pursue their claims in the settlement. The remaining claimants either withdrew their claims or could not be located. A total of 14 claimants with alleged injuries that occurred after December 21, 1998 elected to opt out of the class settlement. Subsequently, we have settled nine of the opt out claims. The five remaining opt out claimants may pursue claims for damages against us in separate lawsuits. As of October 5, 2006, three of the five remaining opt-out claimants have filed lawsuits against us that we are continuing to defend. The other two opt-outs have not filed lawsuits against us and we think statutes of limitation have run against their claims.

In accordance with the terms of the class action settlement, approximately $70,885 was initially funded into a settlement trust by our insurance carriers and Sidmak Laboratories, Inc., the manufacturer of Dexatrim products containing

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PPA. Over the past two years, we have resolved all of the claims submitted in the Dexatrim PPA settlement. All claims in the settlement and expenses of the trust have now been paid. On June 14, 2006, we filed a motion to dissolve the settlement trust. The court granted this motion on July 14, 2006. On August 31, 2006, the settlement trust paid us $10,720, which is included as a component of litigation settlement in our condensed consolidated statement of income for the three and nine months ended August 31, 2006. The settlement trust currently has a balance of approximately $2,805. We expect to use those funds to resolve pending opt-out PPA cases. Any funds remaining after we resolve opt-out cases will be returned to one of our insurance carriers. We currently do not expect to record any additional charges relative to the settlement of the PPA litigation, except for legal expenses that will be recorded in the period incurred. During the three and nine months ended August 31, 2006, we also recorded net (recoveries) expenses of $(80) and $165, respectively, related to the Dexatrim litigation.

We were also named as a defendant in approximately 206 lawsuits relating to Dexatrim containing PPA which involve alleged injuries by Dexatrim products containing PPA manufactured and sold prior to our acquisition of Dexatrim on December 21, 1998. In these lawsuits, we have been defended on the basis of indemnification obligations assumed by The DELACO Company (“DELACO”), successor by merger to the Thompson Medical Company, Inc., which owned the brand prior to December 21, 1998. On February 12, 2004, DELACO filed a Chapter 11 bankruptcy petition in the United States Bankruptcy Court for the Southern District of New York. We filed a claim in DELACO’s bankruptcy case in order to preserve our claims for indemnification against DELACO.

In order to resolve DELACO’s indemnity obligations to us, we entered into a settlement agreement with DELACO dated June 30, 2005 (“the DELACO Agreement”). The DELACO Agreement was approved by the DELACO bankruptcy court on July 28, 2005. Pursuant to the DELACO Agreement, we agreed to assume responsibility for all claims against DELACO and its predecessor, Thompson Medical Company, Inc., or us relating to Dexatrim products involving an injury date after December 21, 1998, and hold the DELACO bankruptcy estate harmless from any such claims. In exchange, a settlement trust that was established under DELACO’s bankruptcy plan agreed to pay us $8,750 and assume responsibility for all claims related to Dexatrim products alleging injury dates on or before December 21, 1998. On February 17, 2006, the DELACO bankruptcy court entered an order confirming the DELACO bankruptcy plan which incorporated the terms of the DELACO Agreement. In accordance with the DELACO bankruptcy plan, the settlement trust established under the plan paid us $8,750 on March 17, 2006, which is included in our condensed consolidated statement of income, net of legal expenses, as litigation settlement for the nine months ended August 31, 2006. In addition, this order will allow us to dismiss all cases against us with injury dates prior to December 21, 1998, and channel these cases to the DELACO settlement trust whether brought by an injured party or a co-defendant to a Dexatrim products liability case. We expect all claims with injury dates prior to December 21, 1998 to be channeled to the DELACO settlement trust. The DELACO settlement trust is currently resolving and paying Dexatrim claims with injury dates prior to December 21, 1998 in accordance with the DELACO bankruptcy plan.

The confirmation of the DELACO bankruptcy plan effectively released us from liability for all PPA products liability cases with injury dates prior to December 21, 1998. The payment to us by the DELACO settlement trust of $8,750 and the channeling of cases to the DELACO settlement trust as described above has conclusively compromised and settled our indemnity claim filed in the DELACO bankruptcy.

On December 30, 2003, the United States Food and Drug Administration (“FDA”) issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacturing and shipment of Dexatrim containing ephedrine in September 2002, the FDA’s final rule may result in additional lawsuits being filed against us alleging damages related to the use or purchase of Dexatrim containing ephedrine. There are currently two Dexatrim with ephedrine products liability lawsuits pending against us.

We maintain insurance coverage for product liability claims relating to our products, including Dexatrim products containing ephedrine, under claims-made policies which are subject to annual renewal. For the current annual policy period beginning June 1, 2006, we maintain product liability insurance coverage in the amount of $25,000 through our captive insurance subsidiary, of which approximately $6,564 has been funded as of October 5, 2006. We also have $20,000 of excess coverage through a third party reinsurance policy, which excludes coverage for our Dexatrim products containing ephedrine.

We were named as a defendant in a putative class action lawsuit filed in the Superior Court of the State of California for the County of Los Angeles on February 11, 2004, relating to the labeling, advertising, promotion and sale of our Bullfrog suncare products. We filed an answer to this lawsuit on June 28, 2004. An amended complaint was filed March 29, 2006, pursuant to a court order formally consolidating this lawsuit with eight existing lawsuits involving other manufacturers of sunscreen products into a coordinated proceeding in California state court. The amended lawsuit seeks class certification of

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all persons who purchased our Bullfrog sun care products in California during a four-year period prior to February 11, 2004. The amended lawsuit seeks restitution and/or disgorgement of profits, actual damages, injunctive relief, punitive damages and attorneys fees and costs arising out of alleged deceptive, untrue or misleading advertising and breach of warranty, fraudulent or negligent misrepresentations, in connection with the manufacturing, labeling, advertising, promotion and sale of Bullfrog products in California. We filed an answer to the lawsuit in April 2006, and we are vigorously defending this lawsuit.

On March 9, 2006, we were named in a lawsuit filed in the Southern District of New York by Novogen, Inc. Novogen alleges that our product New Phase infringes upon Novogen patents by containing certain phytoestrogens from clover or equivalent sources. Novogen seeks to force us to reformulate our product and to recover damages. We filed an answer to the lawsuit on April 12, 2006 and we are vigorously defending Novogen’s allegations.

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

REGULATORY

On December 30, 2003, the FDA issued a consumer alert on the safety of dietary supplements containing ephedrine alkaloids and on February 6, 2004 published a final rule with respect to these products. The final rule prohibits the sale of dietary supplements containing ephedrine alkaloids because such supplements present an unreasonable risk of illness or injury. The final rule became effective on April 11, 2004. Although we discontinued the manufacturing and shipment of Dexatrim containing ephedrine in September 2002, the FDA’s final rule may result in lawsuits in addition to those we currently have being filed against us alleging damages related to the use or purchase of Dexatrim containing ephedrine. In April 2005, a Utah federal court called into question the 2004 final rule. The court decision is being appealed and may have an effect on the FDA’s enforcement of the ephedrine alkaloid final rule.

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

Certain of our topical analgesic products are currently marketed under a FDA tentative final external analgesic monograph. The FDA has proposed that the final monograph exclude external analgesic products in patch, plaster or poultice form, unless the FDA receives additional data supporting the safety and efficacy of these products. On October 14, 2003, we submitted to the FDA information regarding the safety of our Icy Hot patches and arguments to support our product’s inclusion in the final monograph. We have also participated in an industry effort coordinated by Consumer Healthcare Products Association (“CHPA”) to establish with the FDA a protocol of additional research that will allow the patches to be marketed under the final monograph even if the final monograph does not explicitly allow them. The CHPA submission to FDA was made on October 15, 2003. Thereafter, in April 2004, we launched the Icy Hot Sleeve, a flexible, non-occlusive fabric patch containing 16% menthol. In February 2006, we launched the Icy Hot Pro-Therapy Medicated Foam Pad with Knee Wrap containing 5% menthol, and the Capzasin Back & Body patch containing 0.025% capsaicin. All of these drug products contain levels of active ingredients consistent with levels permitted in the OTC monograph. If additional research is required either as a preliminary to final FDA monograph approval and/or as a requirement of future individual product sale, we may need to invest in a considerable amount of expensive testing and data analysis. Any preliminary cost may be shared with other patch manufacturers. Because the submissions made into the FDA docket have been forwarded from its OTC Division to its Dermatological Division within the Center for Drug Evaluation and Research (“CDER”), we are uncertain as to when this matter is likely to become final. For example, the FDA could choose to hold in abeyance a final ruling on alternative dose forms even if the monograph is otherwise finalized. If neither action described above is successful and the final monograph excludes such products, we will have to file a new drug application (“NDA”) for previously marketed drugs in order to continue to market the Icy Hot and Aspercreme Patches, the Icy Hot Sleeve, the Icy

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Hot Pro-Therapy Medicated Foam Pad with Knee Wrap, Capzasin Back & Body Patch and/or similar delivery systems under our other topical analgesic brands. In such case, we would have to remove the existing products from the market one year from the effective date of the final monograph, pending FDA review and approval of an NDA. The preparation of an NDA would likely take us six to 18 months and would be expensive. It typically takes the FDA at least twelve months to rule on an NDA once it is submitted.

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

In early 2005, infrequent, but serious, adverse cardiovascular events were reported to the FDA associated with patients who were prescribed a subclass of COX-2 inhibitor non-steroidal anti-inflammatory drugs (“NSAID’s”) for long periods to relieve pain of chronic diseases such as arthritis. These products include Vioxx®, Bextra®, and Celebrex®. In February 2005, the FDA held a joint advisory committee meeting to seek external counsel on the extent to which manufacturers might further warn patients of these cardiovascular risks on prescription product labeling, or prohibit sale of these prescription products. As part of its response on this issue, the FDA has recommended labeling changes for both the prescription and OTC NSAID’s. Well-known OTC NSAID’s such as ibuprofen and naproxen, which have been sold in vast quantities since the 1970s, were affected by this regulatory action. Manufacturers of OTC NSAID’s were asked to revise their labeling to provide more specific information about the potential cardiovascular and gastrointestinal risks recognizing the limited dose and duration of treatment of these products. Our Pamprin All Day product, which contains naproxen sodium, is subject to these new labeling requirements. Pamprin All Day is manufactured for us by The Perrigo Company (“Perrigo”), holder of an abbreviated NDA for naproxen sodium. As holder of the abbreviated NDA, Perrigo made the mandated labeling changes within the time frame required by the FDA. Product with revised labeling compliant with new FDA regulations began shipping in February 2006. We are also aware of the FDA’s concern about the potential toxicity due to concomitant use of OTC and prescription products that contain the analgesic ingredient acetaminophen, an ingredient also found in Pamprin and Prēmsyn PMS. We are also aware that the FDA will revise acetaminophen labeling to reflect the concerns similar to NSAID analgesics such as naproxen. We are participating in an industry-wide effort to reassure the FDA that the current recommended dosing regimen is safe and effective and that proper labeling and public education by both OTC and prescription drug companies are the best policies to abate the FDA’s concern. The FDA will address both issues in its effort to finalize the monograph on internal analgesic products. We believe the FDA may issue revised labeling requirements within the next year, perhaps prior to monograph closure that will cause the industry to relabel its analgesic products to better inform consumers.

During the finalization of the monograph on sunscreen products, the FDA chose to hold in abeyance specific requirements relating to the characterization of a product’s ability to reduce UVA radiation. A final ruling on this matter would be expected to result in new UVA testing requirements and subsequent labeling changes related to sun protection factor, or SPF, ratings, and other labeling claims. We expect that the FDA may take action on this matter within the next six months. If implemented, the final rules would likely result in new testing requirements and revised labeling of our Bullfrog product line, and all of our competitors’ products in the suncare category, within one year after issuance of the final rules.

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

19

In March 2006, the FDA conducted a routine site audit of our manufacturing plants and laboratories. There were no material adverse findings resulting from the audit.

19.           SUBSEQUENT EVENT

On October 5, 2006, we entered into an Asset Purchase Agreement (the “Agreement”) with Johnson & Johnson and Pfizer Inc., pursuant to which we have agreed to acquire the United States rights to certain brands currently owned by Johnson & Johnson and the consumer healthcare business of Pfizer Inc., including ACT®, Unisom®, Cortizone, Kaopectate® and Balmex®. We agreed to pay $410,000 in cash for the brands and assume certain obligations related to such brands. The transaction is subject to review and approval by the Federal Trade Commission and certain closing conditions, including the acquisition by Johnson & Johnson of the consumer healthcare business of Pfizer Inc., which is expected to close by the end of calendar 2006. The transaction will be funded through a $425,000 six year term loan facility led by Bank of America, N.A.

20.          CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

The condensed consolidating financial statements, for the dates or periods indicated, of Chattem, Inc. (“Chattem”), Signal Investment & Management Co. (“Signal”), SunDex, LLC (“SunDex”) and Chattem (Canada) Holdings, Inc. (“Canada”), the guarantors of the long-term debt of Chattem, and the non-guarantor direct and indirect wholly-owned subsidiaries of Chattem are presented below. Signal is 89% owned by Chattem and 11% owned by Canada. SunDex and Canada are wholly-owned subsidiaries of Chattem. The guarantees of Signal, SunDex and Canada are full and unconditional and joint and several. The guarantees of Signal, SunDex and Canada as of August 31, 2006 arose in conjunction with Chattem’s Amended Revolving Credit Facility and Chattem’s issuance of the 7.0% Subordinated Notes (See Note 12). The maximum amount of future payments the guarantors would be required to make under the guarantees as of August 31, 2006 is $161,000.

20

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEETS

AUGUST 31, 2006

(Unaudited and in thousands)

ASSETS	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES		ELIMINATIONS			CONSOLIDATED
CURRENT ASSETS:
Cash and cash equivalents	$	17,184		$	1,984		$	7,735	$	—		$	26,903
Accounts receivable, less allowances of $4,210		28,665			10,946			5,062		(10,946	)		33,727
Other receivables		249			—			—		—			249
Interest receivable		17			625			—		(642	)		—
Inventories		23,191			2,877			2,835		—			28,903
Refundable income taxes		—			—			—		—			—
Deferred income taxes		1,975			—			35		—			2,010
Prepaid expenses and other current assets		4,217			—			2,214		1,131			7,562
Total current assets		75,498			16,432			17,881		(10,457	)		99,354
PROPERTY, PLANT AND EQUIPMENT, NET		28,921			775			533		—			30,229
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net		226			268,273			—		(62,290	)		206,209
Debt issuance costs, net		8,225			—			—		—			8,225
Investment in subsidiaries		305,401			33,000			66,860		(405,261	)		—
Note receivable		—			33,000			—		(33,000	)		—
Other		4,976			—			—		—			4,976
Total other noncurrent assets		318,828			334,273			66,860		(500,551	)		219,410
TOTAL ASSETS	$	423,247		$	351,480		$	85,274	$	(511,008	)	$	348,993
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt	$	—		$	—		$	—	$	—		$	—
Accounts payable and other		5,568			—			2,066		—			7,634
Accrued liabilities		23,991			1,590			2,437		(10,456	)		17,562
Total current liabilities		29,559			1,590			4,503		(10,456	)		25,196
LONG-TERM DEBT, less current maturities		161,000			—			33,000		(33,000	)		161,000
DEFERRED INCOME TAXES		(3,323	)		34,185			—		—			30,862
OTHER NONCURRENT LIABILITIES		1,425			—			—		—			1,425
INTERCOMPANY ACCOUNTS		104,072			(107,599	)		3,527		—			—
SHAREHOLDERS’ EQUITY:
Preferred shares, without par value, authorized 1,000, none issued		—			—			—		—			—
Common shares, without par value, authorized 50,000, issued and outstanding 18,576		30,975			—			—		—			30,975
Shares of subsidiaries		—			329,705			39,803		(369,508	)		—
Retained earnings		101,055			93,599			4,195		(97,794	)		101,055
Total		132,030			423,304			43,998		(467,302	)		132,030
Unamortized value of restricted common shares issued		(1,161	)		—			—		—			(1,161	)
Cumulative other comprehensive income, net of tax:
Interest rate cap adjustment		(18	)		—			—		—			(18	)
Foreign currency translation adjustment		(337	)		—			246		(250	)		(341	)
Total shareholders’ equity		130,514			423,304			44,244		(467,552	)		130,510
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	423,247		$	351,480		$	85,274	$	(511,008	)	$	348,993

21

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING BALANCE SHEETS

NOVEMBER 30, 2005

(In thousands)

ASSETS	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES		ELIMINATIONS			CONSOLIDATED
CURRENT ASSETS:
Cash and cash equivalents	$	36,647		$	1,982		$	8,698	$	—		$	47,327
Accounts receivable, less allowances of $2,338		29,220			11,181			4,452		(11,181	)		33,672
Other receivables		9,600			—			—		—			9,600
Interest receivable		17			625			—		(642	)		—
Inventories		18,192			2,429			3,010		—			23,631
Refundable income taxes		1,207			—			—		—			1,207
Deferred income taxes		2,478			—			—		—			2,478
Prepaid expenses and other current assets		4,241			—			1,285		(420	)		5,106
Total current assets		101,602			16,217			17,445		(12,243	)		123,021
PROPERTY, PLANT AND EQUIPMENT, NET		28,567			775			542		—			29,884
OTHER NONCURRENT ASSETS:
Patents, trademarks and other purchased product rights, net		404			268,273			—		(62,290	)		206,387
Debt issuance costs, net		4,297			—			—		—			4,297
Investment in subsidiaries		276,987			33,000			66,860		(376,847	)		—
Note receivable		—			33,000			—		(33,000	)		—
Other		4,704			—			—		—			4,704
Total other noncurrent assets		286,392			334,273			66,860		(472,137	)		215,388
TOTAL ASSETS	$	416,561		$	351,265		$	84,847	$	(484,380	)	$	368,293
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Current maturities of long-term debt	$	37,000		$	—		$	—	$	—		$	37,000
Accounts payable and other		14,841			—			2,397		—			17,238
Accrued liabilities		21,432			969			6,169		(12,243	)		16,327
Total current liabilities		73,273			969			8,566		(12,243	)		70,565
LONG-TERM DEBT, less current maturities		145,500			—			33,000		(33,000	)		145,500
DEFERRED INCOME TAXES		(795	)		28,531			—		—			27,736
OTHER NONCURRENT LIABILITIES		1,865			—			—		—			1,865
INTERCOMPANY ACCOUNTS		74,088			(75,941	)		1,853		—			—
SHAREHOLDERS’ EQUITY:
Preferred shares, without par value, authorized 1,000, none issued		—			—			—		—			—
Common shares, without par value, authorized 50,000, issued and outstanding 19,668		63,876			—			—		—			63,876
Share capital of subsidiaries		—			329,705			39,803		(369,508	)		—
Retained earnings		60,853			68,001			1,582		(69,583	)		60,853
Total		124,729			397,706			41,385		(439,091	)		124,729
Unamortized value of restricted common shares issued		(1,818	)		—			—		—			(1,818	)
Cumulative other comprehensive income, net of tax:
Interest rate cap adjustment		(83	)		—			—		—			(83	)
Foreign currency translation adjustment		(198	)		—			43		(46	)		(201	)
Total shareholders’ equity		122,630			397,706			41,428		(439,137	)		122,627
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	416,561		$	351,265		$	84,847	$	(484,380	)	$	368,293

22

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF INCOME

FOR THE NINE MONTHS ENDED AUGUST 31, 2006

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
TOTAL REVENUES	$	194,859		$	63,036		$	14,736		$	(37,191	)	$	235,440
COSTS AND EXPENSES:
Cost of sales		60,764			7,730			6,789			(1,971	)		73,312
Advertising and promotion		63,346			8,371			3,858			—			75,575
Selling, general and administrative		33,800			(167	)		341			—			33,974
Litigation settlement		(19,305	)		—			—			—			(19,305	)
Equity in subsidiary income		(28,211	)		—			—			28,211			—
Total costs and expenses		110,394			15,934			10,988			26,240			163,556
INCOME FROM OPERATIONS		84,465			47,102			3,748			(63,431	)		71,884
OTHER INCOME (EXPENSE):
Interest expense		(8,328	)		—			(1,846	)		1,856			(8,318	)
Investment and other income, net		316			1,897			2,134			(3,731	)		616
Loss on early extinguishment of debt		(2,805	)		—			—			—			(2,805	)
Royalties		(30,743	)		(4,477	)		—			35,220			—
Corporate allocations		2,625			(2,578	)		(47	)		—			—
Total other income (expense)		(38,935	)		(5,158	)		241			33,345			(10,507	)
INCOME BEFORE INCOME TAXES		45,530			41,944			3,989			(30,086	)		61,377
PROVISION FOR INCOME TAXES		5,328			14,471			1,376			—			21,175
NET INCOME	$	40,202		$	27,473		$	2,613		$	(30,086	)	$	40,202

23

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF INCOME

FOR THE NINE MONTHS ENDED AUGUST 31, 2005

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
TOTAL REVENUES	$	174,335		$	58,811		$	15,654		$	(33,367	)	$	215,433
COSTS AND EXPENSES:
Cost of sales		47,868			7,095			7,137			(2,149	)		59,951
Advertising and promotion		46,165			9,252			3,322			—			58,739
Selling, general and administrative		35,321			271			749			—			36,341
Executive severance charges		2,269			—			—			—			2,269
Litigation settlement		(4,476	)		—			2,075			—			(2,401	)
Equity in subsidiary income		(24,632	)		—			—			24,632			—
Total costs and expenses		102,515			16,618			13,283			22,483			154,899
INCOME FROM OPERATIONS		71,820			42,193			2,371			(55,850	)		60,534
OTHER INCOME (EXPENSE):
Interest expense		(10,285	)		—			(1,873	)		1,873			(10,285	)
Investment and other income, net		545			1,878			2,001			(3,748	)		676
Loss on early extinguishment of debt		(744	)		—			—			—			(744	)
Royalties		(26,758	)		(4,460	)		—			31,218			—
Corporate allocations		2,547			(2,499	)		(48	)		—			—
Total other income (expense)		(34,695	)		(5,081	)		80			29,343			(10,353	)
INCOME BEFORE INCOME TAXES		37,125			37,112			2,451			(26,507	)		50,181
PROVISION FOR  INCOME TAXES		3,504			12,247			809			—			16,560
NET INCOME	$	33,621		$	24,865		$	1,642		$	(26,507	)	$	33,621

24

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED AUGUST 31, 2006

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY  COMPANIES			NON-GUARANTOR      SUBSIDIARY        COMPANIES			ELIMINATIONS			CONSOLIDATED
OPERATING ACTIVITIES:
Net income	$	40,202		$	27,473		$	2,613		$	(30,086	)	$	40,202
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		4,124			—			215			—			4,339
Deferred income taxes		(2,064	)		5,653			(35	)		—			3,554
Excess tax benefit from stock-based compensation		(744	)		—			—			—			(744	)
Stock-based compensation		3,322			—			—			—			3,322
Loss on early extinguishment of debt		2,805			—			—			—			2,805
Other, net		78			—			177			—			255
Equity in subsidiary income		(30,086	)		—			—			30,086			—
Changes in operating assets and liabilities:
Accounts receivable		9,906			235			(610	)		(235	)		9,296
Inventories		(4,826	)		(447	)		174			—			(5,099	)
Refundable income taxes		1,951			—			—			—			1,951
Prepaid expenses and other current assets		23			—			403			(1,551	)		(1,125	)
Accounts payable and accrued liabilities		(5,402	)		621			(4,062	)		1,786			(7,057	)
Net cash provided by (used in) operating activities		19,289			33,535			(1,125	)		—			51,699
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(3,350	)		—			(207	)		—			(3,557	)
Increase in other assets, net		(949	)		—			(1,129	)		—			(2,078	)
Net cash used in investing activities		(4,299	)		—			(1,336	)		—			(5,635	)
FINANCING ACTIVITIES:
Repayment of long-term debt		(75,000	)		—			—			—			(75,000	)
Proceeds from borrowings under revolving credit facility		75,500			—			—			—			75,500
Payment under revolver		(22,000	)		—			—			—			(22,000	)
Proceeds from exercise of stock options		911			—			—			—			911
Repurchase of common shares		(39,332	)		—			—			—			(39,332	)
Increase in debt issuance costs		(5,634	)		—			—			—			(5,634	)
Debt retirement costs		(1,501	)		—			—			—			(1,501	)
Excess tax benefit from stock-based compensation		744			—			—			—			744
Changes in intercompany accounts		31,859			(31,658	)		(201	)		—			—
Dividends paid		—			(1,875	)		1,875			—			—
Net cash (used in) provided by financing activities		(34,453	)		(33,533	)		1,674			—			(66,312	)
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS		—			—			(176	)		—			(176	)
CASH AND CASH EQUIVALENTS:
(Decrease) increase for the period		(19,463	)		2			(963	)		—			(20,424	)
At beginning of period		36,647			1,982			8,698			—			47,327
At end of period	$	17,184		$	1,984		$	7,735		$	—		$	26,903

25

Note 20

CHATTEM, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED AUGUST 31, 2005

(Unaudited and in thousands)

	CHATTEM			GUARANTOR SUBSIDIARY COMPANIES			NON-GUARANTOR SUBSIDIARY COMPANIES			ELIMINATIONS			CONSOLIDATED
OPERATING ACTIVITIES:
Net income	$	33,621		$	24,865		$	1,642		$	(26,507	)	$	33,621
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		4,397			—			(25	)		—			4,372
Deferred income taxes		2,479			4,632			—			—			7,111
Stock-based compensation		1,057			—			—			—			1,057
Loss on early extinguishment of debt		744			—			—			—			744
Restricted stock modification expense		1,360			—			—			—			1,360
Other, net		74			—			131			—			205
Equity in subsidiary income		(26,507	)		—			—			26,507			—
Changes in operating assets and liabilities:
Accounts receivable		(3,723	)		2,068			(893	)		1,070			(1,478	)
Interest receivable		(17	)		—			—			17			—
Inventories		(524	)		1,081			(1,685	)		—			(1,128	)
Refundable income taxes		4,285			—			—			—			4,285
Prepaid expenses and other current assets		(3,240	)		—			(572	)		540			(3,272	)
Accounts payable and accrued liabilities		(9,328	)		328			1,625			(1,627	)		(9,002	)
Net cash provided by operating activities		4,678			32,974			223			—			37,875
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(2,255	)		—			(98	)		—			(2,353	)
Sales of patents, trademarks and other product rights		3,252			—			—			—			3,252
Decrease (increase) in other assets, net		86			—			(593	)		—			(507	)
Net cash provided by (used in) investing activities		1,083			—			(691	)		—			392
FINANCING ACTIVITIES:
Repayment of long-term debt		(17,500	)		—			—			—			(17,500	)
Repayment of policy loans		(1,031	)		—			—			—			(1,031	)
Proceeds from exercise of stock options		5,286			—			—			—			5,286
Repurchase of common shares		(21,664	)		—			—			—			(21,664	)
Debt retirement costs		(282	)		—			—			—			(282	)
Changes in intercompany accounts		31,183			(31,088	)		(95	)		—			—
Dividends paid		—			(1,875	)		1,875			—			—
Net cash (used in) provided by financing activities		(4,008	)		(32,963	)		1,780			—			(35,191	)
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH   EQUIVALENTS		—			—			(131	)		—			(131	)
CASH AND CASH EQUIVALENTS:
Increase for the period		1,753			11			1,181			—			2,945
At beginning of period		28,344			1,967			9,882			—			40,193
At end of period	$	30,097		$	1,978		$	11,063		$	—		$	43,138

26

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the audited consolidated financial statements and related notes thereto included in our 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including, but not limited to, those described in our filings with the Securities and Exchange Commission.

Overview

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

• Topical pain care products such as Icy Hot, Icy Hot Pro-Therapy and Aspercreme;

• Medicated skin care products such as Gold Bond medicated skin care powder, cream, lotion and foot care products;

• Selsun Blue and Selsun Salon medicated dandruff shampoos;

• Dietary supplements including Dexatrim, Garlique and New Phase; and

• Other OTC and toiletry products such as Pamprin, a menstrual analgesic; Herpecin-L, a lip care product; Benzodent, a dental analgesic cream; Bullfrog, a line of suncare products; and toiletries such as Ultraswim, a chlorine-removing shampoo; and Sun-In, a hair lightener.

Our products typically target niche markets that are often outside the core product areas of larger companies where we believe we can achieve and sustain significant market penetration through innovation and strong advertising and promotion support. Many of our products are among the U.S. market leaders in their respective categories. For example, our portfolio of topical analgesic brands and our Gold Bond medicated body powders have the leading U.S. market share in these categories. We support our brands through extensive and cost-effective advertising and promotion, the expenditures for which represented approximately 32.8% of our total revenues in the nine months ended August 31, 2006. We sell our products nationally through mass merchandiser, drug and food channels principally utilizing our own sales force.

Developments During Fiscal 2006

Products

In the first quarter of fiscal 2006, we introduced or completed the introduction of the following product line extensions: Icy Hot Pro-Therapy, Selsun Salon,BullfrogMosquito Coast, Garlique CardioAssist, Capzasin Back & Body Patch and Pamprin Max. In the second quarter of fiscal 2006, we introduced Dexatrim Max₂O.

Debt

On November 30, 2005, we called our $75.0 million of Floating Rate Senior Notes for full redemption on December 30, 2005. The terms of the indenture for the Floating Rate Senior Notes required the repayment at a price of 102% of the principal amount of the notes plus accrued interest. The $75.0 million of Floating Rate Senior Notes were fully redeemed on December 30, 2005. We utilized borrowings of $38.0 million under our Amended Revolving Credit Facility and $38.9 million of our cash on hand to fund the redemption of the Floating Rate Senior Notes. As a result of the redemption, a loss on early extinguishment of debt of $2.8 million was recorded in the first quarter of fiscal 2006.

Stock Repurchase

During the first nine months of fiscal 2006, we repurchased 1,172 shares of our common stock under our stock repurchase program for $39.3 million at an average price per share of $33.57.

On July 25, 2006, the Company successfully completed the consent solicitation from the holders of the 7% Subordinated Notes to an amendment to the indenture to increase our capacity to make restricted payments by an additional

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$85.0 million, including payments for the repurchase of our common stock and adjust the fixed charge coverage ratio as defined in the indenture. In connection with the consent solicitation, our Board of Directors authorized the repurchase of up to an additional $100.0 million of our common stock under the terms of our existing stock repurchase program. As of October 5, 2006, the current amount available under the authorization from the Board of Directors was $88.1 million.

Litigation

Over the past two years, we have resolved all of the claims submitted in the Dexatrim PPA settlement. A total of $70.9 million was previously funded into a settlement trust by our insurers and Sidmak Laboratories, Inc., the manufacturer of Dexatrim products containing PPA, for the purpose of paying claims in the settlement. All claims in the settlement and expenses of the trust have now been paid. On June 14, 2006, we filed a motion to dissolve the settlement trust. The court granted this motion on July 14, 2006. On August 31, 2006, the settlement trust paid us $10.7 million which is included as a component of litigation settlement in our condensed consolidated statement of income for the three and nine months ended August 31, 2006. The settlement trust currently has a balance of approximately $2.8 million. We expect to use those funds to resolve pending PPA opt-out cases. Any funds remaining after we resolve opt-out cases will be returned to one of our insurance carriers. We currently do not expect to record any additional charges relative to the settlement of the PPA litigation, except for legal expenses that will be recorded in the period incurred. During the three and nine months ended August 31, 2006, we also recorded net (recoveries) expenses of $(0.1) million and $0.2 million, respectively, related to the Dexatrim litigation.

During the third quarter of fiscal 2005, we entered into a settlement agreement with the DELACO Company (“DELACO”), successor by merger to the Thompson Medical Company, Inc., which owned the Dexatrim brand prior to December 21, 1998 (the “DELACO Agreement”). The DELACO Agreement was approved by the DELACO bankruptcy court on July 28, 2005. Pursuant to the DELACO Agreement, we agreed to assume responsibility for all claims against DELACO and its predecessor, Thompson Medical Company, Inc., or us relating to Dexatrim products involving an injury date after December 21, 1998 and hold the DELACO bankruptcy estate harmless from any such claims. In exchange, a settlement trust to be established under DELACO’s bankruptcy plan agreed to pay us $8.75 million and assume responsibility for all claims related to Dexatrim products alleging injury dates on or before December 21, 1998. On February 17, 2006, the DELACO bankruptcy court entered an order confirming the DELACO bankruptcy plan which incorporated the terms of the DELACO Agreement. In accordance with the DELACO bankruptcy plan, the settlement trust established under the plan paid us $8.75 million on March 17, 2006, which is included in our condensed consolidated statements of income, net of legal expenses, as litigation settlement for the six months ended May 31, 2006. In addition, this order will allow us to dismiss all cases against us with injury dates prior to December 21, 1998, and channel these cases to the DELACO settlement trust whether brought by an injured party or a co-defendant to a Dexatrim products liability case. We expect all claims with injury dates prior to December 21, 1998 to be channeled to the DELACO settlement trust.

The confirmation of the DELACO bankruptcy plan effectively releases us from liability for all PPA products liability cases with injury dates prior to December 21, 1998. The payment to us by the DELACO settlement trust of $8.75 million and the channeling of cases to the DELACO settlement trust as described above has conclusively compromised and settled our indemnity claim filed in the DELACO bankruptcy.

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Results of Operations

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

	For the Three Months Ended						For the Nine Months Ended
	August 31, 2006			August 31, 2005			August 31, 2006			August 31, 2005
TOTAL REVENUES		100.0	%		100.0	%		100.0	%		100.0	%
COSTS AND EXPENSES:
Cost of sales		30.9			27.2			31.2			27.8
Advertising and promotion		32.8			25.9			32.1			27.3
Selling, general and administrative		15.1			17.8			14.4			16.9
Executive severance charges		—			3.3			—			1.0
Litigation settlement		(15.0	)		0.6			(8.2	)		(1.1	)
Total costs and expenses		63.8			74.8			69.5			71.9
INCOME FROM OPERATIONS		36.2			25.2			30.5			28.1
OTHER INCOME (EXPENSE):
Interest expense		(4.2	)		(4.9	)		(3.5	)		(4.8	)
Investment and other income, net		0.3			0.4			0.3			0.3
Loss on early extinguishment of debt		—			—			(1.2	)		(0.3	)
Total other income (expense)		(3.9	)		(4.5	)		(4.4	)		(4.8	)
INCOME BEFORE INCOME TAXES		32.3			20.7			26.1			23.3
PROVISION FOR INCOME TAXES		11.2			6.8			9.0			7.7
NET INCOME		21.1	%		13.9	%		17.1	%		15.6	%

Critical Accounting Policies

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to use estimates. Several different estimates or methods can be used by management that might yield different results. The following are the significant estimates used by management in the preparation of the condensed consolidated financial statements for the three and nine months ended August 31, 2006:

Allowance for Doubtful Accounts

As of August 31, 2006, an estimate was made of the collectibility of the outstanding accounts receivable balances. This estimate requires the utilization of outside credit services, knowledge about the customer and the customer’s industry, new developments in the customer’s industry and operating results of the customer as well as general economic conditions and historical trends. When all these facts are compiled, a judgment as to the collectibility of the individual account is made. Many factors can impact this estimate, including those noted in this paragraph. The adequacy of the estimated allowance may be impacted by the deterioration in the financial condition of a large customer, weakness in the economic environment resulting in a higher level of customer bankruptcy filings or delinquencies and the competitive environment in which the customer operates. During the third quarter of fiscal 2006, we performed a detailed assessment of the collectibility of trade accounts receivable and did not make any significant adjustments to our estimate of allowance for doubtful accounts. The balance of allowance for doubtful accounts was $0.3 at August 31, 2006 and November 30, 2005.

Revenue Recognition

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

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 by our customers and retail point of sale data on existing and newly introduced products. The level of returns may fluctuate from our estimates due to several factors including weather conditions, customer inventory levels and competitive conditions. We charge the allowance account for product returns when the customer provides appropriate supporting documentation that the product is properly destroyed or upon receipt of the product.

We separate returns into the two categories of seasonal and non-seasonal products. We use the historical return detail of seasonal and non-seasonal products for at least the most recent three fiscal years on generally all products, which is normalized for any specific occurrence that is not reasonably likely to recur, to determine the amount of product returned as a percentage of sales, and estimate an allowance for potential returns based on product sold in the current period. To consider product sold in current and prior periods, an estimate of inventory held by our retail customers is calculated based on customer inventory detail. This estimate of inventory held by our customers, along with historical returns as a percentage of sales, is used to determine an estimate of potential product returns. This estimate of the allowance for seasonal and non-seasonal returns is further analyzed by considering retail customer point of sale data. We also consider specific events, such as discontinued product or product divestitures, when determining the adequacy of the allowance. Our estimate of product returns for seasonal and non-seasonal products as of August 31, 2006 was $2.3 million and $0.8 million, respectively, and $0.2 million and $0.6 million, respectively, as of November 30, 2005. As of August 31, 2006 and November 30, 2005, estimated returns of pHisoderm product was $0.2 million and $0.7 million, respectively, due to our November 30, 2005 divestiture of this brand. As a result of higher sales volumes in the nine months ended August 31, 2006 and 2005, we increased our estimate of seasonal returns by approximately $2.1 million and $0.8 million, respectively, which resulted in a decrease to net sales in our condensed consolidated financial statements. During the nine months ended August 31, 2006 and 2005, as a result of our estimate of customer inventory levels, historical non-seasonal product returns and retail point of sale data, we increased our estimate of non-seasonal returns by approximately $0.1 million and $0.7 million, respectively, which resulted in a decrease to net sales in our condensed consolidated financial statements. Each percentage point change in the seasonal return rate would impact net sales by approximately $0.2 million for the nine months ended August 31, 2006. Each percentage point change in the non-seasonal return rate would impact net sales by approximately $0.4 million for the nine months ended August 31, 2006.

We routinely enter into agreements with customers to participate in promotional programs. The cost of these programs is recorded as either advertising and promotion expense or as a reduction of sales as prescribed by Emerging Issues Task Force 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)”. A significant portion of the programs are recorded as a reduction of sales and generally take the form of coupons and vendor allowances, which are normally taken via temporary price reductions, scan downs, display activity and participations in in-store programs provided uniquely by the customer. We also enter into cooperative advertising programs with certain customers, the cost of which is recorded as advertising and promotion expense. In order for retailers to receive reimbursement under such programs, the retailer must meet specified advertising guidelines and provide appropriate documentation of the advertisement being run. During the first nine months of fiscal 2006 and 2005, our cooperative advertising reimbursements did not exceed the fair value of the benefits received under those programs.

We analyze promotional programs in two primary categories -- coupons and vendor allowances. Customers normally utilize vendor allowances in the form of temporary price reductions, scan downs, display activity and participations in in-store programs provided uniquely by the customer. We estimate the accrual for outstanding coupons by utilizing a third-party clearinghouse to track coupons issued, coupon value, distribution and expiration dates, quantity distributed and estimated redemption rates that are provided by us. We estimate the redemption rates based on internal analysis of historical coupon redemption rates and expected future retail sales by considering recent point of sale data. The estimate for vendor allowances is based on estimated unit sales of a product under a program and amounts committed for such programs in each fiscal year. Estimated unit sales are determined by considering customer forecasted sales, point of sale data and the nature of the program being offered. The three most recent years of expected program payments versus actual payments made and current year retail point of sale trends are analyzed to determine future expected payments. Customer delays in requesting promotional program payments due to their audit of program participation and resulting request for reimbursement is also considered to evaluate the accrual for vendor allowances. The costs of these programs is often variable based on the number of units actually sold. As of August 31, 2006, the coupon and vendor allowances accruals were $2.7 million and $4.2 million, respectively, and $0.6 million and $1.1 million, respectively, as of November 30, 2005. Each percentage point change in promotional program participation would impact net sales by $0.1 million and advertising and promotion expense by an insignificant amount for the nine months ended August 31, 2006.

Income Taxes

We account for income taxes using the asset and liability approach as prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes”. This approach requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our condensed consolidated financial statements or tax returns. Using the enacted tax rates in effect for the year in which the differences are expected to reverse, deferred tax assets and liabilities are determined based on the differences between the financial reporting and the tax basis of an

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asset or liability. We record income tax expense in our condensed consolidated financial statements based on an estimated annual effective income tax rate. Our effective tax rate for the nine months ended August 31, 2006 was 34.5%, as compared to 33.0% in the nine months ended August 31, 2005. The increased tax rate is primarily the result of the expiration of a previously enacted tax law related to tax credits for qualifying research and development costs.

Compensation Expense

Effective December 1, 2005, we adopted SFAS 123R using the modified prospective method. Under this method, compensation expense is recognized for new stock option grants beginning in fiscal year 2006 and for the unvested portion of outstanding stock options that were granted prior to the adoption of SFAS 123R. We recognize compensation expense on a straight-line basis over the vesting period or to the date a participant becomes eligible for retirement, if earlier. In accordance with the modified prospective method, the financial statements for prior periods have not been restated. In the third quarter of fiscal 2006, we recorded compensation expense related to stock options that reduced income from operations by $1.1 million, provision for income taxes by $0.4 million, net income by $0.7 million and basic and diluted net earnings per share by $.04. In the first nine months of fiscal 2006, we recorded stock option expense that reduced income from operations by $3.3 million, provision for income taxes by $1.1 million, net income by $2.2 million and basic and diluted net earnings per share by $.11. We capitalized $0.2 million of stock option compensation cost as a component of the carrying cost of inventory on-hand as of August 31, 2006. As of August 31, 2006, we had $9.9 million of unrecognized compensation cost related to stock options that is expected to be recorded over a weighted average period of approximately two years.

For a summary of our significant accounting policies, see Note 2 of Notes to Condensed Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended November 30, 2005 filed with the Securities and Exchange Commission.

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Comparison of Three Months Ended August 31, 2006 and 2005

To facilitate discussion of our operating results for the three months ended August 31, 2006 and 2005, we have included the following selected data from our Condensed Consolidated Statements of Income:

						Increase (Decrease)
	2006			2005		Amount			Percentage
	(dollars in thousands)
Domestic net sales	$	66,311		$	61,787	$	4,524			7.3	%
International revenues (including royalties)		5,694			6,428		(734	)		(11.4	)
Total revenues		72,005			68,215		3,790			5.6
Cost of sales		22,238			18,575		3,663			19.7
Advertising and promotion expense		23,607			17,657		5,950			33.7
Selling, general and administrative expense		10,855			12,122		(1,267	)		(10.5	)
Executive severance charges		—			2,269		(2,269	)		(100.0	)
Litigation settlement		(10,800	)		431		(11,231	)		(2,605.8	)
Interest expense		3,018			3,332		(314	)		(9.4	)
Net income		15,229			9,449		5,780			61.2

Domestic Net Sales

Domestic net sales for the three months ended August 31, 2006 increased $4.5 million, or 7.3%, to $66.3 million from $61.8 million in the prior year quarter. A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:

					Increase (Decrease)
	2006		2005		Amount		Percentage
	(dollars in thousands)
Topical pain care products	$	21,767	$	20,965	$	802		3.8	%
Medicated skin care products		17,340		15,775		1,565		9.9
Dietary supplements		9,934		8,521		1,413		16.6
Medicated dandruff shampoos and conditioner		7,798		7,653		145		1.9
Other OTC and toiletry products		9,472		8,873		599		6.8
Total	$	66,311	$	61,787	$	4,524		7.3

Net sales in the topical pain care category increased $0.8 million, or 3.8% in the third quarter of fiscal 2006 compared to the prior year quarter due to sales of the new Icy HotPro-Therapy line of elastic support braces and pain relieving insert products. Excluding sales of Icy Hot Pro-Therapy, the category declined 2.3% in the third quarter of fiscal 2006 compared to the prior year quarter.

Net sales in the medicated skin care products category increased $1.6 million, or 9.9%, in the third quarter of fiscal 2006 compared to the prior year quarter which included pHisoderm sales of $2.1 million. Net sales of Gold Bond in the third quarter of fiscal 2006 increased 24.1% compared to the prior year quarter behind strong sales of Gold Bond Medicated Body Lotion, Gold Bond Ultimate Healing Lotion, Gold BondUltimate Comfort Body Powder and the Gold Bond Cream line of products, offset in part by the discontinued first aid business and decreases in sales in the Gold Bond Baby line of products.

Net sales in the dietary supplements category increased $1.4 million, or 16.6%, in the third quarter of fiscal 2006 compared to the prior year quarter. Excluding the discontinued All-in-One bar, net sales of Dexatrim increased 68.3%, led by Dexatrim Max₂0. The sales increase in the category was offset by a reduction in net sales of New Phase in the third quarter of fiscal 2006 compared to the prior year quarter.

Net sales in the medicated dandruff shampoos and conditioner category increased $0.1 million, or 1.9%, in the third quarter of fiscal 2006 compared to the prior year quarter as a result of the distribution of SelsunSalon. Sales of Selsun Blue declined 11.5% in the third quarter of fiscal 2006 compared to the prior year quarter primarily due to increased media support and promotional activity among competitive brands.

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Net sales in the other OTC and toiletry products category increased $0.6 million, or 6.8%, in the third quarter of fiscal 2006 compared to the prior year quarter due primarily to increased sales of Pamprin and Bullfrog, led by the new products, Pamprin MAX and Bullfrog Mosquito Coast.

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

International Revenues

For the third quarter of fiscal 2006, international revenues decreased $0.7 million, or 11.4%, as compared to the prior year quarter of fiscal 2005, primarily due to the reduction of sales as a result of the divestiture of pHisoderm at the end of fiscal 2005 and the suspension of distribution in a single European market in 2005, partially offset by the successful introductions of Icy Hot in Canada and Mexico. Sales variances for our international operations were principally the result of changes in unit sales volume.

Cost of Sales

Cost of sales as a percentage of total revenues was 30.9% for the third quarter of fiscal 2006 as compared to 27.2% in the prior year quarter. Gross margin for the third quarter of fiscal 2006 was 69.1% compared to 72.8% in the prior year quarter. The gross margin decline was largely attributable to the launch of Icy HotPro-Therapy in February 2006 which has lower gross margins than our other products.

Advertising and Promotion Expense

Advertising and promotion expenses in the third quarter of fiscal 2006 increased $6.0 million, or 33.7%, as compared to the prior year quarter and were 32.8% of total revenues for third quarter of fiscal 2006 compared to 25.9% for the prior year quarter. The increase in advertising and promotion expense for the current period reflects the support for new product introductions.

Selling, General and Administrative Expense

Selling, general and administrative expenses decreased $1.3 million, or 10.5%, in the third quarter of fiscal 2006 compared to the prior year quarter. Selling, general and administrative expenses were 15.1% and 17.8% of total revenues for the third quarter of fiscal 2006 and 2005, respectively. The decrease was attributable to lower compensation expense and no executive severance charge in the third quarter of fiscal 2006 similar to the fiscal 2005 charge, offset in part by share-based payment expense under SFAS 123R (as defined below in Recent Accounting Pronouncements) in the current period.

Litigation Settlement

Litigation settlement for the third quarter of fiscal 2006 reflected a $10.7 million recovery of proceeds from the settlement trust in the Dexatrim litigation settlement and net recoveries related to the Dexatrim litigation of $0.1 million, compared to $0.4 million of legal expenses for the prior year quarter related to the Dexatrim litigation.

Interest Expense

Interest expense decreased $0.3 million, or 9.4%, in the third quarter of fiscal 2006 as compared to the prior year quarter, reflecting the impact of the redemption of the $75.0 million of Floating Rate Senior Notes, offset in part by borrowings under our Amended Revolving Credit Facility. Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our income from operations.

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Comparison of Nine Months Ended August 31, 2006 and 2005

To facilitate discussion of our operating results for the nine months ended August 31, 2006 and 2005, we have included the following selected data from our Condensed Consolidated Statements of Operations:

							Increase (Decrease)
	2006			2005			Amount			Percentage
	(dollars in thousands)
Domestic net sales	$	216,907		$	196,039		$	20,868			10.6	%
International revenues (including royalties)		18,533			19,394			(861	)		(4.4	)
Total revenues		235,440			215,433			20,007			9.3
Cost of sales		73,312			59,951			13,361			22.3
Advertising and promotion expense		75,575			58,739			16,836			28.7
Selling, general and administrative expense		33,974			36,341			(2,367	)		(6.5	)
Executive severance charges		—			2,269			(2,269	)		(100.0	)
Litigation settlement		(19,305	)		(2,401	)		(16,904	)		704.0
Interest expense		8,318			10,285			(1,967	)		(19.1	)
Loss on early extinguishment of debt		2,805			744			2,061			277.0
Net income		40,202			33,621			6,581			19.6

Domestic Net Sales

Domestic net sales for the nine months ended August 31, 2006 increased $20.9 million, or 10.6%, as compared to the corresponding period of 2005. A comparison of domestic net sales for the categories of products included in our portfolio of OTC healthcare products is as follows:

					Increase (Decrease)
	2006		2005		Amount		Percentage
	(dollars in thousands)
Topical pain care products	$	82,605	$	67,415	$	15,190		22.5	%
Medicated skin care products		49,620		49,232		388		0.8
Dietary supplements		27,696		27,461		235		0.9
Medicated dandruff shampoos and conditioner		28,075		25,341		2,734		10.8
Other OTC and toiletry products		28,911		26,590		2,321		8.7
Total	$	216,907	$	196,039	$	20,868		10.6

Net sales in the topical pain care products category increased $15.2 million, or 22.5%, for the first nine months of fiscal 2006 compared to the same period in fiscal 2005, due to the launch of the new Icy Hot Pro-Therapy line of elastic support braces and pain relieving insert products and a 26.0% increase in sales of Capzasin, led by the new Capzasin Back & Body Patch. Excluding sales of Icy Hot Pro-Therapy, the category declined 2.2% in the nine month period ended August 31, 2006 compared to the same period in fiscal 2005.

Net sales in the medicated skin care products category increased $0.4 million, or 0.8%, for the first nine months of fiscal 2006 compared to the same period in fiscal 2005, which included pHisoderm sales of $7.4 million. Net sales of Gold Bond increased 15.9% in the nine month period ended August 31, 2006 compared to the same period of the prior year behind increased sales of Gold Bond Medicated Body Lotion, Gold Bond Ultimate Healing Lotion and the Gold Bond cream line of products.

Net sales in the dietary supplements category increased $0.2 million, or 0.9%, for the first nine months of fiscal 2006 as compared to the same period in 2005. Excluding the discontinued All-in-One bar, net sales of Dexatrim increased 43.6%, which was led by the initial sell-in of Dexatrim Max₂O in the first nine months of fiscal 2006. The sales increase in the category was offset by a reduction in net sales of New Phase compared to the prior year period principally due to New Phase Extra Strength being introduced in the first quarter of 2005.

Net sales in the medicated dandruff shampoos and conditioner category increased $2.7 million, or 10.8%, for the first nine months of fiscal 2006 compared to the same period in fiscal 2005 reflecting the launch of Selsun Salon. Sales of Selsun Blue decreased 8.2% in the first nine months of fiscal 2006 compared to the same period in 2005 due to increased media support and promotional activity among competitive brands.

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Net sales in the other OTC and toiletry products category increased $2.3 million, or 8.7%, for the first nine months of fiscal 2006 compared to the same period in fiscal 2005 due principally to the introduction of new products, Pamprin MAX and Bullfrog Mosquito Coast.

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

International Revenues

For the nine months ended August 31, 2006, international revenues decreased $0.9 million, or 4.4%, as compared to the same period in fiscal 2005, primarily due to the reduction of sales as a result of the divestiture of pHisoderm at the end of fiscal 2005, and the suspension of distribution in a single European market in 2005, partially offset by the successful introductions of Icy Hot in Canada and Mexico. Sales variances for international operations were principally the result of changes in unit sales volumes.

Cost of Sales

Cost of sales as a percentage of total revenues was 31.2% for the nine months ended August 31, 2006 as compared to 27.8% for the comparable period of fiscal 2005. Gross margin for the nine months ended August 31, 2006 was 68.8% compared to 72.2% for the same period in fiscal 2005. The gross margin decline was largely attributable to the launch of Icy Hot Pro-Therapy which has lower gross margins than our other products.

Advertising and Promotion Expense

Advertising and promotion expenses for the nine months ended August 31, 2006 increased $16.8 million, or 28.7%, as compared to the same period in fiscal 2005 and were 32.1% of total revenues for the nine months ended August 31, 2006 compared to 27.3% for the comparable period of fiscal 2005. The increase in advertising and promotion expense for the first nine months of fiscal 2006 reflects the support for new product introductions.

Selling, General and Administrative Expense

Selling, general and administrative expenses for the nine months ended August 31, 2006 decreased $2.4 million, or 6.5%, as compared to the same period of fiscal 2005. Selling, general and administrative expenses were 14.4% and 16.9% of total revenues for the nine months ended August 31, 2006 and 2005, respectively. The decrease was attributable to lower compensation expense in the current period related to lower incentive compensation, payments associated with restricted stock grants in the prior year period and an executive severance charge in the third quarter of fiscal 2005, offset in part by share-based payment expense under SFAS 123R (as defined below in Recent Accounting Pronouncements).

Litigation Settlement

Litigation settlement for the nine months ended August 31, 2006 reflected the $8.8 million recovery from the DELACO settlement trust in the first quarter of 2006, the $10.7 million recovery from the litigation settlement trust on August 31, 2006 in the Dexatrim litigation settlement and net legal expenses related to the Dexatrim litigation of $0.2 million, compared to the reversal of a charge of $6.0 million related to the Dexatrim litigation, $0.5 million reimbursement from the settlement trust for previously incurred administrative costs for the same period of fiscal 2005, offset by legal expenses and ephedrine-related claims of $4.1 million related to the settlement of Dexatrim litigation.

Interest Expense

Interest expense decreased $2.0 million, or 19.1%, in the nine months ended August 31, 2006 as compared to the same period in fiscal 2005. The decrease was largely the result of the redemption of the $75.0 million of Floating Rate Senior Notes, offset in part by borrowings under our Amended Revolving Credit Facility. Until our indebtedness is reduced substantially, interest expense will continue to represent a significant percentage of our income from operations.

Loss on Early Extinguishment of Debt

Our $75.0 million of Floating Rate Senior Notes were fully redeemed in the first quarter of fiscal 2006. As a result of the redemption, a loss on early extinguishment of debt of $2.8 million was recorded in the nine months ended August 31, 2006. During the second quarter of 2005, we repurchased $17.5 million of our 7.0% Subordinated Notes, which resulted in a loss on early extinguishment of debt of $0.7 million.

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Liquidity and Capital Resources

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

Cash of $51.7 million and $37.9 million was provided by operations for the nine months ended August 31, 2006 and 2005, respectively. The increase in cash flows from operations over the prior year period was primarily attributable to the reduction in other receivables, which includes the $9.6 million receivable from the sale of pHisoderm, a loss on early extinguishment of debt of $2.8 million related to the redemption of our $75.0 million of Floating Rate Senior Notes and non-cash stock based compensation expense, offset by increased inventories related to new products.

Investing activities used cash of $5.6 million and provided cash of $0.4 million in the nine months ended August 31, 2006 and 2005, respectively. The increase in cash used in 2006 is primarily related to the first six months of 2005 containing proceeds of $3.3 million received from the sale of our Selsun business in certain countries in Africa and Asia and an increase in capital expenditures in the first nine months of 2006 as compared to the same period of 2005.

Financing activities used cash of $66.3 million and $35.2 million in the nine months ended August 31, 2006 and 2005, respectively. The increase was primarily attributable to the redemption of our $75.0 million of Floating Rate Senior Notes offset by net borrowings under our Amended Revolving Credit Facility of $53.5 million and $39.3 million of common stock repurchases as compared to $21.7 million of common stock repurchases in the first nine months of 2005.

As of October 5, 2006, our borrowing capacity under our Amended Revolving Credit Facility was $62.0 million.

We believe that cash provided by operating activities, our cash and cash equivalents balance and funds available under our Amended Revolving Credit Facility will be sufficient to fund our capital expenditures, debt service and working capital requirements for the foreseeable future as our business is currently conducted. It is likely that any acquisitions we make in the future will require us to obtain additional financing.

Foreign Operations

Historically, our primary foreign operations have been conducted through our Canadian and United Kingdom (“U.K.”) subsidiaries. Effective November 1, 2004, we transitioned our European business to Chattem Global Consumer Products Limited, a wholly-owned subsidiary located in Limerick, Ireland. The functional currencies of these subsidiaries are Canadian dollars and Euros, respectively. Fluctuations in exchange rates can impact operating results, including total revenues and expenses, when translations of the subsidiary financial statements are made in accordance with SFAS No. 52, “Foreign Currency Translation”. For the nine months ended August 31, 2006 and 2005, these subsidiaries accounted for 6% and 7% of total revenues, respectively, and 3% and 5% of total assets, respectively. It has not been our practice to hedge our assets and liabilities in Canada, the U.K. and Ireland or our intercompany transactions due to the inherent risks associated with foreign currency hedging transactions and the timing of payments between us and our foreign subsidiaries. Following our acquisition of Selsun Blue, our international business operations have expanded significantly, which will increase our exposure to fluctuations in foreign exchange rates. During fiscal 2006 and 2005, a portion of these foreign sales was reflected as royalties, which have been paid to us in U.S. dollars. In addition, until July 2005 Abbott Laboratories (“Abbott”), from whom we acquired Selsun Blue, continued to supply a portion of our international product and billed us in U. S. dollars in certain instances. Beginning April 1, 2004, a portion of our international supply of Selsun was billed to us in local currencies. Historically, gains or losses from foreign currency transactions have not had a material impact on our operating results. Gains and losses for the nine months ended August 31, 2006 and 2005 were insignificant and are included in selling, general and administrative expenses in the Condensed Consolidated Statements of Income.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and amends SFAS No. 95, “Statement of Cash Flows”. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and requires all share-based payments to employees, including grants of employee stock options, to be recognized as additional compensation expense in the financial statements based on the calculated fair value of the awards. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation costs to be reported as a financing cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. We adopted SFAS 123R effective for our fiscal year beginning December 1,

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2005. We have described the impact of adopting SFAS 123R in our condensed consolidated financial statements in Note 5, Stock-Based Compensation.

The American Jobs Creation Act of 2004 (the “AJCA”) was enacted on October 22, 2004. The AJCA repeals an export incentive, creates a new deduction for qualified domestic manufacturing activities and includes a special one-time deduction of 85% of certain foreign earnings repatriated to the U.S.

In December 2004, the FASB issued FASB Staff Position No. 109-1, “Application of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004” (“FSP 109-1”). FSP 109-1 clarifies that the manufacturer’s deduction provided for under the AJCA should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. In accordance with FSP 109-1, we treat the deduction for qualified domestic manufacturing activities, which became effective beginning December 1, 2005, as a reduction of the income tax provision in future years when realized.

In July 2006, FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, or our fiscal year beginning December 1, 2007. We are evaluating the impact of adopting FIN 48 on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities and is intended to respond to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value but does not expand the use of fair value in any new circumstances. SFAS 157 also requires expanded disclosure of the effect on earnings for items measured using unobservable data, establishes a fair value hierarchy that prioritizes the information used to develop those assumptions and requires separate disclosure by level within the fair value hierarchy. The provisions of SFAS 157 are effective for interim financial statements issued for fiscal years beginning after November 15, 2007, or our fiscal 2008.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans -- An Amendment of FASB Statements No. 87, 88, 106, and 132R” (“SFAS 158”). SFAS 158 requires an employer to recognize in its balance sheet an asset or liability for a plan’s funded status, measure a plan’s assets and obligations as of the end of the employer’s fiscal year and recognize changes in the funded status in the year in which the changes occur. SFAS 158 also enhances the current disclosure requirements for pension and other postretirement plans to include disclosure related to certain effects on net periodic benefit cost. The requirement to recognize the funded status of a benefit plan and the disclosure requirements are effective as of the end of the fiscal year ending after December 15, 2006, or our fiscal 2007. The requirement to measure plan assets and benefit obligations as of the employer’s fiscal year-end is effective for fiscal years ending after December 15, 2008, or our fiscal 2009.

Forward Looking Statements

We may from time to time make written and oral forward-looking statements. Written forward-looking statements may appear in documents filed with the Securities and Exchange Commission, in press releases and in reports to shareholders or be made orally in publicly accessible conferences or conference calls. The Private Securities Litigation Reform Act of 1995 contains a safe harbor for forward-looking statements. We rely on this safe harbor in making such disclosures. The forward-looking statements are based on management’s current beliefs and assumptions about expectations, estimates, strategies and projections. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. We undertake no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. The risks, uncertainties and assumptions of the forward-looking statements include, but are not limited to, the lack of availability, limits of coverage and expense related to product liability insurance; the reduction of available insurance coverage as proceeds are used to fund any product liability settlements or awards; the possibility of other product liability claims, including claims relating to the prior existence of ephedrine in Dexatrim products or arising from the FDA’s rule banning the sale of dietary supplements containing ephedrine; our ability to fund liabilities from product liability claims greater than our insurance coverage or outside the scope of insurance coverage; the possible effect of the negative public

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perception resulting from product liability claims on sales of Dexatrim products without PPA or ephedrine; the impact of brand acquisitions and divestures; the impact of gains or losses resulting from product acquisitions or divestures; product demand and market acceptance risks; product development risks, such as delays or difficulties in developing, producing and marketing new products or line extensions; the impact of competitive products, pricing and advertising; our ability to sell and market Selsun internationally where we have only limited experience and infrastructure; constraints resulting from our financial condition, including the degree to which we are leveraged, debt service requirements and restrictions under indentures and loan agreements; government regulations; risks of loss of material customers; public perception regarding our products; dependence on third party manufacturers; environmental matters; and other risks described in our Securities and Exchange Commission filings.

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Item 3. Quantitative and Qualitative Disclosures About Market Risks

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

Our exposure to interest rate risk currently relates to amounts outstanding under our Amended Revolving Credit Facility. Loans under our Amended Revolving Credit Facility bear interest at LIBOR plus applicable percentages of 1.00% to 2.00% or a base rate (the higher of the federal funds rate plus 0.5% or the prime rate) plus applicable percentages of up to 0.5%. The applicable percentages are calculated based on our leverage ratio. As of August 31, 2006, $53.5 million was outstanding under the Amended Revolving Credit Facility, and the variable rate on the Amended Revolving Credit Facility was LIBOR plus 1.25%, or 6.65%. The 7.0% Subordinated Notes are fixed interest rate obligations. On March 8, 2004, we entered into an interest rate cap agreement effective June 1, 2004 with decreasing annual notional principal amounts of $15.0 million beginning March 1, 2006 and cap rates ranging from 4.0% to 5.0% over the life of the agreement. The amortized value of the premium on the interest rate cap was compared to its fair value as of August 31, 2006, and a gain of approximately $0.1 million net of tax, was recorded to other comprehensive income. The interest rate cap agreement terminates on March 1, 2010. The impact on our results of operations of a one-point rate change on the October 5, 2006 outstanding balance of $38.0 million of our Amended Revolving Credit Facility for the next twelve months would be approximately $0.2 million, net of tax.

We are subject to risk from changes in the foreign exchange rates relating to our Canadian, U.K. and Irish subsidiaries. Assets and liabilities of these subsidiaries are translated to U.S. dollars at year-end exchange rates. Income and expense items are translated at average rates of exchange prevailing during the year. Translation adjustments are accumulated as a separate component of shareholders’ equity. Gains and losses, which result from foreign currency transactions, are included in the Condensed Consolidated Statements of Income. Until July 2005, Abbott continued to supply us with a portion of our international supply of Selsun and billed us in U.S. dollars in certain instances. Beginning April 1, 2004, a portion of our international supply of Selsun was billed to us in local currencies. The potential loss resulting from a hypothetical 10% adverse change in the quoted foreign currency exchange rate amounts to approximately $0.7 million as of August 31, 2006.

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

Item 4. Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and Principal Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of August 31, 2006 (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective in alerting them on a timely basis to material information relating to us (including our consolidated subsidiaries) required to be included in our reports filed or submitted under the Exchange Act. There has been no change in our internal control over financial reporting during the three months ended August 31, 2006 that has materially affected, or is reasonably likely to materially affect, such internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

See Note 18 of Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1 of this Report.

Item 1A. Risk Factors

There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended November 30, 2005.

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

(a) Not applicable.

(b) Not applicable.

(c) A summary of the common stock repurchase activity for our third quarter of fiscal 2006 is as follows:

Period	Total Number of  Shares Purchased		Average Price Paid Per Share (1)		Total Number of  Shares Purchased as Part of Publicly Announced Plans or      Programs (2)		Approximate Dollar Value that may yet be Purchased under the Plans or          Programs (2)
June 1- June 30		236,200	$	30.69		236,200	$	98,899,394
July 1 - July 31		172,092		30.91		172,092		93,579,201
August 1 - August 31		164,571		33.01		164,571		88,147,224
Total Third Quarter		572,863		31.42		572,863		88,147,224

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

(2)   In January 2005, our board of directors increased the total authorization to repurchase our common stock under our stock buyback program to $30.0 million. A total of $17.3 million remained available under the stock buyback authority prior to July 29, 2005, when our board of directors increased the total buyback authorization back to $30.0 million. Subsequent to share purchases made in the fourth quarter of fiscal 2005, our board of directors again increased the total buyback authorization back to $30.0 million, effective November 29, 2005. On June 26, 2006 our board of directors authorized the repurchase of up to an additional $100.0 million of our common stock under our existing stock repurchase program. There is no expiration date specified for our stock buyback program.

Item 3. Defaults Upon Senior Securities

None.

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

None.

Item 5. Other Information

None.

Item 6. Exhibits

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

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

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CHATTEM, INC.

SIGNATURES

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

	CHATTEM, INC. (Registrant)
Dated: October 10, 2006	By:	/s/ Zan Guerry
		Zan Guerry
		Chairman and Chief Executive Officer

Dated: October 10, 2006	By:	/s/ Robert E. Bosworth
		Robert E. Bosworth
		President and Chief Operating Officer

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Chattem, Inc. and Subsidiaries

Exhibit Index

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

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