Introduction

The following information should be read in conjunction with the consolidated financial statements and notes in Part I, Item 1 of this Quarterly Report and with Management's Discussion and Analysis of Financial Condition and Results of Operations contained in the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 2008.

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

Critical Accounting Policies

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

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

Consolidation of Variable Interest Entity - The Company consolidates any Variable Interest Entity ("VIE") of which we are the primary beneficiary. The liabilities recognized as a result of consolidating a VIE do not represent additional claims on our general assets; rather, they represent claims against the specific assets of the consolidated VIE. Conversely, assets recognized as a result of consolidating a VIE do not represent additional assets that could be used to satisfy claims against our general assets. Reflected in the March 31, 2009 and June 30, 2008 balance sheets are consolidated VIE assets of approximately $1.9 million, which is comprised mainly of land and building. VIE liabilities consist of a mortgage on that property in the amount of approximately $1.7 and $1.8 million at March 31, 2009 and June 30, 2008, respectively. This VIE was initially consolidated by Cody, as Cody has been the primary beneficiary. Cody has then been consolidated within Lannett's financial statements since its acquisition in April 2007.

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

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

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

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

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

credits are issued or payments are made for actual returns received. The reserve for returns is included in the rebates, chargebacks and returns payable account on the balance sheet.

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

The following tables identify the reserves for each major category of revenue allowance and a summary of the activity for the nine months ended March 31, 2009 and 2008:

For the nine months ended March 31, 2009

Reserve Category                 Chargebacks      Rebates       Returns        Other         Total

Reserve Balance as of June 30,
2008                             $  4,049,407   $   632,314   $ 13,642,589   $    2,107   $ 18,326,417
Actual credits issued related
to sales recorded in prior
fiscal years                       (3,930,992 )    (632,314 )  (12,246,259 )          -    (16,809,565 )
Reserves or (reversals)
charged during Fiscal 2009
related to sales in prior
fiscal years                                -             -          2,107       (2,107 )            -
Reserves charged to net sales
during Fiscal 2009 related to
sales recorded in Fiscal 2009      24,342,932     8,498,516      3,441,427      208,649     36,491,524
Actual credits issued related
to sales recorded in Fiscal
2009                              (19,914,114 )  (6,754,177 )            -     (167,911 )  (26,836,202 )
Reserve Balance as of
March 31, 2009                   $  4,547,233   $ 1,744,339   $  4,839,864   $   40,738   $ 11,172,174

For the nine months ended March 31, 2008

Reserve Category                 Chargebacks      Rebates       Returns       Other         Total

Reserve Balance as of June 30,
2007                             $  4,649,478   $   871,339   $   113,313   $   52,234   $  5,686,364
Actual credits issued related
to sales recorded in prior
fiscal years                       (4,429,923 )  (1,741,804 )    (146,917 )          -     (6,318,644 )
Reserves or (reversals)
charged during Fiscal 2008
related to sales in prior
fiscal years                                -       870,465        50,000      (50,000 )      870,465
Reserves charged to net sales
during Fiscal 2008 related to
sales recorded in Fiscal 2008      17,985,506     6,240,517     2,200,267      473,423     26,899,713
Actual credits issued related
to sales recorded in Fiscal
2008                              (14,721,493 )  (4,988,844 )    (805,702 )   (473,552 )  (20,989,591 )
Reserve Balance as of
March 31, 2008                   $  3,483,568   $ 1,251,673   $ 1,410,961   $    2,105   $  6,148,307

The total reserve for chargebacks, rebates, returns and other adjustments decreased from $18,326,417 at June 30, 2008 to $11,172,174 at March 31, 2009. The significant decrease in the returns reserve balance was primarily the result of credits issued during the first nine months of Fiscal 2009 related to the returns of the Prenatal Multivitamin product shipped in Fiscal 2008. It is our expectation that all of the product will be returned based on our inability to have the product specified as a brand equivalent, and information from our customers regarding their intentions to return the product. As of March 31, 2009 approximately $9,507,000 of the return reserve was applied to accounts receivable for customers who had returned the Prenatal Multivitamin product by

that date, leaving a balance of approximately $1,038,000 of Multivitamin returns reserve on the books at March 31, 2009. The increase in chargeback reserves between June 30, 2008 and March 31, 2009 was primarily due to an increase in inventory levels at wholesaler distribution centers

Credits issued during the quarter that relate to prior year sales are charged against the opening balance. In aggregate, additional reserves or reversals of reserves have historically offset each other. The table above shows the effects of reversals within the rebates, returns and other categories. It is the Company's intention that all reserves be charged to sales in the period that the sale is recognized, however, due to the nature of this estimate, it is possible that the Company may sometimes need to increase or decrease the reserve based on prior period sales. If that were to occur, management would disclose that information at that time. If the historical data the Company uses and the assumptions management makes to calculate its estimates of future returns, chargebacks, and other credits do not accurately approximate future activity, its net sales, gross profit, net income and earnings per share could change. However, management believes that these estimates are reasonable based upon historical experience and current conditions.

The rates of reserves will vary, as well as the category under which the credit falls. This variability comes about when the Company is working with indirect customers to compete with the pricing of other generic companies. The Company has improved its computer systems in order to improve the accuracy of tracking and processing chargebacks and rebates and will continue to look at ways for further improvements. Improvements to automate calculation of reserves will not only reduce the potential for human error, but also will result in more in-depth analysis and improved customer interaction for resolution of open credits.

The rate of credits issued is monitored by the Company at least on a quarterly basis. The Company may change the estimate of future reserves based on the amount of credits processed, or the rate of sales made to indirect customers. The decrease of reserves to $11,172,174 at March 31, 2009 from $18,326,417 at June 30, 2008 is due to the timing of credits being processed by the customers and by the Company. Approximately $16,810,000 or 92% of the reserve balance from June 30, 2008 has been processed through the first nine months of Fiscal 2009. Approximately $9,507,000 of that amount relates to credits issued due to the return by customers of the Prenatal Multivitamin product through December 31, 2008. Management estimates reserves based on sales mix. A comparison to wholesaler inventory reports is performed quarterly, in order to justify the balance of unclaimed chargebacks and rebates. The Company has historically found a direct correlation between the calculation of the reserve based on sales mix, and the wholesaler inventory analysis.

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

The Company also regularly monitors customer Accounts Receivable (AR) balances through a tool known as Days Sales Outstanding ("DSO"). This calculation for Net DSO begins with the Gross AR less the Rebates and Chargeback reserve. This net amount is then divided by the average daily net sales for the period. The table below shows the results of these calculations for the relevant periods.

                                  Nine months   Fiscal Year   Nine months
                                     ended         ended         ended
                                    3/31/09       6/30/08       3/31/08
            Net DSO (in days)         59            65            75
            Gross DSO (in days)       64            70            63

The Gross DSO above shows the result of the same calculation without regard to rebates and chargebacks. The Company monitors both Net DSO and Gross DSO as an overall check on collections and reasonableness of reserves. In order to be effective indicators, both types of DSO are evaluated on a quarterly basis. The Gross DSO calculation provides management with an understanding of the frequency of customer payments, and the ability to process customer payments and deductions. The Net DSO calculation provides management with an understanding of the relationship of the A/R balance net of the reserve liability compared to net sales after reserves charged during the period.

The Company's payment terms are consistent with the generic pharmaceutical industry at 60 days for payment from all customers, including wholesalers. Net DSO for the third quarter of Fiscal 2009, net of rebates and chargebacks, decreased as a result of timing of return credits being taken by certain customers. Management expects the DSO calculation normal levels to be 60 to 70 days. Significant variances greater or less than this range are reviewed and, if necessary, action is taken.

Inventories - The Company values its inventory at the lower of cost (determined by the first-in, first-out method) or market, regularly reviews inventory quantities on hand, and records a provision for excess and obsolete inventory based primarily on estimated forecasts of product demand and production requirements. The Company's estimates of future product demand may prove to be inaccurate, in which case it may have understated or overstated the provision required for excess and obsolete inventory. In the future, if the Company's inventory is determined to be overvalued, the Company would be required to recognize such costs in cost of goods sold at the time of such determination.

Share-based Compensation - Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), "Share-Based Payment," ("FAS 123(R)") was adopted effective July 1, 2005. Share-based compensation cost is measured using the Black-Scholes option pricing model. The following table highlights relevant stock-option plan information for the nine months ended:

                                                             March 31,      March 31,
                                                               2009           2008
Share based compensation expense
Stock options                                               $   731,000    $   657,000
Employee stock purchase plan                                $    70,000    $    20,000
Restricted stock                                            $   230,000    $    92,000
Total unrecognized compensation cost related to
non-vested share-based compensation awards                  $ 1,213,000    $ 1,981,000
Weighted average period over which it is to be
recognized                                                   1.34 years      1.6 years

As part of the former CFO's resignation, the Company repurchased all of his 185,000 outstanding stock options. Therefore, the Company recorded, as incremental stock compensation expense, the previously unrecognized compensation cost totaling approximately $83,000 related to options for which the requisite service period had not been rendered as of the repurchase date.

Results of Operations - Three months ended March 31, 2009 compared with three months ended March 31, 2008

Net sales for the three months ended March 31, 2009 ("Fiscal 2009") increased 73% to $28,761,000 from $16,580,000 for the three months ended March 31, 2008 ("Fiscal 2008"). The increase was primarily due to sales of $4,890,000 of our Prenatal vitamins during the third quarter of Fiscal 2009. The increase can also be attributed to increases in demand for Lannett's products used for the treatment of congestive heart failure and thyroid deficiency. The Company looks to continue increasing the number of products available for sale to our customers. FDA approvals are needed to continue this growth. Several recent FDA approvals have resulted in more sales of new products in the current fiscal year compared to the prior fiscal year. In addition to the sales of the Prenatal vitamins, the following factors contributed to the $12,181,000 increase in sales:

                           Sales volume   Sales price
Medical indication           change %      change %
Congestive Heart Failure            189 %          36 %
Antibiotics                          -8 %         -89 %
Thyroid                              28 %         - 1 %
Migraine Headache                     0 %           4 %

Drugs for the treatment of congestive heart failure experienced a large increase in sales price and volume as a result of the Company being one of the major suppliers for the generic market of this product. This is due to several competitor recalls of this product. The increase in volume in drugs used for the treatment of thyroid deficiency was mainly due to the push of generic sales at one of our large existing retail chain customers.

The increase in product sales can be attributed primarily to three products. Sales of drugs for the treatment of congestive heart failure increased by approximately $2,934,000 in the third quarter of Fiscal 2009 compared to the third quarter of Fiscal 2008 due to a product recall by several of our major competitors. Sales of drugs used in the treatment of thyroid deficiency increased by approximately $2,422,000. This increase was due to an increase in sales to one large existing retail chain customer. The increase can also be contributed to the continued sales of our prenatal vitamins discussed above.

During Lannett's third quarter of 2009, the brand version of the Prenatal vitamin was removed from the marketplace. It is expected that, due to the lack of selling activities by the branded drug company, Lannett will experience a decline in sales for this product. Accordingly, the Company entered into a settlement agreement with this brand drug company related to the outstanding litigation between the two companies. Pursuant to the settlement, the Company will receive a license to sell the generic version of the drug and will become an authorized generic provider. Lannett will cease offering its Prenatal vitamin product if and when the brand is restored to the marketplace.

The Company sells its products to customers in various categories. The table below identifies the Company's approximate net sales to each category for the three months ended March 31, 2009 and 2008:

Customer Category             2009           2008

Wholesaler/ Distributor   $ 12,252,000   $  7,152,000
Retail Chain                15,015,000      8,465,000
Mail-Order Pharmacy          1,356,000        892,000
Private Label                  138,000         71,000

Total                     $ 28,761,000   $ 16,580,000

The sales to all customer categories increased significantly as a result of an increase in the demand for products for which the Company is the major supplier and also an increase in the number of products available for sale.

Cost of sales for the third quarter increased 35% to $17,154,000 in Fiscal 2009 from $12,682,000 in Fiscal 2008. The increase is due to the 73% increase in sales. Gross profit margins for the third quarter of Fiscal 2009 and Fiscal 2008 were 40% and 24%, respectively. Gross profit percentage increased due to strong profit margins on the new prenatal vitamin, increased margins for our congestive heart failure medication, and the overall fixed nature of some production costs versus the 73% increase in revenues. While the Company is continuously striving to keep product costs low, there can be no guarantee that profit margins will not fluctuate in future periods. Pricing pressure from competitors and costs of producing or purchasing new drugs may also fluctuate in the future. Changes in the future sales product mix may also occur. These changes may affect the gross profit percentage in future periods.

Amortization expense for the intangible asset for each of the three months ended March 31, 2009 and 2008 was approximately $446,000. The amortization expense relates to the March 23, 2004 exclusive marketing and distribution rights agreement with JSP. For the remaining five and a fourth years of the contract, the Company will incur annual amortization expense of approximately $1,785,000.

Research and development ("R&D") expenses in the third quarter increased 31% to $1,981,000 for Fiscal 2009 from $1,517,000 for Fiscal 2008. The increase is primarily due to an increase in production of drugs in development and preparation for submission to the FDA. The Company expenses all production costs as R&D until the drug is approved by the FDA. R&D expenses may fluctuate from period to period, based on R&D plans for submission to the FDA.

Selling, general and administrative expenses in the third quarter increased 77% to $7,492,000 in Fiscal 2009 from $4,222,000 in Fiscal 2008. The increase is primarily due to litigation expenses related to the patent challenge with KV Pharmaceuticals of $2,530,000, severance costs related to the departure of the Company's former chief financial officer of approximately $452,000, as well as increases in other legal, accounting and professional services compared to the same period in Fiscal 2008. While the Company is focused on controlling costs, increases in personnel costs may have an ongoing and longer lasting impact on the administrative cost structure. Other costs are being incurred to facilitate improvements in the Company's infrastructure. These costs are expected to be . . .