**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**


**FORM
      10-KSB**




(Mark
      One)




x ANNUAL
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For
      the
      fiscal year ended December 31, 2006





oTRANSITION
      REPORT UNDER
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For
      the
      transition period from ___________ to ___________





Commission
      file number: 000-27642





**TRANSDERM
      LABORATORIES CORPORATION**


(Name
      of
      small business issuer in its charter)





Delaware
              (State
                or other jurisdiction of incorporation or organization)
            13-3518345
              (I.R.S.
                Employer Identification No.)





101
                Sinking Springs Lane, Emigsville, PA
            17318(Address
                of principal executive offices)
            (Zip
                code)




Issuer's
      telephone number, including area code:    717-764-1191





Securities
      registered under Section 12(b) of the Exchange Act: None





Securities
      registered under Section 12(g) of the Exchange Act:





Common
      Stock, $.001 Par Value


(Title
      of
      class)





Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 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. o   Yes x No





Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of registrant's knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB. x




State
      the
      issuer's revenues for its most recent fiscal year:  $5,940,000





State
      the
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      sold, or the average bid and asked price of such common equity, as of a
      specified date within the past 60 days. (See definition of affiliate in Rule
      12b-2 of the Exchange Act.): Not applicable.







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


Yes o No
x




State
      the
      number of shares outstanding of each of the issuer's classes of common equity,
      as of the latest practicable date:  40,000,000  as
      of
      March 30, 2007.




**DOCUMENTS
      INCORPORATED BY REFERENCE**




None.





Transitional
      Small Business Disclosure Format (Check one): o  Yesx  No









SPECIAL
                  NOTE REGARDING FORWARD-LOOKING STATEMENTS
                
                3INTRODUCTORY
                  NOTE
                
                5PART
                    I
                
                
                5ITEM
                    1.
                DESCRIPTION
                    OF BUSINESS
                
                5ITEM
                    2.
                DESCRIPTION
                    OF PROPERTIES
                
                30ITEM
                    3.
                LEGAL
                    PROCEEDINGS
                
                30ITEM
                    4.
                SUBMISSION
                    OF MATTERS TO A VOTE OF SECURITY HOLDERS
                
                30PART
                    II
                
                
                30ITEM
                    5.
                MARKET
                    FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
                
                30ITEM
                    6.
                MANAGEMENT'S
                    DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
                    OPERATIONS
                
                31ITEM
                    7.
                FINANCIAL
                    STATEMENTS
                
                44ITEM
                    8.
                CHANGES
                    IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
                    DISCLOSURE
                
                45ITEM
                    8A.
                CONTROLS
                    AND PROCEDURES
                
                45ITEM
                    8B.
                OTHER
                    INFORMATION
                
                45PART
                    III
                
                
                45ITEM
                    9.
                DIRECTORS,
                    EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
                    WITH SECTION
                    16(A) OF THE EXCHANGE ACT
                
                45ITEM
                    10.
                EXECUTIVE
                    COMPENSATION
                
                48ITEM
                    11.
                SECURITY
                    OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
                    STOCKHOLDER MATTERS.
                
                49ITEM
                    12.
                CERTAIN
                    RELATIONSHIPS AND RELATED TRANSACTIONS
                
                50ITEM
                    13.
                EXHIBITS
                    AND REPORTS ON FORM 8-K
                
                51ITEM
                    14.
                PRINCIPAL
                    ACCOUNTANT FEES AND SERVICES
                
                56SIGNATURES
                
                57




-2-




SPECIAL
      NOTE REGARDING FORWARD-LOOKING STATEMENTS





This
      Annual Report on Form 10-KSB for the year ended December 31, 2006 ("Annual
      Report") contains forward-looking statements. We have based these
      forward-looking statements on our current expectations and projections about
      future events. These statements include, but are not limited to:





·
            statements
                relating to our ability to restructure our outstanding past due
                liabilities;





·
            statements
                as to the development of new products and the commercialization of
                products;  ·
            statements as to the anticipated timing of clinical
              tests
              and other business developments;




·
            expectations
                as to the adequacy of our cash balances to support our operations
                for
                specified periods of time and as to the nature and level of cash
                expenditures; and





·
            expectations
                as to the market opportunities for our products, as well as our ability
                to
                take advantage of those
                opportunities.




These
      statements may be found in the sections of this Annual Report entitled
“Description of Business”, “Risk Factors”, and “Management’s Discussion and
      Analysis of Financial Condition and Results of Operations,” as well as in this
      Annual Report generally. Actual results could differ materially from those
      anticipated in these forward-looking statements as a result of various factors,
      including all the risks discussed in “Risk Factors” and elsewhere in this Annual
      Report.





In
      addition, statements that use the terms “can,” “continue,” “could,” “may,”
“potential,” “predicts,” “should,” “will,” “believe,” “expect,” “plan,”
“intend,” “estimate,” “anticipate,” “scheduled” and similar expressions are
      intended to identify forward-looking statements. All forward-looking statements
      in this Annual Report reflect our current views about future events and are
      based on assumptions and are subject to risks and uncertainties that could
      cause
      our actual results to differ materially from future results expressed or implied
      by the forward-looking statements. Many of these factors are beyond our ability
      to control or predict. Forward-looking statements do not guarantee future
      performance and involve risks and uncertainties. Actual results will differ,
      and
      may differ materially, from projected results as a result of certain risks
      and
      uncertainties. The risks and uncertainties include, without limitation, those
      described under “Risk Factors” and those detailed from time to time in our
      filings with the Securities and Exchange Commission, and include, among others,
      the following:





·
            our
                ability to restructure outstanding liabilities and continue as a
                going
                concern;





·
            our
                ability to successfully develop and commercialize new products;





·
            a
                lengthy approval process and the uncertainty of the Food and Drug
                Administration and other government regulatory
                requirements;





·
            the
                degree and nature of our competition;





·
            our
                continued ability to obtain certain raw materials from which we
                manufacture our products;





·
            our
                ability to employ and retain qualified employees; and




-3-




·
            the
                other factors referenced in this Annual Report, including, without
                limitation, under the section entitled “Risk Factors”, “Management’s
                Discussion and Analysis of Financial Condition and Results of Operations,”
                and “Description of Business.”





These
      risks are not exhaustive. Other sections of this Annual Report may include
      additional factors that could adversely impact our business and financial
      performance. Moreover, we operate in a very competitive and rapidly changing
      environment. New risk factors emerge from time to time, and it is not possible
      for our management to predict all risk factors, nor can we assess the impact
      of
      all factors on our business or the extent to which any factor, or combination
      of
      factors, may cause actual results to differ materially from those contained
      in
      any forward-looking statements. Given these risks and uncertainties, investors
      should not place undue reliance on forward-looking statements as a prediction
      of
      actual results. These forward-looking statements are made only as of the date
      of
      this Annual Report. Except for our ongoing obligation to disclose material
      information as required by federal securities laws, we do not intend to update
      you concerning any future revisions to any forward-looking statements to reflect
      events or circumstances occurring after the date of this Annual
      Report.




-4-




INTRODUCTORY
      NOTE





In
      January 2007, Transderm Laboratories Corporation (“Transderm”) filed an Annual
      Report on Form 10-KSB for the years ended December 31, 2003 and 2004 (the “2004
      Annual Report”). Prior to filing the 2004 Annual Report, Transderm had not filed
      any annual or quarterly reports with the Securities and Exchange Commission
      since it filed an annual report for the year ended December 31, 1998 in November
      1999 and quarterly reports for the first three quarters of 1999. In March 2007,
      Transderm filed an Annual Report on Form 10-KSB for the year ended December
      31,
      2005. This Annual Report covers the year ended December 31, 2006 and includes
      audited financial statements for the year then ended. Transderm does not plan
      to
      file any quarterly reports for the 2006 fiscal year unless so requested by
      the
      Securities and Exchange Commission and expects to file all periodic reports
      required by the Securities Exchange Act of 1934, as amended, during the 2007
      fiscal year.





PART
      I





ITEM
      1.  DESCRIPTION
      OF BUSINESS





Overview .





Transderm
      Laboratories Corporation (“Transderm”, the “Company”, “we”, “us”, or like terms)
      is a Delaware corporation that conducts its business primarily through its
      subsidiary, Hercon Laboratories Corporation ("Hercon"). Unless the context
      otherwise requires, the terms “we”, “us”, the “Company” or similar terminology,
      includes Transderm Laboratories Corporation and Hercon, of which Transderm
      owns
      98.5%. Transderm is a 90%-owned subsidiary of Health-Chem Corporation
      ("Health-Chem" which, together with Transderm, Hercon and Health-Chem’s other
      subsidiaries, may be referred to as the “Group”).





We
      develop, manufacture and market transdermal drug delivery systems. A transdermal
      drug delivery system is an adhesive patch containing medication which is
      released through the skin into the bloodstream at a controlled rate over an
      extended period of time. Transdermal delivery can significantly enhance the
      therapeutic benefit of certain drugs, through improved efficacy, safety and
      patient compliance, when compared to conventional methods of drug
      administration, such as oral or parenteral (drugs that are delivered other
      than
      by the digestive tract, such as subcutaneous or intramuscular injection, or intravenous ly)
      delivery. Over the last several years, our sole product and continuing source
      of
      revenue has been a transdermal nitroglycerin patch for the relief of the
      vascular and cardiovascular symptoms related to angina pectoris (chest pain). We
      manufacture our nitroglycerin patch both on a contract basis for specific
      clients and for sale to distributors and wholesalers for distribution in the
      United States. We manufacture our products in accordance with Good Manufacturing
      Practices, or GMP’s, prescribed by the United States Food and Drug
      Administration, or FDA, at our facility in Emigsville,
      Pennsylvania.





Transderm
      has developed a base of technology in the design of transdermal systems by
      applying its expertise in the area of skin biology, pharmaceutical and polymer
      chemistry, drug diffusion, adhesive technology, pharmacokinetics and clinical
      protocol design. We believe that the integration of our technology and
      manufacturing experience gives us a competitive advantage by providing us with
      the capability to custom design and produce individual, cost-effective
      transdermal delivery systems for specific drugs. As a result, over the last
      several years, we have been engaged by third parties to conduct
      feasibility studies and development and related activities with respect to
      new
      pharmaceutical products that may be amenable to transdermal delivery and, in
      some cases, to manufacture such products for them on a commercial basis if
      they
      reach the market.




-5-





Current
      Financial Condition of Transderm.





Transderm
      continues its efforts to recover from the operational and financial adversity
      it
      has experienced since 1997, the basis for which is more fully described in
      the
      2004 Annual Report. While net sales had increased during the period 2001 through
      2004 (the financial information for the years 2001 and 2002 is unaudited),
      net
      revenues decreased significantly during each of 2005 and 2006 as a result of
      a
      decline in orders in each such year by one of our principal customers, as
      described elsewhere in this Report. Transderm has posted significant operating
      losses in each year since 1997, and as of December 31, 2006 had an accumulated
      deficit of $35.6 million and a working capital deficiency of approximately
      $26
      million.





At
      December 31, 2006, the
      Company had total liabilities of
      $41.3
      million, which included
      approximately (i) $7.3 million
      due under the terms of a license acquired from Key Pharmaceuticals, Inc. to
      utilize certain technology in its current generation transdermal patch (the
“Key
      License”), which represents royalty payments owed over the last seven years (the
“Key Royalty”), and (ii) $30.5 million owed to Health Chem, including $14.1
      million related to redeemable preferred stock under which Transderm is currently
      in default, $7.2 million related to a subordinated promissory note under which
      Transderm is currently in default, and $9.2 million related to a long-term
      payable (each of which items is more fully described under the heading
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operations” and in the notes to the Financial Statements, and which are herein
      collectively referred to as the “Intercompany Obligations”).





Transderm’s
      current financial condition negatively impacts its day-to-day operations and
      undermines its ability to grow its business. In addition, at December 31, 2006,
      Health-Chem, Transderm’s parent corporation, had total outstanding liabilities
      of approximately $22.4 million, including $11.5 million of principal and
      interest due under certain debentures under which it has been in default since
      April 1999, and had a working capital deficiency of approximately $16.2 million,
      which conditions also bear on Transderm’s current and future prospects.
      Transderm’s ability to return to profitability from the precarious financial
      condition which it has experienced over the last several years is predicated
      on
      a number of factors, including the Group’s ability to reach agreements with its
      largest creditors, its ability to reduce operating expenses as a percentage
      of
      revenues, its ability to obtain financing and its ability to identify and bring
      new products to market.





Transderm’s
      and the Group’s fragile financial condition leaves them vulnerable
      because:





·
            existing
                creditors of either company could seek the immediate collection of
                amounts
                due them which could cause either company to seek protection under
                federal
                bankruptcy laws;





·
            their
                obligations and liabilities, as well as their respective stockholders’
                deficiencies, do not allow them to obtain financing for
                operations;





·
            their
                working capital deficiencies prevent the Group from diversifying
                operations by developing new products and reducing reliance on revenues
                generated from sales of a single
                product;




-6-




·
            the
                extraordinary conditions make it difficult to endure business cycles
                resulting from general economic conditions or the effects of competition,
                among other things, as they occur;





·
            the
                condition prevents them from taking advantage of business opportunities
                as
                they may arise; and





·
            the
                condition does not allow them to retain senior management who have
                experience in the pharmaceutical industry or in any business in which
                they
                may become involved in the future.





Transdermal
      Delivery Systems .





A
      transdermal drug delivery system, known as a transdermal
      patch or skin patch, is a medicated adhesive patch that is placed on the skin
      to
      deliver a time released dose of medication through the skin and into the bloodstream . These
      systems utilize
      a
      special membrane to control the rate at which the liquid drug
      contained in the patch can pass through the skin and into the bloodstream. Transdermal
      drug delivery involves the inherent challenge of overcoming the skin barrier.
      Skin protects the body from the environment very effectively and generally
      is
      only permeable to small molecule, lipophilic (oil soluble) drugs which require
      only limited dose sizes. Transdermal delivery systems, therefore, not only
      have
      to provide drug to the skin under stable conditions in controlled dosages and
      in
      a format convenient to the patient, but also serve to locally increase the
      permeability of skin to larger, charged, or hydrophilic (easily dissolved in
      water) drug molecules while minimizing irritation.





The
      first
      transdermal patch was approved by the FDA in 1979. It contained the drug
      scopolamine used to prevent the nausea and vomiting associated with motion
      sickness. In 1981, the FDA approved a patch for nitroglycerin and as of 2003
      patches have been approved to deliver 15 molecules spanning 35 different drugs,
      including combination patches utilized for, among other purposes, contraception
      and hormone replacement.





The
      first
      transdermal systems consisted of plastic dipped into a drug that was dissolved
      in alcohol. The plastic had an adhesive around the edges. These patches created
      a significant number of skin reactions and frequently became dislodged from
      the
      skin. Second,
      third and fourth generation patches have been developed which have significantly
      advanced adhesion properties, delivery control and skin permeability. There
      are
      four major
      types of transdermal drug delivery systems in use today :
      single
      layer drug-in-adhesive systems, multi-layer drug-in-adhesive systems, reservoir
      transdermal systems and matrix systems. The
      basic
      components of current transdermal delivery systems include the drug(s) either
      incorporated directly into the adhesive or dissolved or dispersed in a reservoir
      or inert polymer matrix; an outer backing film of paper, plastic, or foil;
      and a
      pressure-sensitive adhesive that anchors the patch to the skin. Developments
      and
      improvements to transdermal systems are being made rapidly.





Transdermal
      drug delivery has numerous advantages over conventional drug delivery methods.
      In contrast to orally delivered drugs, compounds entering the body through
      the
      skin escape first-pass metabolism in the liver (which
      may destroy the drug) ,
      often
      resulting in higher bioavailability of the drug. Transdermal delivery is
      effective for use in patients who experience nausea from the medication because
      there are few or no gastrointestinal effects from the drug itself and is useful
      for those drugs that have poor oral uptake, need frequent administration or
      that
      interact with stomach acid and allows effective use of drugs with short
      half-lives that otherwise require large initial doses (bolus dosing) to achieve
      desired drug levels, such as nitroglycerin. As a result, the side effects,
      or
      variability in therapeutic effect due to peaks and troughs in plasma
      concentration, that are seen with bolus administration are minimized. In
      contrast to intravenous drug delivery, transdermal administration is noninvasive
      and poses little risk of infection. It is also relatively easy for patients
      to
      apply and remove a transdermal system.




-7-





Our
      Nitroglycerin Transdermal Patch.





In
      1986,
      we introduced the first FDA-approved generic transdermal nitroglycerin patch
      into the United States market. Nitroglycerin, also known as glycerin trinitrate,
      provides relief from vascular
      and cardiovascular symptoms related to angina
      pectoris or angina. Angina pectoris, or "heart pain," is the chest discomfort
      that occurs when the blood oxygen supply to an area of the heart muscle does
      not
      meet the demand. Nitroglycerin corrects the imbalance between the flow of blood
      and oxygen to the heart and relieves the work that the heart must do by dilating
      the arteries and veins in the body. Dilation of the veins reduces the amount
      of
      blood that returns to the heart that must be pumped. Dilation of the arteries
      lowers the pressure in the arteries against which the heart must pump. As a
      consequence, the heart works less and requires less blood and oxygen.
      Additionally, nitroglycerin preferentially dilates blood vessels that supply
      the
      areas of the heart where there is not enough oxygen, thereby delivering oxygen
      to the heart tissue that needs it most.





Since
      no
      one holds a valid patent covering nitroglycerin, which would grant to the patent
      holder the exclusive right to sell the drug while the patent is in effect and
      which is intended to protect the holder’s development investment, others can
      seek to obtain FDA approval to sell nitroglycerin-based products, assuming
      the
      proposed product meets certain specific criteria, by submitting an Abbreviated
      New Drug Application, or ANDA. The ANDA approval process can be substantially
      quicker and significantly less expensive than the new drug approval process
      because the applicant can rely on results collected from clinical trials
      conducted by the original drug developer.





Our
      nitroglycerin transdermal patch comprises a multi-layer drug-in-adhesive system
      wherein the medication and all the excipients (the inert substances used as
      a
      diluents or vehicles for a drug) are incorporated into a membrane between two
      distinct drug-in-adhesive layers under a single backing film. Our patch
      is
      comprised of three layers; a transparent outer backing layer composed of a
      composition plastic film and printed with the name of the drug and strength;
      nitroglycerin in a acrylic-based polymer adhesive with a cross-linking agent;
      and a protective, translucent peelable liner which covers the second layer
      and
      must be removed prior to use. Our nitroglycerin
      transdermal patch is
      AB2
      rated, which means it is considered bioequivalent to Novartis’ NitroDermTM
product based on clinical trial data. Our patch is a one-day use patch and
      is
      sold in shelf cartons, with each shelf carton containing thirty patches. Our
      patch is produced in three different dosage sizes, with each size delivering
      different milligrams per hour (mg/hr) amounts of nitroglycerin to the patient.
      The three sizes are: 0.2mg/hr, 0.4mg/hr and 0.6mg/hr.





Our
      second generation transdermal patch technology developed during the mid 1990’s
      incorporates certain technology which, unbeknownst to us at the time of
      development, was the subject of a patent held by Key Pharmaceuticals, Inc.,
      or
      Key, a subsidiary of Schering-Plough Corporation. In December 1997, Key obtained
      a court order enjoining us from manufacturing or selling transdermal
      nitroglycerin patches that have been found to infringe Key's patent before
      the
      expiration of Key's patent on February 16, 2010. In March 2000, we acquired
      a
      non-exclusive license from Key to manufacture, use, import, sell and offer
      for
      sale any drug-in-adhesive transdermal nitroglycerin patch product developed
      by
      the Company either before or during the term of the license which provided
      for
      the payment of a royalty per unit sold in amounts ranging from $2 to $3, based
      upon the dosage delivered. The license extends to February 16, 2010, the
      expiration of Key’s patents. We are in breach of the Key License for not having
      made royalty payments under the Key License since its execution and as of
      December 31, 2006 we owed aggregate royalties to Key of approximately
      $7,321,000. We recently entered into discussions with Key with respect to
      payment of past due royalties. If we are unable to negotiate an agreement with
      Key with respect to the royalties due and are prevented from utilizing the
      Key
      technology, we would have to discontinue selling our transdermal patches unless
      we could develop our own technology to replace that covered by the Key License
      or otherwise locate and obtain a license for similar technology which can be
      incorporated into our manufacturing process, of which we can give no assurance.
      Moreover, our failure to negotiate a repayment agreement with Key on terms
      favorable to us could have a material negative impact on our Company. See
“BUSINESS-Risk Factors” and “Management’s Discussion and Analysis of Financial
      Statements and Results of Operations.”





-8-




Research
      and Development .





Our
      research and development efforts are severely constrained by our lack of cash,
      as described elsewhere in this Annual Report, and other than activities
      currently being undertaken for third parties as described below, we are not
      engaging in any research and development on our own behalf.





If
      and
      when we possess the financial resources to resume proprietary research and
      development activities, we expect that our primary strategy will be to identify
      generic drugs which
      can
      be delivered
      transdermally, which
      correspond with our
      technical and manufacturing capabilities and which we believe have substantial
      market potential or for which a product niche may exist. We may also explore
      developing transdermal products that use FDA-approved drugs that currently
      are
      being delivered to patients through means other than transdermal delivery.
      In
      addition, we may seek to supplement our research and development efforts by
      entering into research and development agreements, joint ventures and other
      collaborative arrangements with other companies.




By
      focusing on bringing new products to market based upon unprotected, generic
      drugs that are
      then being delivered transdermally ,
      we will
      not have to bear the same level of research and development costs and other
      expenses associated with bringing a new drug
      formulation to
      market. Thus, we believe that we would be able to charge significantly less
      for
      a product, a decided competitive advantage in our industry, given that managed
      care organizations typically favor generic products over brand name drugs,
      and
      governments encourage, or under some circumstances, mandate generic
      drugs.





We
      currently are developing transdermal products for two companies, one of which
      has engaged us to assist in the development of two drug formulations to be
      delivered transdermally. In all cases, we act as an independent contractor
      for
      the party that engaged us and said party owns all intellectual property which
      may emanate from the projects we are retained to complete or the services which
      we render.





In
      February 2001, Hercon entered into a series of agreements with Ranbaxy
      Pharmaceuticals Inc. under which we:





·
            granted
                a worldwide, non-exclusive, royalty-free license to Ranbaxy to use
                certain
                intellectual property we developed relating to the transdermal delivery
                of
                a certain generic pharmaceutical
                compound;





·
            acquired
                a license from Ranbaxy to use certain intellectual property it had
                developed in connection with the pharmaceutical compound and were
                retained
                by Ranbaxy to assist in the development of commercial products to
                deliver
                the pharmaceutical compound transdermally; and




·
            agreed
                to supply the products which may be developed and approved by the
                FDA
                exclusively to Ranbaxy which agreed to purchase from us all of its
                requirements for such products from us on an exclusive
                basis.




-9-




We
      recently completed certain milestones under these agreements, including
      producing a supply of the pharmaceutical compound which permitted Ranbaxy to
      complete pilot bioequivalence study results which were filed by Ranbaxy with
      the
      FDA as part of the ANDA filed in connection with this compound.





We
      have
      undertaken to provide certain services, including, completing the development
      of
      the initial formulation of the pharmaceutical compound for transdermal delivery,
      demonstrating that our production techniques can be scaled-up to meet
      anticipated production runs of the transdermal patch, providing all laboratory
      data relating to the utilization of our patch technology for this pharmaceutical
      compound, completing documentation necessary for GMP production of the product,
      providing dosage forms for the pilot and bioequivalence studies, conducting
      the
      pilot and other studies and providing underlying documentation required for
      Ranbaxy to gain regulatory approval for the product and support Ranbaxy’s ANDA
      filing. We are performing under this agreement as requested by
      Ranbaxy.





Ranbaxy
      granted us a license to utilize certain intellectual property we will require
      for the manufacture of the products which are the subject of the agreement
      and
      we have agreed to supply Ranbaxy with such product in the strengths and amounts
      as Ranbaxy may require for its bioequivalence studies. Thereafter, assuming
      Ranbaxy’s ANDA for this product is approved by the FDA, of which neither we nor
      Ranbaxy can be certain, we will manufacture and supply Ranbaxy with all of
      its
      commercial requirements of the product, subject to its right to acquire the
      product elsewhere if we are unable to furnish the supplies it requires, under
      the circumstances provided in the agreement. We have agreed to sell the product
      exclusively to Ranbaxy. We also have agreed to conform to GMP’s in connection
      with the manufacture of the product and otherwise supply product in conformity
      with Ranbaxy’s specifications as enumerated in the agreement which relate to
      quality control, packaging and labeling, among other things. Ranbaxy will pay
      us
      fixed prices for the products of various dosages and a royalty in excess of
      the
      per product price in the event it achieves certain net sales milestones. The
      agreement has a ten-year term from the date of the first commercial sale of
      the
      products. We have agreed to indemnify Ranbaxy for damages resulting from, among
      other things, our formulation or manufacturing of the product and Ranbaxy has
      agreed to indemnify us for damages relating to regulatory improprieties.





In
      June
      2004, we entered into a Development, Manufacturing and Supply Agreement with
      Ranbaxy relating to a generic pharmaceutical compound subject to transdermal
      delivery. Under the agreement, we have been engaged to manufacture and supply
      products for use both in connection with Ranbaxy’s regulatory approval
      requirements and ANDA application and thereafter, if FDA approval is granted
      for
      the product, of which neither we nor Ranbaxy can be certain, on an ongoing
      basis
      to meet its requirements. In furtherance of our efforts, Ranbaxy extended a
      loan
      to us in the amount of $166,664 to purchase certain equipment required in
      connection with our obligations under the agreement which is repayable by
      offsetting amounts payable for product which may eventually be purchased from
      us, agreed to pay for the active pharmaceutical ingredient incorporated into
      the
      product during the trial phases and to pay for a contract research organization
      to conduct bioequivalence studies of the proposed product. Our obligations
      under
      this agreement are similar to those in our agreement with Ranbaxy described
      above. For example, we have agreed to conform to GMP’s in connection with the
      manufacture of the product and otherwise supply product in conformity with
      Ranbaxy’s specifications as enumerated in the agreement which relate to quality
      control, packaging and labeling, among other things, and in accordance with
      all
      applicable laws. The successful completion of the development portion of the
      agreement could yield us an aggregate of $678,800 of gross revenues, payable
      in
      tranches upon achieving certain milestones. Ranbaxy will purchase products
      from
      us at prices calculated in relation to the price we pay for the underlying
      active pharmaceutical ingredient and in the event that the price for said
      ingredient exceeds the maximum amount set forth in the agreement, Ranbaxy may
      terminate the agreement as to that specific product. We have agreed to indemnify
      Ranbaxy for damages resulting from, among other things, our development and
      related obligations under the agreement and Ranbaxy has agreed to indemnify
      us
      for damages relating to regulatory improprieties.




-10-





In
      April
      2006, we entered into a Development, Manufacturing and Supply Agreement with
      Cure Therapeutics, Inc., or CTI, relating to the development of a transdermal
      patch which delivers a generic pharmaceutical compound which will be utilized
      for new indications (that is, the treatment of conditions not covered by the
      original FDA approval) for such drugs. Under the agreement, CTI engaged us
      to
      undertake all processing of the pharmaceutical compound for the purpose of
      filing a new drug application, or NDA, with the FDA and to manufacture and
      supply sufficient quantities of the compound required for obtaining approval
      of
      the NDA. Our engagement is divided into three stages: technology transfer,
      formulation optimization, and scale-up; FDA phase 2 clinical trial batch
      manufacturing; and FDA phase 3 clinical trial batch manufacturing. Our
      obligations under the agreement include all manner of analyzing, testing,
      optimizing the formulation of our process by which clinical trial products
      are
      made, creation of dedicated tooling, scaling-up our manufacturing facility
      to
      produce commercial quantities of product, finishing, packaging, inspecting,
      labeling and preparing product for shipment, all as required under applicable
      law. In addition, we are required to maintain data and records with respect
      to
      all aspects of the foregoing for the specific purpose of filing same with the
      FDA with respect to the NDA and to report to CTI with respect to each phase
      of
      the process. CTI pays us fees upon our successful completion of milestones
      enumerated in the agreement. We are currently working on the second stage under
      the agreement. CTI has agreed, at its own cost and expense, to engage a contract
      research organization to conduct safety and efficacy studies of the clinical
      trial products we manufacture and, in the event that such studies fail to
      demonstrate the safety or efficacy of such products, CTI may terminate the
      agreement. We have agreed to conform to GMP’s in connection with the manufacture
      of the product and otherwise supply product in conformity with CTI’s
      specifications as enumerated in the agreement which relate to quality control,
      packaging and labeling, among other things, and in accordance with all
      applicable laws. We have agreed to indemnify CTI for damages resulting from,
      among other things, our performance of or failure to perform our obligations
      under the agreement and CTI has agreed to indemnify us for damages relating
      to
      regulatory improprieties. Each party has agreed to maintain the confidentiality
      of the other’s confidential information. The agreement has a term of two years
      but is subject to prior termination by either party in the event of a material
      breach by the other party and by CTI for any reason at any time upon written
      notice. The parties recognize the possibility that no commercial product may
      arise from their efforts.





We
      are
      also conducting a number of feasibility studies on transdermal products on
      behalf of client companies and are pursuing additional contract manufacturing
      opportunities. We do
      not
      undertake clinical studies. As a contract manufacturer for developing products,
      it would be the responsibility of our client to undertake and bear the cost
      of
      these clinical studies, including preparing and filing all documents required
      by
      the FDA. We would, however, perform routine chemical analysis of these products
      to determine if they meet proposed product specifications.





For
      the
      years ended December 31, 2006 and 2005, we spent $491,000 and $438,000,
      respectively, for research and development activities. Our research and
      development expense may vary significantly from quarter to quarter and year
      to
      year depending on, among other things, product development cycles and whether
      we
      or a third party are funding development. These variations in research and
      development spending may not be accurately anticipated and may have a material
      effect on our results of operations. Currently,
      research and development personnel engage in assisting with technical transfers
      of existing formulation and test methodology to our production facility. In
      addition, our personnel perform small scale development work on behalf of
      clients, including producing hand-cut transdermal patches on a research
      laminator for analytical testing or performing permeation studies to demonstrate
      how drug formulations penetrate a skin layer. Our personnel also work on
      improving test methods that may impact day to day testing requirements for
      commercial products. We periodically outsource analytical testing either because
      we do not possess the appropriate equipment or outsourcing such testing is
      more
      economically efficient.




-11-





The
      time
      necessary to complete clinical trials and the regulatory process to obtain
      marketing approval varies significantly. We cannot be certain that we will
      have
      the financial resources necessary to complete products which we propose to
      develop, that those projects to which we dedicate resources will be successfully
      completed, that we will be able to obtain regulatory approval for any such
      product, or that any approved product may be produced in commercial quantities,
      at reasonable costs, and be successfully marketed. Similarly, we cannot assure
      that our competitors, most of which have greater resources than we do, will
      not
      develop and introduce products that will adversely affect our business and
      results of operations.





Manufacturing .





We
      conduct our manufacturing operations in a single facility comprised of an
      approximately 61,000 square foot building located on approximately 3.5 acres
      in
      Emigsville, Pennsylvania. Our products are manufactured in accordance with
      GMPs
      prescribed by the FDA. The FDA visited our facilities in November 2003 and
      June
      2006 and issued establishment inspection reports. The reports indicated that
      there were no objectionable conditions or practices noted during their reviews.
      The FDA did not issue a Form FDA 483 (Inspectional Observations) report to
      us
      during either of these two visits. The FDA uses the Form FDA 483 report to
      communicate all observations of objectionable conditions noted during their
      inspection process. This facility has also been licensed by the United States
      Drug Enforcement Administration (“DEA”) to conduct research and manufacture
      products containing Schedule II controlled substances. To bring new products
      to
      market as quickly as possible, we will seek to have the manufacturing capacity
      to produce the new product prior to obtaining FDA approval.





Our
      products are manufactured according to current GMPs as specified by federal
      regulations which require us to maintain and update procedures and
      specifications as provided under federal law. We must maintain records that
      demonstrate the application of raw materials from receipt to use in a finished
      product. In addition, any complaints received must be documented and
      investigated. We are obligated to submit to the FDA reports covering our
      marketed products that include both chemistry information and adverse event
      information on an annual basis. If we do not adhere to current GMPs, the FDA
      could seek an injunction barring commercial distribution of our
      products.





The
      manufacture of advanced transdermal drug delivery systems requires specialized
      skills in several areas, as well as specialized manufacturing equipment. Our
      process development and design engineers work closely with the research and
      development department starting early in the product design stage, which renders
      the manufacturing development process more efficient. All scale-up work
      (spanning the gamut of initial research on a potential product to large-scale
      manufacturing for clinical and stability work), commencing with initial product
      development trials, is conducted on full-size, completely functional
      manufacturing equipment, reducing delays in the development and approval process
      and smoothing the transition to commercial production. Some of this equipment
      is
      manufactured in-house; the balance is fabricated by outside manufacturers to
      our
      specifications. We believe that this equipment provides a decided advantage
      in
      the manufacture of the complex multi-layer systems necessary for successful
      transdermal drug delivery. We currently have assembly packaging equipment in
      place having a single shift capacity of over 24 million patches annually. We
      believe that our current manufacturing facility is adequate for our intended
      purposes and will be sufficient for product expansion for the foreseeable
      future.




-12-





As
      part
      of the manufacturing process, we have developed and perform appropriate quality
      control procedures including testing of all raw materials and finished product. Quality
      control procedures are specific checks and balances performed on raw materials
      and finished product to ensure materials adhere to the predetermined
      specifications.





Several
      raw materials used in the manufacture of our products are only available from
      single sources, all of which are domestic companies. These materials have
      generally been available to us and the pharmaceutical industry on commercially
      reasonable terms. To date, we have not experienced difficulty acquiring
      necessary materials. We will seek to negotiate supply agreements, as
      appropriate, for certain components.





Any
      curtailment in the availability of such raw materials could result in production
      or other delays, and, in the case of products for which only one raw material
      supplier exists, could result in a material loss of sales, with consequent
      adverse effects on our business and results of operations. In addition, because
      most raw material sources for transdermal patches must generally be approved
      by
      regulatory authorities, changes in raw material suppliers may result in
      production delays, higher raw material costs and loss of sales, customers and
      market share.





We
      do not
      believe that compliance with federal, state or local laws and regulations which
      have been enacted or adopted regulating the discharge of materials into the
      environment or otherwise relating to the protection of the environment has
      had
      or will have any material effect upon our capital expenditures, earnings or
      competitive position. There can be no assurance, however, (i) that changes
      in
      federal, state or local laws or regulations, changes in regulatory policy or
      the
      discovery of unknown problems or conditions will not in the future require
      substantial expenditures, or (ii) as to the extent of the Company's liabilities,
      if any, for past failures, if any, to comply with laws, regulations and permits
      applicable to its operations.





Marketing
      and Sales .





We
      have
      contracted with a full-service sales and marketing outsourcing company that
      focuses on generic and branded pharmaceutical companies to handle the majority
      of the sales and marketing efforts for our transdermal nitroglycerin product.
      This company monitors client sales, as well as examines our competition in
      order
      to anticipate and recommend changes to our sales, marketing and promotional
      strategy. This company also assists in providing the industry contacts to reach
      all distribution channels.





We
      have
      engaged Cardinal Health, Inc. as a non-exclusive distributor of our transdermal
      patches pursuant to an agreement dated October 1, 2001. We sell product to
      Cardinal at our list price and Cardinal is entitled to receive certain discounts
      and rebates as stipulated in the agreement. During the years ended December
      31,
      2005 and 2006, Cardinal purchased products representing in excess of 10% of
      our
      total sales.





We
      market
      our products directly to wholesalers, distributors, retail pharmacy chains,
      mail
      order pharmacies and group purchasing organizations. We also market our products
      indirectly to independent pharmacies, managed care organizations, hospitals,
      nursing homes and pharmacy benefit management companies, collectively referred
      to as “indirect customers.” We may enter into agreements with our indirect
      customers to establish contract pricing for certain products. The indirect
      customers then independently select a wholesaler from which they actually
      purchase the products at these contracted prices. Alternatively, certain
      wholesalers may enter into agreements with indirect customers which establish
      contract pricing for certain products which the wholesalers
      provide.




-13-





Competition .





The
      market for our nitroglycerin transdermal patches is highly competitive. Because
      nitroglycerin is a generic drug, companies willing and able to comply with
      FDA and
      other
      applicable regulations
      can produce nitroglycerin-based products. Moreover, nitroglycerin can be
      administered utilizing a wide array of conventional and alternate forms of
      drug
      delivery. Accordingly, our product faces intense competition from a diverse
      group of domestic and multinational companies most of which possess
      significantly greater financial and personnel resources than we do and that
      includes:





·
            large
                conglomerates of which pharmaceutical formulations,
                including nitroglycerin-based products,represent only a portion of the products they offer;





·
            pharmaceutical
                companies of all sizes which focus on the development of advanced
                transdermal systems which deliver nitroglycerin;





·
            pharmaceutical
                companies which offer nitroglycerin based products delivered other
                than
                transdermally or other formulations which relieve angina; and





·
            companies
                that offer alternate non-drug
                therapies.





In
      addition, medical science is constantly evolving and the
      entities against which we currently compete may change in the future .
      As
      developments in medicine are made, drugs and delivery methods may become
      obsolete or fall out of favor with physicians.





Most
      of
      our competitors have substantially greater financial resources and larger
      research and development staffs than we do and may have substantially greater
      experience in developing products, in obtaining regulatory approvals and in
      manufacturing and marketing pharmaceutical products. Many other pharmaceutical
      companies have the financial resources to acquire the skills necessary to
      develop transdermal systems.





Advances
      in transdermal patch technology have intensified over the last several years.
      As
      new materials have been developed which allow for more efficient delivery of
      drugs through the patch membrane and adhesive, manufacturers have been able
      to
      develop smaller patches which are more comfortable for the user. New adhesive
      technologies have recently been incorporated into patches which have selective
      adhesive properties once in contact with the skin, exhibit substantial strength
      of initial adhesion and duration of adhesion and are compatible with skin and
      various drug molecules. Other advances in patch technology include the
      development of chemical penetration enhancers, substances that make the skin
      more permeable and allow drug molecules to cross the skin at a faster rate,
      and
      the development of micro-needles to enlarge the skin pores through which drugs
      flow. In addition, active transdermal patches which use energy, such as
      electricity and ultrasound, to enhance the extent and rate at which
      pharmaceutical compounds cross the skin and which will allow for larger drug
      molecules to be delivered transdermally, are being developed at a rapid rate.
      All of these new transdermal technologies could supplant our technology and
      render our product obsolete.





Since
      we
      manufacture a generic drug product and are not subject to the myriad of factors
      which impact drug developers, such as high development costs and establishing
      name and brand recognition, we believe that the principal factors that bear
      upon
      our competitive position are price, consistency and quality of product, our
      ability to deliver product on a timely basis, reliability and patient
      convenience. We have been manufacturing nitroglycerin patches for nearly twenty
      years and believe that we have gained significant experience that contributes
      to
      our ability to compete effectively in the market. Our competitive position
      will
      also depend on our ability to attract and retain qualified scientific and other
      personnel, develop effective proprietary products, implement production and
      marketing plans, effect distribution of our products, obtain patent protection
      and secure adequate capital resources.




-14-





Patents
      and Proprietary Rights .





We
      seek
      to obtain patent protection on our delivery systems and manufacturing processes
      whenever possible. We have obtained eleven United States and foreign patents
      and
      trademarks relating to our transdermal delivery systems and manufacturing
      processes. While we view our patents and trademarks as a valuable asset, we
      do
      not consider any single patent or trademark to be of material importance to
      our
      business as a whole.





As
      a
      result of changes in United States patent law under the General Agreement on
      Tariffs and Trade and the accompanying agreement on Trade-Related Aspects of
      Intellectual Property Law, which took effect in their entirety on
      January 1, 1996, the terms of some of our existing patents have been
      extended beyond the original term of seventeen years from the date of grant.
      Our
      patents filed after June 7, 1995 will have a term of twenty years computed
      from the effective filing date.





We
      are
      unaware of any challenge to the validity of our patents or of any third party
      claim of patent infringement with respect to any of our products, in either
      case
      that could have a material adverse effect on our business or prospects.





Although
      there is a statutory presumption as to a patent’s validity, the issuance of a
      patent is not conclusive as to such validity, or as to the enforceable scope
      of
      the claims of the patent. We cannot assure that our patents or any future
      patents will prevent other companies from developing similar or functionally
      equivalent products. We cannot assure that we would have the resources to
      prosecute an action to enforce our patent rights against an alleged infringer
      or
      that we would be successful in any infringement action that we elect to bring.
      Likewise, we cannot assure that we would have the resources to defend an
      infringement action or that we would be successful in any such defense.
      Furthermore, we cannot assure that any of our future processes or products
      will
      be patentable, that any additional patents will be issued in any or all
      appropriate jurisdictions or that our processes or products will not infringe
      upon the patents of third parties. In addition, since our patents typically
      cover our product formulation rather than the compound being delivered,
      competitors may seek to create functionally equivalent products (i.e., patches
      delivering the same compound over the same time period to treat the same
      indication) that avoid our patents. In those cases, we may face competition
      from
      functionally equivalent products even before our patents expire.





We
      also
      attempt to protect our proprietary information under trade secret and
      confidentiality agreements. Generally, our agreements with each employee,
      client, consultant and agent contain provisions designed to protect the
      confidentiality of our proprietary information. There can be no assurance that
      these agreements will not be breached, that we will have adequate legal remedies
      as a result thereof, or that our trade secrets will not otherwise become known
      or be independently developed by others.




-15-





Government
      Regulation .





Our
      operations are subject to extensive regulation by governmental authorities
      in
      the United States and in other countries in which we or our distributors may
      sell products which we manufacture with respect to the testing, approval,
      manufacture, labeling, marketing and sale of pharmaceutical products and the
      possession and use of controlled substances. We devote significant time, effort
      and expense to address the extensive government regulations applicable to our
      business.





The
      marketing of pharmaceutical products requires the approval of the FDA in the
      United States. The process for obtaining such approval varies depending upon
      the
      nature of the product we are seeking to manufacture and sell. The FDA has
      established regulations, guidelines and safety standards, which apply to the
      pre-clinical evaluation, clinical testing, manufacturing and marketing of
      pharmaceutical products. New drugs or drugs to be delivered by a new route
      of
      administration are subject to a more lengthy approval process. Typically, drugs
      that, among other factors, have been previously approved by the FDA are subject
      to a less stringent, less time consuming and less expensive approval
      process.





The
      process of obtaining FDA approval for a new product may take several years
      or
      more and is likely to involve the expenditure of substantial resources. The
      steps required before a product can be produced and marketed for human use
      typically include: (i) pre-clinical studies; (ii) submission to the FDA of
      an Investigational New Drug Exemption (“IND”), which must become effective
      before human clinical trials may commence in the United States;
      (iii) adequate and well controlled human clinical trials;
      (iv) submission to the FDA of a New Drug Application (“NDA”); and
      (v) review and approval of the NDA by the FDA. Approval of a product by the
      FDA does not serve as a guaranty of the product’s safety or
      efficacy.





Generally,
      products with new active ingredients, new indications, new routes of
      administration, new dosage forms or new strengths require an NDA to be filed
      with the FDA. An NDA requires that complete clinical studies of a product’s
      safety and efficacy be submitted to the FDA, the cost of which is substantial.
      These costs can be reduced, however, for delivery systems that utilize approved
      drugs. In these cases, the company seeking approval may refer to safety and
      toxicity data reviewed by the FDA in its approval process for the innovator
      product. In addition, a supplemental NDA may be filed to add an indication
      to an
      already approved product.





Since
      we
      expect that any new products we may bring to market will contain drugs
      previously approved by the FDA for transdermal delivery, an abbreviated approval
      process may be available. Such products must have, among other requirements,
      the
      same active ingredient(s), indication, route of administration, dosage form
      and
      dosage strength as an existing FDA-approved product covered by an NDA, if
      clinical studies have demonstrated bio-equivalence of the new product to the
      FDA-approved product covered by an NDA. For this abbreviated process, we would
      submit an ANDA to the FDA instead of an NDA. Under FDA ANDA regulations,
      companies that seek to introduce an ANDA product must also certify that the
      product does not infringe on any approved product’s patent listed with the FDA
      or that such patent has expired. If the applicant certifies that its product
      does not infringe on the approved product’s patent or that such patent is
      invalid, the patent holder may institute legal action to determine the relative
      rights of the parties and the application of the patent. Under the Drug Price
      Competition and Patent Term Restoration Act of 1984 (the “Hatch-Waxman Act”),
      the FDA may not finally approve the ANDA until the later of thirty months from
      the date of the legal action or a final determination by a court that the
      applicable patent is invalid or would not be infringed by the applicant’s
      product.





With
      respect to any new products we or our clients may seek to develop, the results
      of product development and pre-clinical and clinical studies (if necessary)
      will
      be submitted to the FDA as an NDA or ANDA for approval. If an application is
      submitted, there can be no assurance that the FDA will review and approve the
      NDA or ANDA in a timely manner. The FDA may deny an NDA or ANDA if applicable
      regulatory criteria are not satisfied or it may require additional clinical
      testing. Even if such data is submitted, the FDA may ultimately deny approval
      of
      the product. Further, if there are modifications to the drug, including changes
      in indication, manufacturing process, labeling, or a change in manufacturing
      facility, an NDA or ANDA notification may be required to be submitted to the
      FDA
      and FDA approval required prior to implementation of the change. Product
      approvals may be withdrawn after the product reaches the market if compliance
      with regulatory standards is not maintained or if problems occur regarding
      the
      safety or efficacy of the product. The FDA may require testing and surveillance
      programs to monitor the effect of products that have been commercialized, and
      has the power to prevent or limit further marketing of these products based
      on
      the results of these post-marketing programs.




-16-





Manufacturing
      facilities are subject to periodic inspections for compliance with the FDA’s
      good manufacturing practices (GMP’s) regulations and each domestic drug
      manufacturing facility must be registered with the FDA. In addition, our
      manufacturing operations must be registered with the Pennsylvania Department
      of
      Health. In complying with standards set forth in these regulations, we must
      expend significant time, money and effort in the area of quality assurance
      to
      ensure full technical compliance. Facilities handling controlled substances,
      such as ours, also must be licensed by the Drug Enforcement Administration,
      or
      DEA, and are subject to more extensive regulatory requirements than those
      facilities not licensed to handle controlled substances. We also require
      approval of the DEA to obtain and possess controlled substances. We produce
      transdermal drug delivery products in accordance with United States regulations
      for manufacturing process validation studies and commercial sale. FDA approval
      to manufacture a drug product is site specific. In the event our approved
      manufacturing facility becomes inoperable, obtaining the required FDA approval
      to manufacture such drug at a different manufacturing site could result in
      production delays, which could adversely affect our business and results of
      operations.





Failure
      to comply with governmental regulations may result in fines, warning letters,
      unanticipated compliance expenditures, interruptions or suspension of production
      and resulting loss of sales, product seizures or recalls, injunctions
      prohibiting further sales, withdrawal of previously approved marketing
      applications and criminal prosecution.





Our
      activities are subject to various federal, state and local laws and regulations
      regarding occupational safety, sales practices, laboratory practices,
      environmental protection and hazardous substance control, and may be subject
      to
      other present and possible future local, state, federal and foreign regulations.
      Under certain of these laws, we could be liable for substantial costs and
      penalties in the event that waste is disposed of improperly. While it is
      impossible to accurately predict the future costs associated with environmental
      compliance and potential remediation activities, compliance with environmental
      laws is not expected to require significant capital expenditures and has not
      had, and is not presently expected to have, a material adverse effect on our
      earnings or competitive position.





Employees .





We
      employ
      approximately fifty five employees, of whom seventeen are covered by a
      collective bargaining agreement with a local unit of the Retail Wholesale and
      Department Store Union, AFL-CIO (“R.W.D.S.U.”). The R.W.D.S.U. agreement is for
      a three year period ending December 10, 2007. The contract is subject to annual
      renewal thereafter and acknowledges that the R.W.D.S.U. is the exclusive
      bargaining agent for the Company’s regular production employees, excluding all
      other employees including but not limited to supervisors, foremen, clerical
      employees, time-keepers, watchmen, guards, maintenance personnel and part-time
      employees. We believe our employee relations are good.




-17-





Risk
      Factors .





The
      following is a summary of certain risk factors that may cause our results to
      differ from the “forward-looking statements” made in this Annual Report. The
      risks and uncertainties described below are not listed in order of priority
      and
      are not the only ones we face. Additional risks not presently known to us or
      other factors not perceived by us to present significant risks to our business
      at this time also may impair our business operations. If any of these risks
      actually occur, our business, financial condition, and/or results of operations
      would likely suffer significantly. We do not undertake to update any of these
      forward-looking statements or to announce the results of any revisions to these
      forward-looking statements except as required by law.





**Risks
      Relating to Our Financial Condition.**





**We
      believe that our financial condition as of December 31, 2006 gives rise to
      several risks and uncertainties. In addition, because of our status as a
      majority owned subsidiary of Health-Chem, that company’s financial condition and
      future operating results may directly impact Transderm. We believe that the
      financial information and other factors set forth below are relevant in this
      regard.**





**As
      of December 31, 2006:**





**·**
            **Transderm
                had aggregate liabilities of approximately $41.3 million comprised
                of
                $10.8 million to unrelated parties, including $7.3 million of royalties
                due under the Key License of which we are in breach (the “Key Royalty”),
                and $30.5 million owed to Health-Chem in respect of intercompany
                accounts
                (the “Intercompany Obligations” and collectively with Transderm’s other
                liabilities, the “Transderm
                Liabilities”);**





**·**
            **Transderm
                had a working capital deficiency of approximately $26 million;
                and**





**·**
            **the
                Group had aggregate debts and liabilities of approximately $22.4
                million
                (the “Group Liabilities”), including $11.5 million under the Debentures
                under which Health-Chem currently is in
                default.**





In
      view
      of the foregoing, investors should consider the following risks:





**Risks
      relating to our financial condition include the following:**





*Our
      financial condition and continuing breach under the Key License create
      substantial doubt as to whether we can continue to operate as a going concern.
      If we can not continue to operate as a going concern, we may have to cease
      operations and investors will lose their entire investment in our
      company.*





Transderm’s
      audited consolidated financial statements for the year ended December 31, 2006
      have been prepared assuming that we will continue as a going concern. However,
      Note 3 of the Notes to Consolidated Financial Statements and the auditor’s
      report on our financial statements cite certain financial conditions and other
      factors that raise substantial doubt about our ability to continue to operate
      as
      a going concern, including that:





·
            Transderm
                has significant outstanding liabilities at December 31, 2006, particularly
                the amounts due to Health-Chem and Key, which it is unable to
                satisfy;




-18-


**·**
            our
                breach of the Key License for failing to make royalty payments thereunder
                entitles Key to terminate the license and curtail our use of technology
                incorporated into our transdermal patches, which, unless we were
                able to
                develop our own technology to replace that covered by the Key License
                or
                otherwise obtain a license for similar technology, neither of which
                are
                likely, would require us to discontinue selling ourtransdermal
                patch and we would have no source of continuing meaningful
                revenues;





·
            our
                financial condition has prevented us from securing financing or obtaining
                loans from third parties from which we could repay all or a portion
                of the
                amounts due; and





·
            if
                our creditors were to initiate legal action against us for the amounts
                due
                to them, we would not be able to continue to operate as a going concern
                unless there was an increase in profitability and/or an infusion
                of
                additional funds in order to meet the our obligations to Health Chem
                and
                Key for both the past amounts due and ongoing amounts as they became
                due.





We
      have
      experienced net losses from operations in every year since 1995 and have an
      accumulated deficit of approximately $35.6 million at
      December 31, 2006 .
      In
      addition, we had a working capital deficit of approximately $26.0 million at
      December 31, 2006.





We
      have
      been able to continue operating over the last several years because we have
      not
      paid Health-Chem or Key. We do not have the means to satisfy the amounts due
      to
      Health-Chem or pay the Key Royalty but we have been paying our debts and
      liabilities not related to Health-Chem or the Key License on a current basis
      from cash flow generated from operations. Our financial condition has prevented
      us from securing financing or obtaining loans from which we could repay all
      or a
      portion of the amounts due. We are further constrained from obtaining financing
      because of Health-Chem’s financial condition, as more fully described in the
      ensuing risk factor. We have entered into discussions with Key in an effort
      to
      develop payment arrangements for the amount owed to it, though we cannot be
      certain we will be successful in our efforts in reaching an agreement that
      allows us to continue our operations.





While
      management has formulated a plan to address these conditions as described under
      the heading “Management’s Discussion and Analysis of Financial Condition and
      Results of Operation” and in Note 3 of the Notes to Consolidated Financial
      Statements, we cannot be certain that we will be successful in executing this
      plan or that if we are successful that we will achieve profitability. The
      financial statements do not include any adjustments that might result from
      the
      outcome of this uncertainty.





If
      we are
      unable to address successfully the conditions that raise doubt about our ability
      to continue to operate as a going concern, particularly our efforts to negotiate
      favorable payment terms of the amounts due to Key and Health-Chem, we may have
      to discontinue our operations and possibly seek protection under bankruptcy
      laws, which likely would result in the loss of all value which our stock now
      or
      at such time may have and result in investors losing the entire amount of their
      investment.





*Health-Chem’s
      ability to achieve financial stability will bear on Transderm’s financial
      condition and its ability to continue to operate as a going concern and to
      achieve profitability in the future. If Health-Chem does not effectively address
      its financial concerns, it may be required to take steps to wind-up the Group’s,
      including Transderm’s, operations, in which case holders of Transderm’s stock
      could lose the entire amount of their investment.*




-19-




As
      stated
      in the footnotes to the audited consolidated financial statement included in
      Health-Chem’s annual report for the year ended December 31, 2006 and the
      auditor’s report on such financial statements, Health-Chem’s financial condition
      casts doubt upon its ability to continue operating as a going concern.
      Health-Chem’s principal liability (excluding liabilities and obligations
      attributable exclusively to Transderm) consists of approximately $11.5 million
      of principal and interest due under the Debentures.





Health-Chem
      is in default under several provisions of the Debentures as a result of its
      failure to have paid principal and interest when they became due in April 1999.
      A default allows the Trustee or the holders of at least 25% in aggregate
      principal amount of all Debentures to declare the outstanding principal of
      the
      Debentures plus all accrued and unpaid interest immediately due and payable.
      Health-Chem has been able to continue operating because neither the Trustee
      nor
      the Debenture holders have pursued legal redress to obtain the payment
      due. Health-Chem has approached the Trustee to negotiate a payment plan with the Debenture holders
      but no assurance can be given that Health-Chem will be successful in negotiating
      a payment plan that does not unduly burden or otherwise prohibit normal
      operations, if at all. If Health-Chem is unable to negotiate payment terms
      with
      the Debenture holders, they could initiate legal action against Health-Chem
      for
      the entire amount due under the Debentures. In such case, Health-Chem may have
      to liquidate its assets and dissolve or wind-up the companies comprising the
      Group, including Transderm, or seek protection from creditors under the federal
      bankruptcy laws which likely would result in the loss of all value which our
      stock now or at such time may have and result in investors losing the entire
      amount of their investment.





*Even
      if payment terms for the Group’s debts and liabilities are negotiated, the
      Group’s cash flow and ability to operate may be adversely
      affected.*





If
      the
      Group were to successfully negotiate payment plans with respect to the Key
      Royalties and the amount due under the Debentures, it is likely that a
      significant portion of the Group’s revenues will be allocated to making payments
      under such agreements and there will be little capital to fund other business
      opportunities, including new product development and marketing. In addition,
      the
      Group’s substantial indebtedness could have other important consequences to both
      Transderm and Health-Chem, including, with respect to each company:




·
            negatively
                impacting its ability to remain current in the payment of other
                liabilities and current accounts
                payable;





·
            limiting
                its ability to obtain financing for working capital, capital expenditures,
                acquisitions and general corporate or other
                purposes;





·
            increasing
                its vulnerability to general economic and industry conditions;
                and





·
            placing
                it at a disadvantage compared to its competitors who have less
                debt.




*Even
      if the Group concludes favorable agreements to satisfy its obligations, it
      may
      not be able to generate sufficient cash from operations to abide by the terms
      of
      these agreements.*




Even
      if
      the Group successfully negotiates agreements to pay the Key Royalty and the
      amount due under the Debentures, its ability to make scheduled payments on
      these
      obligations and remain current with respect to its other financial obligations
      will depend on its operating performance, which is subject to prevailing
      economic and competitive conditions and to certain financial, business and
      other
      factors beyond its control. We cannot assure you that the Group will maintain
      a
      level of cash flows from operating activities sufficient to permit it to pay
      Key
      and the Debenture holders under any agreements they reach with these creditors
      and remain current with respect to other outstanding liabilities.




-20-




*Transderm’s
      Intercompany Obligations to Health-Chem at December 31, 2006 are approximately
      $30.5 million. Health-Chem has not sought to collect on these obligations since
      they began to accrue in 1995. If Health-Chem were to seek collection of such
      Intercompany Obligations, Transderm would not be able to pay them and may be
      forced to seek protection under bankruptcy laws.*





Transderm
      owes Health-Chem approximately $30.5 million in intercompany obligations at
      December 31, 2006 as reported in its financial statements, some of which extend
      back to 1995. To date, Health-Chem has not sought to collect the amounts due
      from Transderm. Transderm does not currently have and does not expect to have
      in
      the near future, sufficient funds to repay such obligations. If Health-Chem
      were
      to seek collection of the amounts due, Transderm may have to seek protection
      under bankruptcy laws and investors could lose the amount of their investment
      in
      Transderm.





**Risks
      Relating to Our Failure to File Reports under Federal Securities
      Laws.**





*Our
      failure to abide by our reporting requirements under federal securities laws
      could subject us to enforcement proceedings by the SEC, including the
      de-registration of our securities, which could materially adversely affect
      our
      business and your ability to obtain information about our company and could
      also
      subject Transderm’s management to civil liabilities from private shareholder
      actions.*





Prior
      to
      filing an Annual Report on Form 10-KSB for the years ended December 31, 2003
      and
      2004 (the “2004 Annual Report”) in January 2007, we had not filed any annual or
      quarterly reports with the SEC since we filed an annual report for the year
      ended December 31, 1998 and quarterly reports for the first three quarters
      of
      1999 in November 1999. We have not filed and do not expect to file annual or
      quarterly reports for the years 1999 through 2002 because we do not have the
      financial information necessary to prepare such reports, as detailed in the
      2004
      Annual Report. Additionally, we have not filed and do not expect to file any
      quarterly reports for the years 2003 through 2006 both because we do not believe
      such information would be useful to stockholders and because of the costs we
      would have to incur in connection with the preparation of such
      reports. Our
      failure to file any of the reports we were required to file under federal
      securities laws could give rise to action by the SEC or private litigation
      by
      our current and former stockholders. The SEC’s action against us could take the
      form of penalties, fines, sanctions, enforcement or other actions or
      proceedings, including revocation of registration of our common stock under
      the
      Securities Exchange Act which could result in less public information available
      to our stockholders and negatively impact any opportunity which we might
      otherwise have to raise capital in the future. Moreover, private suits by our
      current and former security holders for failing to make available current
      information about our company could subject us as well as our officers and
      directors to civil liabilities. We cannot predict what, if any, actions the
      SEC
      may impose upon or take against our company or suits stockholders may bring
      against us for our failure to file required reports; however, any such actions
      could cause us to incur significant additional compliance expenditures and
      divert management’s attention from our core business activities.





Health-Chem
      is delinquent in its reporting requirements as well and could be subject to
      similar action by the SEC or stockholders which, if taken or initiated, would
      have a negative impact on our operation.




-21-


**Risks
      Relating to Our Business.**





*We
      are dependent on the Key License which allows us to use certain technology
      incorporated into our transdermal patch under which we are seven years in
      arrears in royalty payments and, consequently, are in breach. If we are unable
      to negotiate a plan with Key that allows us to pay the past due royalties and
      Key revokes the license or if we otherwise lose our right to utilize the
      technology subject to such license we will have to discontinue manufacturing
      our
      sole product.*





We
      rely
      on the Key License to permit us to incorporate certain transdermal patch
      technology owned by Key into our second generation transdermal patch developed
      during the mid 1990’s. If we are unsuccessful in negotiating a plan with Key to
      pay past due royalties which does not impede our ability to operate and does
      not
      materially impact our cash, we may be forced to discontinue selling transdermal
      patches, unless we could develop our own technology to replace that covered
      by
      the Key License or otherwise locate and obtain a license for similar technology
      which can be incorporated into our manufacturing process, neither of which
      is
      unlikely, and will have no source of revenue from product sales. Given our
      current financial condition, it is unlikely we would be able to continue
      operating under such circumstances and investors could lose the entire amount
      of
      their investment in Transderm.





*We
      are subject to all of the risks associated with being a single product company,
      including special risks relating to the fact that we manufacture and sell such
      product pursuant to a license. If we are unable to develop and bring to market
      other products, our current and future operations and financial condition may
      be
      adversely affected.*





We
      manufacture and sell only one product, our nitroglycerin transdermal patch.
      We
      are subject to all of the risks associated with being a single product company,
      including





·
            the
                inordinate effect of competition on our business which could cause
                us to
                reduce the price we charge for the product or erode total sales,
                and the
                corresponding reduction in earnings we generate from such product
                as
                result of competition;





·
            the
                loss of the Key License; and





·
            our
                inability to obtain critical raw materials from which we manufacture
                the
                product.





If
      we
      experience any of the foregoing or other difficulties or impediments with
      respect to sales of such product, our business, financial condition and results
      of operations would be materially adversely affected.





We
      are
      seeking to develop and bring to market other products to broaden our revenue
      base and reduce reliance on revenues generated from sales of our nitroglycerin
      patch. We cannot be certain that we will have sufficient resources to bring
      any
      new products to market and if we do, that our efforts to develop and market
      other products will be successful. To the extent that we are unable to expand
      our product offerings, our business and results of operation could be negatively
      impacted and stockholders in our company may lose all or part of their
      investment.





*The
      development and manufacturing agreements to which we currently are a party
      allow
      our clients to terminate these agreements at will. The termination of these
      agreements for any reason would have a negative impact on our
      operations.*





We
      are
      party to contracts with two clients under which we have agreed to develop and
      manufacture three potential pharmaceutical compounds for transdermal delivery.
      We currently generate revenues from these agreements in connection with our
      product development efforts and may generate revenues under these agreements
      in
      the future from the manufacture of products which ultimately are approved by
      the
      FDA for sale in the United States, of which we can offer no assurance. In some
      cases, our clients are permitted to terminate these agreements at will for
      any
      reason. If our clients elect to terminate these agreements our current and
      future operations would be adversely impacted.




-22-


*We
      are subject to extensive regulation by the FDA and other federal and state
      agencies. If we fail to maintain satisfactory compliance with FDA regulations
      and other governmental agencies, we may be forced to suspend or terminate our
      operations and we could be subject to civil or criminal
      penalties.*





Our
      operations are subject to extensive regulation by governmental authorities
      in
      the United States with respect to the testing, approval, manufacture, labeling,
      marketing and sale of pharmaceutical products. These regulations are
      wide-ranging and govern, among other things: adverse drug experience reporting,
      product promotion, product pricing and discounting, drug sample accountability,
      drug product stability, product manufacturing, including good manufacturing
      practices, and product changes or modifications. Our facilities handle
      controlled substances, resulting in additional extensive regulatory requirements
      and oversight. Compliance with the extensive government regulations applicable
      to our business requires the allocation of significant time, effort and expense.
      Even if a product is approved by a regulatory authority, product approvals
      may
      be withdrawn after the product reaches the market if compliance with regulatory
      standards is not maintained or if problems occur regarding the safety or
      efficacy of the product. If we fail to comply with the regulatory requirements
      of the FDA and other applicable U.S. regulatory authorities or previously
      unknown problems with our products or manufacturing processes are discovered,
      we
      could be subject to administrative or judicially imposed sanctions, including:
      restrictions on the products, manufacturers or manufacturing processes; warning
      letters; civil or criminal penalties; fines; injunctions; product seizures
      or
      detentions; voluntary or mandatory product recalls and publicity requirements;
      unanticipated compliance expenditures; suspension or withdrawal of previously
      approved marketing applications; total or partial suspension of production;
      and
      criminal prosecution.





*Our
      product sales are concentrated among a few customers and a substantial decrease
      in revenues generated from sales to these customers would have an adverse effect
      on our business unless we were able to identify other
      customers.*





During
      each of fiscal years ended December 31, 2006 and 2005, a significant portion
      of
      our revenues were derived from a small number of customers. In 2006, two
      customers accounted for approximately 43% of our revenues and these customers
      accounted for approximately 55% of our revenues during fiscal 2005. During
      2006,
      orders from one of our principal customers decreased by 53% and our revenues
      for
      the year declined commensurately. If we are unable to identify other customers
      to replace the revenues lost from the decline in sales to this customer or
      this
      customer does not place order for products from us at its prior levels, our
      business, financial condition and results of operations will continue to be
      negatively impacted.




Because
      our sales tend to be concentrated among a small number of customers during
      any
      period, our operating results may be subject to substantial fluctuations.
      Moreover, we tend to receive relatively large orders for products from a
      relatively small number of customers. Consequently, a single order from one
      customer may represent a substantial portion of our sales in any one period
      and
      significant orders by any customer during one period may not be followed by
      further orders from the same customer in subsequent periods. These and other
      factors may cause our sales and operating results to be subject to very
      substantial periodic variations. Since quarterly performance is likely to vary
      significantly, our results of operations for any quarter are not necessarily
      indicative of the results that we might achieve for any subsequent period.
      Accordingly, quarter-to-quarter comparisons of our operating results may not
      be
      meaningful.




-23-


*We
      rely on a single supplier or a limited number of suppliers for certain raw
      materials used in our products.*





Certain
      raw materials and components used in the manufacture of our products are
      available from limited sources, and, in some cases, a single source. Generally,
      regulatory authorities must approve raw material sources for transdermal
      products, and in the case of controlled substances, the DEA sets quotas for
      controlled substances and we must receive authorization from the DEA to purchase
      and handle these substances. We cannot be certain that we will be granted
      sufficient DEA quota to meet production requirements for controlled substances.
      Without adequate approved supplies of raw materials or packaging supplies,
      our
      manufacturing operations could be interrupted until another supplier is
      identified, our products approved and trading terms with it negotiated. We
      may
      not be able to identify an alternative supplier and any supplier that we do
      identify may not be able to obtain the requisite regulatory approvals in a
      timely manner, or at all. Furthermore, we may not be able to negotiate favorable
      terms with an alternative supplier. Any disruptions in our manufacturing
      operations from the loss of an approved supplier may cause us to incur increased
      costs and lose revenues and may have an adverse effect on our relationships
      with
      our customers, any of which could have adverse effects on our business and
      results of operations. Our business also faces the risk that third party
      suppliers may supply us with raw materials that do not meet required
      specifications, which, if undetected by us, could cause our products to test
      out
      of specification and require us to recall the affected product.





*We
      rely on the services of a single agent to market our product and if we were
      to
      lose the services of such entity or it is not as successful in its sales
      efforts, our business and results of operations would be adversely
      affected.*





We
      market
      our products through a single marketing representative. If we were to lose
      the
      services of such marketing agent for any reason or said entity does not maintain
      a steady demand for our product, and we are unable to identify an adequate
      replacement, our business, results of operations and financial condition would
      be materially adversely affected.





*We
      may expend significant cash and personnel resources in the development of any
      new products and if we do not generate the anticipated level of revenues from
      sales of such products, our business will be negatively and adversely
      affected.*





Our
      efforts to commercialize new products will require significant expenditures
      of
      resources, including cash, which we do not currently possess, and time, in
      the
      research, development, testing, preparation and execution of applications with
      governmental authorities to manufacture and sell such product. If we do not
      generate revenues from sales of any new product at levels anticipated prior
      to
      embarking on such development, our business, financial condition and results
      of
      operations would be materially adversely affected.





*We
      may lose out to larger and better-established competitors.*





The
      drug
      delivery industry is intensely competitive. We face competition from a number
      of
      companies that develop, market and sell transdermal patches that deliver
      nitroglycerin, and competition is expected to intensify as more companies enter
      the field. Most of our competitors have significantly greater financial,
      technical, manufacturing, marketing and distribution resources as well as
      greater experience in the drug delivery industry than we have. The particular
      medical conditions our product addresses can also be addressed by other drugs
      and other delivery modalities. Many of these alternatives are widely accepted
      by
      physicians and have a long history of use. Physicians may use our competitors'
      products and/or our products may not be competitive with other technologies.
      If
      these things happen, our sales and revenues will decline. Competition may result
      in price reductions, reduced gross margins and loss of market
      share.




-24-




We
      cannot
      assure that our products will compete successfully against competitive products
      or that developments by others will not render our products obsolete or
      uncompetitive. If we cannot maintain competitive products and technologies,
      our
      current and potential strategic partners may choose to adopt the drug delivery
      technologies of our competitors or their own internally developed
      technologies.





*Our
      product may be displaced by more effective medications or newer
      technologies.*





The
      drug
      development and delivery industries are undergoing rapid and significant change.
      Others may succeed in developing and marketing drugs and products that are
      more
      effective than those developed or marketed by us, or that would make our product
      obsolete or non-competitive. Additionally, researchers could develop new
      delivery devices and medications that replace or reduce the importance of our
      products. Accordingly, our success will depend, in part, on our ability to
      respond quickly to medical and technological changes through the development
      and
      introduction of new products. Currently, we do not have the financial or
      personnel resources to do this. If our products become obsolete and our efforts
      to develop new products do not result in any commercially successful products,
      our sales and revenues will decline.





*Competitors
      may use legal, regulatory and legislative strategies to prevent or delay our
      launch of generic products.*





The
      Hatch-Waxman Act provides for a period of 180 days of generic marketing
      exclusivity for each ANDA applicant that is first to file an ANDA containing
      a
      certification of invalidity, non-infringement or unenforceability related to
      a
      patent listed with respect to a reference drug product, commonly referred to
      as
      a Paragraph IV certification. During this exclusivity period, the FDA
      cannot grant final approval to any other Paragraph IV filer. If an ANDA
      containing a Paragraph IV certification is successful, it generally results
      in
      higher market share, net revenues and gross margin for that applicant for a
      period of time. Even if we obtain FDA approval for generic drug products, we
      may
      lose significant advantages to a competitor who was first to file an ANDA
      containing a Paragraph IV certification.





Competitors
      may also pursue legislative and other regulatory or litigation strategies to
      prevent or delay our launch of a generic product. These strategies include,
      but
      are not limited to: seeking to obtain new patents on drugs for which patent
      protection is about to expire, changing the labeling for the branded product,
      filing a citizen petition with the FDA, pursuing state legislative efforts
      to
      limit the substitution of generic versions of brand pharmaceuticals, filing
      patent infringement lawsuits that automatically delay FDA approval of many
      generic products, introducing a second generation product prior to the
      expiration of market exclusivity for the first generation product which may
      reduce demand for a generic first generation product, and obtaining market
      exclusivity extensions by conducting pediatric trials of brand
      drugs.





*Unfavorable
      pricing regulations, third-party reimbursement practices or healthcare reform
      initiatives applicable to our product could limit our potential product
      revenue.*





The
      healthcare industry is undergoing fundamental changes resulting from political,
      economic and regulatory influences. In the United States, comprehensive programs
      have been proposed that seek to increase access to healthcare for the uninsured,
      control the escalation of healthcare expenditures within the economy and use
      healthcare reimbursement policies to balance the federal budget.




-25-




We
      expect
      that Congress and state legislatures will continue to review and assess
      healthcare proposals, and public debate of these issues will likely continue.
      We
      cannot predict which, if any, of such reform proposals will be adopted and
      when
      they might be adopted. Significant changes in the healthcare system could have
      a
      substantial impact on the manner in which we conduct our business and could
      require us to revise our strategies and negatively affect our business,
      prospects and results of operations.





*Legislative
      or regulatory programs that may influence prices of prescription drugs could
      have a material adverse effect on our business, financial position and results
      of operations.*





Current
      or future federal or state laws and regulations may influence the prices of
      drugs and, therefore, could adversely affect the price that we receive for
      our
      product. Programs in existence in certain states seek to set prices of all
      drugs
      sold within those states through the regulation and administration of the sale
      of prescription drugs. Expansion of these programs, in particular, state
      Medicaid programs, or changes required in the way in which Medicaid rebates
      are
      calculated under such programs, could adversely affect the price we can charge
      for our product and could have a material adverse effect on our business,
      financial position and results of operations.





*We
      cannot be certain of the protection or confidentiality of our patents and
      proprietary rights.*





Our
      success will depend, in part, on our ability to obtain or license patents for
      our products, processes and technologies. If we do not do so, our competitors
      may exploit our innovations and deprive us of the ability to realize revenues
      from those innovations. There is no assurance that we will be issued patents
      for
      any patent applications we may file, that any existing or future patents that
      we
      receive or license will provide competitive advantages for our products, or
      that
      we will be able to enforce successfully our patent rights. Additionally, there
      can be no assurance that our patents or any future patents we may be issued
      will
      prevent other companies from developing similar or functionally equivalent
      products, or challenging, invalidating or avoiding our patent applications
      or
      any existing or future patents that we receive or license.





We
      also
      rely on trade secrets, unpatented proprietary know-how and continuing
      technological innovation. We use confidentiality agreements with purchasers,
      suppliers, employees and consultants to protect our trade secrets, unpatented
      proprietary know-how and continuing technological innovation, but there can
      be
      no assurance that these parties will not breach their agreements with us or
      that
      we will be able to effectively enforce our rights under those agreements. We
      also cannot be certain that we will have adequate remedies for any breach.
      Disputes may arise concerning the ownership of intellectual property or the
      applicability of confidentiality agreements. Furthermore, we cannot be sure
      that
      our trade secrets and proprietary technology will not otherwise become known
      or
      that our competitors will not independently develop our trade secrets and
      proprietary technology.





*Third
      parties may claim that we infringe their proprietary rights, forcing us to
      expend substantial resources in resulting litigation, the outcome of which
      is
      uncertain. Any unfavorable outcome could negatively affect our financial
      position and results of operations.*





Our
      success will depend, in part, on our ability to operate without infringing
      the
      proprietary rights of others, and there can be no assurance that our products
      and processes will not infringe upon the patents of others. Third parties may
      also institute patent litigation against us for competitive reasons unrelated
      to
      any infringement by us. If a third party asserts a claim of infringement, we
      may
      have to seek licenses, defend infringement actions or challenge the validity
      of
      those third-party patents in court. If we cannot obtain the required licenses,
      or are found liable for infringement or are not able to have these patents
      declared invalid, we may be liable for significant monetary damages, encounter
      significant delays in bringing products to market or be precluded from
      participating in the manufacture, use or sale of products or methods of drug
      delivery covered by the patents of others. There can be no assurance that we
      have identified, or that in the future we will be able to identify, all U.S.
      and
      foreign patents that may pose a risk of potential infringement
      claims.




-26-




*We
      may not be able to manufacture new products in commercial quantities
      efficiently.*





We
      may
      seek to bring to market new products that we have never manufactured on a
      commercial scale. Accordingly, inefficiencies and other scale-up problems may
      occur in the process of manufacturing new products in commercial quantities.
      If
      we experience manufacturing difficulties, our overall manufacturing costs may
      be
      higher than we had anticipated.





*We
      may be subject to product liability claims and we cannot be certain that we
      will
      have adequate insurance coverage.*





The
      testing, manufacturing and marketing of our products may expose us to potential
      product liability and other claims resulting from their use. If any such claims
      against us are successful, we may be required to make significant compensation
      payments and suffer adverse publicity. Even unsuccessful claims could result
      in
      the expenditure of funds in litigation and the diversion of management time
      and
      resources. We maintain product liability insurance, but there can be no
      assurance that our insurance will cover all future claims or that we will be
      able to maintain existing coverage or obtain additional coverage at reasonable
      rates. If a claim is not covered or if our coverage is insufficient, we may
      incur significant liability payments that would negatively affect our business,
      financial position or results of operations.





*All
      of our products are manufactured at one location and any interruption of
      production at this facility could negatively affect our business, financial
      position and results of operations.*





All
      of
      our products are manufactured at a single facility located in Emigsville,
      Pennsylvania. An interruption of manufacturing resulting from regulatory issues,
      technical problems, casualty loss or other factors could result in our inability
      to meet production requirements, which may cause us to lose revenues and which
      could have an adverse effect on our relationships with our partners and
      customers, any of which could have a material adverse effect on our business,
      financial position or results of operations. We maintain business interruption
      insurance, but we cannot assure investors that our insurance will cover all
      future claims or that we will be able to maintain existing coverage or obtain
      additional coverage at reasonable rates. Without our existing production
      facility, we would have no other means of manufacturing our products until
      we
      were able to restore the manufacturing capability at our facility or develop
      an
      alternative manufacturing facility.





*Our
      insurance coverage may not be adequate and rising insurance premiums could
      negatively affect our profitability.*





We
      rely
      on insurance to protect us from many business risks, including product
      liability, business interruption, property and casualty loss and employment
      practices liability. The cost of insurance has risen significantly in recent
      years. In response, we may increase deductibles and/or decrease certain
      coverages to mitigate these costs. There can be no assurance that the insurance
      that we maintain and intend to maintain will be adequate, or that the cost
      of
      insurance and limitations in coverage will not adversely affect our business,
      financial position or results of operations. Furthermore, it is possible that,
      in some cases, coverage may not be available at any price.




-27-




*We
      enter into agreements that include provisions that require us to indemnify
      the
      other party under certain circumstances. If we are required to perform under
      these indemnification provisions, our financial condition and results of
      operations could be negatively affected.*





Many
      of
      the license, development, supply, employment and other agreements we enter
      into
      include indemnification provisions. The various indemnification provisions
      in
      these agreements are not uniform and may be subject to differing legal
      interpretations. Accordingly, it may be difficult for us to determine or
      accurately predict in advance what indemnification obligations we may owe under
      these provisions or, alternatively, what obligations may be owed to us by these
      parties, including as it relates to potential damages, settlement amounts and
      defense costs associated with the product liability lawsuits that claim the
      use
      of products manufactured by us and distributed by third parties. Our insurance
      coverage may mitigate the costs of some of our obligations under these
      indemnification provisions but our business, financial position and results
      of
      operations could be harmed if we are required to perform under these
      indemnification provisions and there is no or insufficient insurance
      coverage.





*We
      may have difficulty raising capital, which could deprive us of necessary
      resources.*





We
      expect
      to require capital for many purposes, including developing new products,
      retaining qualified personnel, funding research and development and maintaining
      existing manufacturing capacity. In order to support the initiatives envisioned
      in our business plan, we may need to raise additional funds through the sale
      of
      assets, public or private debt or equity financing, collaborative relationships
      or other arrangements. Our ability to raise financing depends on many factors
      beyond our control, including the state of capital markets and the development
      or prospects for development of competitive technology by others. Because our
      common stock is not listed on a major stock market, many investors may not
      be
      willing or allowed to purchase it or may demand steep discounts. Our
      current financial condition and the status of our obligations under the Key
      License and Health-Chem’s obligations under the Debentures have prevented us and
      the Group from borrowing money from third parties or raising capital from the
      sale of equity. Sufficient
      additional financing may not be available to us or may be available only on
      terms that would result in further dilution to the current owners of our common
      stock. If we are unable to raise additional funds when we need them, we may
      have
      to severely curtail our operations.





*Our
      success depends on attracting and retaining our key employees.*





Our
      success depends on our ability to attract and retain qualified, experienced
      personnel. We face significant competition in recruiting talented personnel.
      The
      loss of key personnel, or the inability to attract and retain additional,
      competent employees, could adversely affect our business, financial position
      or
      results of operations.





*Limitations
      on liability and indemnification matters.*





As
      permitted by the corporate laws of the State of Delaware, we have included
      in
      our Certificate of Incorporation a provision to eliminate the personal liability
      of our directors for monetary damages for breach or alleged breach of their
      fiduciary duties as directors, subject to certain exceptions. In addition,
      our
      By-Laws provide that we are required to indemnify our officers and directors
      under certain circumstances, including those circumstances in which
      indemnification would otherwise be discretionary, and we will be required to
      advance expenses to our officers and directors as incurred in connection with
      proceedings against them for which they may be indemnified.




-28-




*We
      have no intention of paying dividends on our common stock in the near future
      and
      holders of our common stock will have to rely on the appreciation thereof to
      realize any monies from holding these securities.*





We
      have
      not paid any dividends on our common stock and do not anticipate paying cash
      dividends in the foreseeable future. Management intends to retain any earnings
      to finance the growth of the Company’s business. Management cannot assure you
      that the Company will ever pay cash dividends. Accordingly, holders of our
      common stock will have to rely on the appreciation thereof to realize any monies
      from holding these securities.





*Our
      common stock is not traded or admitted to quotation on any market, so you may
      not be able to sell your shares of common stock and thus you may never realize
      any monies from holding these securities.*





Our
      common stock is not listed on any stock market or admitted to quotation on
      the
      over-the-counter bulletin board, accordingly, there is no established public
      trading market for our common stock. Management does not expect to seek to
      develop a market for our common stock. Therefore, you may only be able to
      dispose of our common stock in a private transaction.





*We
      must maintain adequate internal controls and in the future be able, on an annual
      basis, to provide an assertion as to the effectiveness of such
      controls.*





Effective
      internal controls are necessary for the Company to provide reasonable assurance
      with respect to its financial reports. We may be required to spend a substantial
      amount of management time and resources to comply with changing laws,
      regulations and standards relating to corporate governance and public
      disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC regulations.
      In
      particular, Section 404 of the Sarbanes-Oxley Act of 2002 requires
      management’s annual review and evaluation of our internal control systems, and
      attestations as to the effectiveness of these systems by our independent public
      accounting firm. If we fail to maintain the adequacy of our internal controls,
      we may not be able to ensure that we can conclude on an ongoing basis that
      we
      have effective internal control over financial reporting. Additionally, internal
      control over financial reporting may not prevent or detect misstatements because
      of its inherent limitations, including the possibility of human error, the
      circumvention or overriding of controls, or fraud. Therefore, even effective
      internal controls can provide only reasonable assurance with respect to the
      preparation and fair presentation of financial statements. In addition,
      projections of any evaluation of effectiveness of internal control over
      financial reporting to future periods are subject to the risk that the control
      may become inadequate because of changes in conditions, or that the degree
      of
      compliance with the policies or procedures may deteriorate. If the Company
      fails
      to maintain the adequacy of its internal controls, including any failure to
      implement required new or improved controls, this could have a material adverse
      effect on our business, financial position and results of
      operations.





*There
      are inherent uncertainties involved in estimates, judgments and assumptions
      used
      in the preparation of financial statements in accordance with
      GAAP.*





The
      consolidated and condensed consolidated financial statements included in the
      periodic reports we are required to file with the SEC are prepared in accordance
      with accounting principles generally accepted in the United States of America
      (“GAAP”). The preparation of financial statements in accordance with GAAP
      involves making estimates, judgments and assumptions that affect reported
      amounts of assets (including intangible assets), liabilities, revenues, expenses
      and income. Estimates, judgments and assumptions are inherently subject to
      change in the future and any necessary revisions to prior estimates, judgments
      or assumptions could lead to a restatement. Any such changes could result in
      corresponding changes to the amounts of assets (including goodwill and other
      intangible assets), liabilities, revenues, expenses and income. Any such changes
      could have a material adverse effect on our business, financial position and
      results of operations.




-29-




ITEM
      2.  DESCRIPTION
      OF PROPERTIES





We
      lease
      an approximately 61,000 square foot building, from a related party, located
      on
      approximately 3.5 acres in Emigsville, Pennsylvania which is used for
      manufacturing, laboratory, engineering, quality control, research and
      development, warehousing, administrative and office purposes. Our manufacturing
      facility complies with GMP standards and is operating under registration from
      both the FDA and DEA and pursuant to registration with the Pennsylvania
      Department of Health. The lease, which expires December 6, 2019, has an annual
      rental of $212,400, payable in equal monthly installments of
      $17,700.





We
      believe that our present facilities are in good condition and are adequate
      for
      our current and immediate future requirements.





ITEM
      3.  LEGAL
      PROCEEDINGS





The
      Company is not currently party to any legal proceedings.




ITEM
      4.  SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS





None




PART
      II




ITEM
      5.  MARKET
      FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS





Quotes
      for our common stock are reported on the Pink Sheets from time to time. The
      Pink
      Sheets is a centralized quotation service that collects and publishes market
      maker quotes for over-the-counter securities in real time.





The
      table
      below provides information regarding the high and low sales prices for the
      Company’s common stock, as reported by the Pink Sheets, for each calendar
      quarter during the period January 1, 2004 through December 31, 2006. The last
      quote of our common stock was reported in July 2005.





2006
            
            2005Quarter
            
            High
            
            Low
            
            High
            
            Low1st
            
            $
            0.0001
            
            $
            0.0001
            
            $
            0.0001
            
            $
            0.00012nd
            
            
            0.0001
            
            
            0.0001
            
            
            0.0001
            
            
            0.00013rd
            
            
            0.0001
            
            
            0.0001
            
            
            0.0001
            
            
            0.00014th
            
            
            0.0001
            
            
            0.0001
            
            
            0.0001
            
            
            0.0001




-30-




As
      of
      March 30, 2007, there were approximately 142 holders of record of our common
      stock. This number of holders of record does not include beneficial owners
      of
      our common stock whose shares are held in the names of various security holders,
      dealers and clearing agencies.





We
      have
      not paid any cash dividends on our common stock and we do not anticipate paying
      cash dividends in the foreseeable future.





Recent
      Sales of Unregistered Securities.





Transderm
      has not sold or issued any securities since 1998.




ITEM
                6.
              MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS
                  OF OPERATIONS





The
      following discussion and analysis, as well as other sections in this Annual
      Report, should be read in conjunction with the Consolidated Financial Statements
      and related Notes to Consolidated Financial Statements included elsewhere in
      this Annual Report.





This
      discussion and analysis may contain “forward-looking statements”. These
      statements are made pursuant to the safe harbor provisions of the Private
      Securities Litigation Reform Act of 1995. Such forward-looking statements may
      include, without limitation, statements about the Company’s market
      opportunities, strategies, competition and expected activities and expenditures,
      and at times may be identified by the use of words such as “may”, “will”,
“could”, “should”, “would”, “project”, “believe”, “anticipate”, “expect”,
“plan”, “estimate”, “forecast”, “potential”, “intend”, “continue” and variations
      of these words or comparable words. Forward-looking statements inherently
      involve risks and uncertainties. Accordingly, actual results may differ
      materially from those expressed or implied by these forward-looking statements.
      Factors that could cause or contribute to such differences include, but are
      not
      limited to, the risks described under “Risk Factors” in Item 1. The Company
      undertakes no obligation to update any forward-looking statements for revisions
      or changes after the date of this Annual Report.





Company
      Overview .





We
      manufacture controlled release products to deliver drugs topically or
      transdermally (transdermal patches). Since
      1986, the Company has manufactured a transdermal nitroglycerin patch which
      is
      used for transdermal relief of vascular and cardiovascular symptoms related
      to
      angina pectoris. This patch was the first such product introduced in the United
      States for the generic market and is currentl y
      our
      sole product. We manufacture our nitroglycerin patch both on a contract basis
      for specific clients and for sale to distributors and wholesalers for
      distribution in the United States. We have the technical expertise and
      manufacturing capability to produce transdermal patches which deliver other
      medications. We manufacture our products in accordance with GMP’s prescribed by
      the FDA at our facility in Emigsville, Pennsylvania. We utilize the services
      of
      an independent sales organization to identify customers and to market and sell
      our transdermal patches. We conduct the majority of our business through our
      98.5%-owned subsidiary, Hercon Laboratories Corporation. Health-Chem owns 90%
      of
      our outstanding common stock.




-31-




We
      generate revenues principally from sales of transdermal patches and secondarily
      from research and development projects we undertake for third parties on a
      contract basis.





Our
      business faces certain important risks, including that:





·
            the
                pharmaceutical industry is highly regulated and intensely competitive;





·
            we
                generate the vast majority of our revenue from sales of a single
                product;





·
            we
                are in breach of the terms of a technology license agreement (the
                Key
                License) upon which we rely to manufacture our sole product because
                we
                have never made royalty payments thereunder, which totaled$7,321,000
                at December 31, 2006;





·
            we
                have no borrowing capacity to expand our product lines and reduce
                our
                reliance on sales from our nitroglycerin patches or to take advantage
                of
                other business opportunities as they arise;





·
            as
                of December 31, 2006, we had a working capital deficiency of $26.0
                million;





·
            as
                of December 31, 2006, we had aggregate liabilities of approximately
                $41.3
                million, comprised of liabilities of $10.8 million to third parties
                (including $7.3 million under the Key License) and liabilities in
                favor of
                Health-Chem of $30.5 million; and





·
            as
                of December 31, 2006, Health-Chem had aggregate liabilities of
                approximately $22.4 million, including $11.5 million under the
                Debentures,
                which cast doubt on its ability to continue to operate as a going
                concern.





During
      the year ended December 31, 2006, our operating results declined over the prior
      year. When comparing 2006 to 2005, net sales decreased by 22% from $7.6 million
      to $5.9 million. Management attributes the decrease in net sales during 2006
      to
      a decline in orders from one of our largest customers. The decrease in net
      sales
      reduced our gross profit from $1.1 million to $583,000. As a result, we
      experienced a net loss of $2.8 million during 2006 compared to a net loss of
      $2.5 million in 2005.





Prior
      to
      filing an Annual Report on Form 10-KSB for the years ended December 31, 2003
      and
      2004 in January 2007 (the “2004 Annual Report”), Transderm had not filed any
      annual or quarterly reports with the Securities and Exchange Commission since
      it
      filed an annual report for the year ended December 31, 1998 and quarterly
      reports for the first three quarters of 1999 in November 1999. As more fully
      described in the 2004 Annual Report, commencing in 1998 the Company encountered
      acute economic difficulties which caused it to restructure its business and
      discontinue reporting under federal securities laws. Management suggests that
      investors refer to the 2004 Annual Report and Health-Chem’s Annual Report on
      Form 10-KSB for the years ended December 31, 2004 and 2003 for a more complete
      understanding of the Company’s economic travails during this period, the
      restructuring of its operations, intercompany relationships and the reasons
      it
      suspended filing reports under federal securities laws.





Intercompany
      Accounts .





As
      of
      December 31, 2006, Transderm owed Health-Chem an aggregate of $30.5 million,
      representing nearly 74% of Transderm’s total liabilities. The intercompany
      accounts arose in connection with the reorganization of the Group in 1995.
      Pursuant to a Plan of Reorganization and Asset Exchange Agreement effective
      as
      of August 31, 1995 (the “Plan of Reorganization”), Transderm, Health-Chem and
      the subsidiaries of each corporation realigned the Group’s organizational
      structure to: separate the Group’s disparate businesses; take advantage of
      certain tax laws; and consolidate certain of the Group’s administrative
      functions in Health-Chem. In connection with the corporate
      restructuring:


·
              Transderm
                  issued 1,000,000 shares of redeemable preferred stock to Health-Chem.
                  Transderm has redeemed 150,000 of the shares as required by the
                  terms of
                  their designation and currently remains obligated to redeem the
                  remaining
                  outstanding 850,000 shares. As of December 31, 2006, the total
                  cost to
                  redeem the preferred stock was $14.1 million, consisting of $8.5
                  million
                  of principal and $5.6 million of accumulated
                  dividends.


-32-




·
            Transderm
                participates in Health-Chem’s cash management practices, wherein all of
                Transderm’s excess cash is advanced to Health-Chem and all of its cash
                requirements are borrowed from Health-Chem. The intercompany balance
                was
                $9,231,000 at December 31, 2006. Transderm pays interest on the amount
                due
                at a rate calculated based upon the average outstanding intercompany
                balance and the interest rate on Health-Chem’s debt. The average interest
                rate charged was 10.375% during 2006. On August 31, 1995, Hercon
                (a 98.5%
                subsidiary of Transderm) issued to Health-Chem a $7,000,000, 9%
                Subordinated Promissory Note in exchange for the then outstanding
                borrowings from affiliates under these cash management practices.
                Under
                this promissory note, Hercon was required to make semi-annual interest
                payments each March and September, with the principal amount of $7,000,000
                payable on March 31, 1999. Hercon did not make any interest payments
                on
                the promissory note nor did it repay the principal amount of the
                promissory note when it came due and has been in default under this
                note
                since March 2002 (after giving effect to Health-Chem’s extension of the
                note). As of December 31, 2006, Transderm carried on its books an
                amount
                due to Health-Chem under the terms of this promissory note of $7,000,000.
                Health-Chem has not sought collection of the amount due under the
                promissory note.





·
            Transderm
                and Health-Chem entered into a Corporate Services Agreement under
                which
                Health-Chem provides certain administrative and general corporate
                services
                to Transderm for which it reimburses Health-Chem. Transderm has reimbursed
                Health-Chem in the amount of approximately $459,000 and $348,000
                for the
                years ended December 31, 2006 and 2005, respectively.





Health-Chem
      has not sought collection of any of the above-described amounts due but is
      not
      precluded from making a demand for payment at any time. As described under
      Item
      1. Business-Risk Factors, if Health-Chem were to seek collection of the amounts
      due, Transderm could not pay such amounts and may have to seek protection under
      bankruptcy laws and investors could lose the amount of their investment in
      Transderm.





Factors
      Which We Believe Affect Our Current Operations and May Materially Impact Our
      Future Operations .





Certain
      existing conditions and known material uncertainties could impact our business
      in the short- and long- term. Investors should analyze our business in light
      of
      the issues and uncertainties described in the following discussion which is
      intended to highlight and amplify numerical and other information contained
      in
      the remainder of this section and throughout this Annual Report, particularly
      as
      described under the heading “Business-Risk Factors.”




-33-




Our
      Company faces several challenges as we continue our efforts to emerge from
      the
      financial and operating crisis of the late 1990’s (as more fully described in
      the 2004 Annual Report and Health-Chem’s Annual Report on Form 10-KSB for the
      years ended December 31, 2004 and 2003). In addition to matters internal to
      the
      Company, issues relating to Health-Chem’s financial condition may impact our
      operations in the future because it owns 90% of our outstanding stock.
      Management has identified the following existing factors and known uncertainties
      as those most likely to materially impact our current and future
      operations:





·
            the
                resolution of our obligations under the Key
                License;





·
            Health
                Chem’s ability to resolve its obligations under the
                Debentures;





·
            issues
                relating to reliance on a single product for the majority of our
                revenues;





·
            the
                difficulty we will have diversifying our product offerings given
                our
                financial condition;





·
            short-
                and long- term liquidity issues;





·
            the
                need to identify and retain senior management who have experience
                in the
                pharmaceutical industry or in any business in which we may become
                involved
                in the future;





·
            the
                impact of competition on our business;
                and





·
            our
                dependence upon sales to two
                customers.





Since
      2000, sales of nitroglycerin transdermal patches by the Company have been the
      sole source of recurring revenue for the Company and the Group. Since 2003,
      revenues generated from sales of this product have been sufficient to allow
      Transderm to retain the personnel necessary to reform its internal accounting
      practices and resume reporting under federal securities laws but the Company
      has
      not posted net income since 1995. With the exception of fiscal 2004 during
      which
      Health-Chem posted net income of $9,000, it has experienced net losses in each
      year since 1999. Accordingly, neither company has the financial resources to
      satisfy its respective outstanding obligations and liabilities. In order to
      avoid litigation for the collection of the sums due, in the case of Transderm,
      the royalties due under the Key License, and in the case of Health-Chem, the
      amount due under the Debentures, a possible outcome of which for both companies,
      among others, could be filings for protection from creditors under the
      bankruptcy laws, we will have to reach an agreement with Key and Health-Chem
      will have to achieve a settlement with the holders of the Debentures. These
      agreements will have to provide, among other critical features, sufficient
      latitude to permit the Company and the Group to take the steps necessary to permit
      us
      to develop new products and take the other actions necessary to strengthen
      our
      companies .





As
      the
      Company has re-established product sales over the last few years, the Group
      has
      been able to forestall taking action with respect to resolving its obligations
      under the Key License and the Debentures. Management of Transderm has commenced
      discussions with representatives of Key to develop a plan to pay the royalties
      due under the Key License but no substantive terms have been agreed upon as
      of
      the date hereof. Over the last several years, management of Health-Chem has
      been
      in sporadic contact with the Trustee of the Debentures which has proposed
      opening negotiations with respect to satisfying its obligations under these
      instruments, though no meetings have taken place as yet. Health-Chem has
      executed tolling agreements with the Trustee in each of the last two years
      extending the time in which the Trustee is permitted to seek legal redress
      for
      Health-Chem’s default under the Debentures. The nature of the agreements with
      these creditors, if the companies are able to negotiate them, and the manner
      in
      which the parties will be required to satisfy their respective obligations
      represent a known uncertainty and will bear materially on each company’s
      business and financial condition and likely will significantly impact their
      respective liquidity positions and cash resources for the foreseeable future.




-34-




Accordingly,
      short - and long-term liquidity issues represent a significant challenge as
      we
      seek to balance rebuilding and restructuring our business with paying past
      royalties due under the Key License. Our liquidity likely will be affected
      by
      the structure of the agreement Health-Chem negotiates with respect to repayment
      of the amount due under the Debentures. Our lack of liquidity impacts our
      business in many ways, some of which are inexorably intertwined and affect
      all
      aspects of our operations, as more fully described below.





While
      net
      sales have increased in 4 of the last 6 years, the Company has reported a net
      loss in each of those years. Moreover, at December 31, 2006 the Company had
      a
      total stockholders’ deficiency of $35.6
      million .
      The
      Company has no credit facilities upon which to draw and no assets to utilize
      as
      collateral for borrowings. The Group’s lack of liquidity and its constituent’s
      obligations to Key and the Debenture holders currently and in the future affect
      its ability to:





·
            diversify
                operations by developing new products and reduce reliance on revenues
                generated from sales of a single
                product;





·
            obtain
                financing for operations;





·
              engage
                  senior management with experience in the pharmaceutical industry
                  or any
                  other industry in which we might become involved in the
                  future;





·
            endure
                business cycles resulting from general economic conditions or the
                effects
                of competition, among other things, as they occur;
                and





·
            take
                advantage of business opportunities as they may
                arise.





Assuming
      the Group is successful in its efforts to reach favorable agreements with both
      Key and the holders of the Debentures, it is severely constrained by financial
      and personnel resources from taking the steps required to diversify its
      operations to reduce reliance on revenues generated solely from the sale of
      transdermal nitroglycerin patches. Management believes it is critical to the
      Company’s and the Group’s future to develop additional sources of revenue to
      offset potential adverse business developments which may impact sales of our
      transdermal nitroglycerin patch, which include:





·
            any
                decrease in orders from our major customers, as was the case in 2005
                and
                2006;





·
            the
                potential negative impact of competition, which could require us
                to reduce
                the price we charge for our product or which would result in diminished
                sales, either of which would reduce our revenues;





·
            the
                introduction by others of new products, such as new drugs or delivery
                methods which render our nitroglycerin transdermal patches obsolete;
                or




-35-




·
            other
                events or general economic conditions, some of which are described
                under
                the heading “Business-Risk Factors,” which result in diminished demand for
                our transdermal patch.





Our
      efforts to diversify our operations may entail developing a new product that
      is
      compatible with our manufacturing and personnel capabilities or merging with
      or
      acquiring (perhaps in exchange for capital stock) an entity that already is
      selling or proposes to market a product within the same general industry as
      our
      transdermal patch. Developing or otherwise acquiring a new product or entering
      into a new business, particularly in a highly regulated industry such as the
      pharmaceutical business, entails significant risks, including that it will
      be
      expensive, time consuming and will divert the attention of management from
      a
      company’s core operations. Moreover, at this time, we do not employ the
      personnel we likely will require, such as a chief operating officer who has
      experience in the pharmaceutical or other industry we enter, to attempt to
      add
      new products or otherwise diversify our operations. Further, we can not be
      certain that we would derive any material revenues from any diversification
      and
      may suffer significant losses from any such venture.





At
      this
      time, we do not have capital on-hand nor do we have access to capital to fund
      product development or complete an acquisition. Given our current financial
      and
      business condition, it is unlikely that we will be able to obtain outside
      financing from any source for any purpose, including introducing new products.
      We have no material assets to offer as collateral given that we sold our real
      property and equipment in 2004 (though we are able to carry these items on
      our
      financial statements because York Realty Leasing LLC, the entity that purchased
      the real property and equipment, is considered a “variable interest entity” and,
      according to GAAP, our consolidated balance sheet must include the assets and
      liabilities of York Realty Leasing LLC) and the risks and uncertainties that
      attach to our operations would present significant impediments to locating
      a
      source of financing. We expect that any available cash from operations we may
      have in the foreseeable future will be utilized to satisfy our existing
      obligations. Our inability to obtain outside financing, among
      other things :





·
            will
                restrict our ability to develop or add new products;





·
            limit
                our ability to add new personnel;





·
            restrict
                our ability to take advantage of business opportunities as they arise;
                and





·
            puts
                us at risk to period-to-period operating fluctuationsresulting
                from general economic conditions or the effects of
                competition.





Accordingly,
      we expect that available cash is and will be limited to net income generated
      from continuing operations, if any, without giving effect to how the terms
      of
      any agreements we may enter with Key or Health-Chem may enter with the Debenture
      holders will impact on our cash position. We are uncertain as to whether we
      will
      post net profits in any future years and the extent to which any such profits
      would be subject to remittance to the Debenture holders or Key under our
      obligations to these entities.





We
      have
      contracted with a full-service sales and marketing outsourcing company that
      focuses on generic and branded pharmaceutical companies to undertake the
      majority of the sales and marketing efforts for our transdermal nitroglycerin
      product. This company monitors client sales, as well as scrutinizes the
      competition in order to anticipate and recommend changes to our sales, marketing
      and promotional strategy. This company also assists in providing the industry
      contacts to reach all distribution channels. Two customers accounted for approximately 43% of the sales volume of our patch
      during 2006. Management recognizes the need to expand distribution channels
      to
      reduce our reliance on sales to a few customers and will seek to take the steps
      necessary to address this situation and alleviate these risks.




-36-




Results
      of Operations .





Year
      ended December 31, 2006 versus December 31, 2005





For
      the
      year ended December 31, 2006, our net sales were $5.9 million consisting
      solely of transdermal nitroglycerin patches. For the 2005 year, our net sales
      were $7.6 million, comprised solely of net sales of transdermal nitroglycerin
      patches. Net sales of transdermal nitroglycerin patches decreased by 22% during
      the 2006 period. This decrease is due primarily to a 53% decline in sales of
      transdermal nitroglycerin patches to one of our largest customers in 2006 as
      compared to 2005.





Product
      development income for the twelve months ended December 31, 2006 was $509,000,
      consisting of revenues from four research and development projects we are
      undertaking for three customers. Product development income for the same period
      in 2005 was $349,000. The $160,000 increase is due primarily to additional
      development work income associated with a new project that commenced in
      2006.





Gross
      profit decreased $556,000, or 49%, to $583,000 for the twelve months ended
      December 31, 2006 as compared to $1.1 million for the same period in 2005.
      Gross
      profit as a percent of sales decreased from 15% during 2005 to 10% during
      2006. **** The
      decrease in gross profit was due primarily to decreased sales volumes of lower
      margin products.





Selling,
      general and administrative expenses for the twelve months ended December 31,
      2006 was $1.8 million, virtually unchanged from the 2005 period.




Research
      and development expenses increased by $53,000, or 12%, to $491,000 for the
      twelve months ended December 31, 2006 as compared to research and development
      expenses of $438,000 for the same period in 2005. The increase is due primarily
      to higher labor costs. Research and development costs were incurred principally
      in connection with our research and development efforts for third
      parties.





Net
      interest expense decreased by $80,000, or 7%, to $1,046,000 for the twelve
      months ended December 31, 2006 as compared to $1,126,000 for the same period
      in
      2005. The decrease consists of a


$33,000
      decrease in interest expense and a $47,000 increase in interest income. The
      interest expense decrease is due primarily to the Company refinancing existing
      debt with new parties at lower interest rates. The interest income increase
      is
      due primarily to the Company adopting an investment policy in 2006 whereby
      all
      excess cash is automatically invested in interest-bearing instruments.





Year
      ended December 31, 2005 versus December 31, 2004





For
      the
      year ended December 31, 2005, our net sales were $7.6 million consisting
      solely of transdermal nitroglycerin patches. For the 2004 year, our net sales
      were $9.2 million, comprised solely of net sales of transdermal nitroglycerin
      patches. Net sales of transdermal nitroglycerin patches decreased by 17% during
      the 2005 period. This decrease is due primarily to a 44% decline in sales of
      transdermal nitroglycerin patches to one of our largest customers in 2005 as
      compared to 2004.




-37-




Product
      development income for the twelve months ended December 31, 2005 was $349,000,
      consisting of revenues from three research and development projects we are
      undertaking for two customers. Product development income for the same period
      in
      2004 was $239,000. The $110,000 increase is due primarily to additional
      development work income associated with a new project that commenced in
      2005.





Gross
      profit decreased by $1.8 million, or 61%, to $1.1 million for the twelve months
      ended December 31, 2005 as compared to $2.9 million for the same period in
      2004.
      Gross profit as a percent of sales decreased from 32% during 2004 to 15% during
      2005. **** The
      decrease in gross profit was due primarily to decreased sales volumes of lower
      margin products.





Selling,
      general and administrative expenses increased by $.1 million, or 7%, to $1.8
      million for the twelve months ended December 31, 2005 as compared to $1.7
      million for the same period in 2004. The increase is due primarily to increases
      in wages and professional/consulting fees of $241,000 and $93,000, respectively,
      partially offset by decreases in commission expense and legal fees of $190,000
      and $44,000, respectively.




Research
      and development expenses increased by $24,000, or 6%, for the twelve months
      ended December 31, 2005 as compared to 2004. The increase is due primarily
      to
      higher expenditures for lab supplies.





Net
      interest expense for the twelve months ended December 31, 2005 was $1.1 million,
      virtually unchanged from the 2004 period.





Liquidity
      and Capital Resources .





In
      addition to the discussion relating to our liquidity and capital resources
      below, we refer readers to the section titled “ Factors
      Which We Believe Affect Our Current Operations and May Materially Impact Our
      Future Operations” appearing above, for additional explanation of the issues
      that affect our financial and operating condition.





During
      2006, we incurred a net loss applicable to common stockholders of $2,817,000
      whereas during 2005 our net loss applicable to common stockholders was
      $2,482,000. Our total stockholders’ deficiency at December 31, 2006 was $35.6
      million as compared to December 31, 2005 when our total stockholders’ deficiency
      was $32.8 million. As of December 31, 2006, we had an accumulated deficit
      of approximately $35.6 million. Our principal sources of liquidity have been
      cash provided by loans from management and cash generated by operations. Our
      principal uses of cash have been for working capital and research and
      development.





At
      December 31, 2006, our available cash totaled approximately $1,145,000 compared
      to $759,000 at December 31, 2005. We have no borrowing capacity and as
      of
      December 31, 2006 we had debts and liabilities to third parties of approximately
      $10.8 million (including $7.3 million under the Key License) and to Health-Chem
      (which owns 90% of our outstanding shares of common stock) of approximately
      $30.5 million.





Our
      working capital deficit increased by approximately $1.7 million to $26.0 million
      from December 31, 2005 to December 31, 2006 due principally to a decrease of
      $.9
      million in current assets, consisting primarily of decreases in accounts
      receivable and inventory of $1.0 million and $.2 million, respectively,
      partially offset by an increase in cash of $.4 million, and to an increase
      of
      $.8 million in current liabilities, consisting primarily of increases in
      royalties payable and preferred stock dividends payable of $1.2 million and
      $.6
      million, respectively, partially offset by decreases in accounts payable and
      other liabilities of $.1 million and $.8 million, respectively. The decrease
      in
      accounts receivable resulted from a decrease in sales in the month of December
      2006 as compared to the month of December 2005 and also reflects the timing
      of
      customer payments. The decrease in inventory reflects reduced transdermal
      nitroglycerin product sales and the timing of raw material purchases. The
      royalties payable increase is due to the Company not making payments to Key.
      The
      increase in preferred stock dividends payable is due to legally available funds
      not being available to make the required dividend payment. The other liabilities
      decrease is due primarily to decreases in accrued chargebacks, rebates &
allowances and trade show discounts.





-38-


Cash
      used
      for operating activities for the twelve months ended December 31, 2006 was
      $397,000, as compared to cash used for operating activities of $154,000 for
      the
      same period in 2005. The decrease is due primarily to the $2.8 million net
      loss
      applicable to common stockholders in 2006 and to decreasing accounts receivable,
      inventory, accounts payable, and other liabilities of $1.0 million, $.2 million,
      $.1 million and $.8 million, respectively, and increasing royalties payable
      of
      $1.2 million in 2006 as compared to the $2.5 million net loss applicable to
      common stockholders in 2005 and to decreasing accounts receivable, amount due
      from financing agency, inventory and accounts payable of $.1 million, $.1
      million, $.1 million and $.8 million, respectively, and increasing royalties
      payable, other liabilities and mortgage escrow deposit of $1.6 million, $.5
      million and $.2 million, respectively, in 2005. Investing activities for the
      twelve months ended December 31, 2006 used cash of $126,000 as compared to
      the
      same period in 2005 which used cash of $87,000. This increase in use of cash
      is
      attributable to higher spending for additions to property, plant and equipment
      in 2006. Financing activities for the twelve months ended December 31, 2006
      provided $909,000 of cash as compared to the same period in 2005 which provided
      $149,000 of cash.





As
      of
      December 31, 2006, we owed an aggregate of $7.3 million to Key under the Key
      License. Management has entered into discussions with Key to resolve the
      outstanding royalties but the parties have not achieved a resolution, if one
      is
      reached at all. Any failure to enter into an agreement to satisfy our
      obligations under the Key License would have a material adverse effect on the
      financial condition and operations of the Company.





Expenditures
      in 2007 such as capital expenditures, research and development costs and other
      operating expenses have been financed by cash generated from operating
      activities. The Company anticipates that it will not require any material
      capital expenditures for property, plant or equipment in 2007.





Given
      our
      current financial condition and outstanding obligations, we are uncertain as
      to
      our future sources of cash as we expect to encounter difficulty accessing
      capital markets or obtaining financing from traditional lenders. We expect
      that
      our liquidity position and ability to obtain cash from outside sources will
      be
      materially impacted by the terms of the agreements we may enter into with the
      holders of the Debentures and Key and the other factors enumerated above under
      the heading “Factors which
      Affect or May Impact Our Current and Future Operations .”





-39-





Contractual
      Obligations .





The
      following table summarizes our contractual obligations at December 31, 2006
      (in
      thousands):





Payments
                due by Period (in thousands)Total
            
            Less
                than
              1
                Year
            
            1-3
              Years
            
            3-5
              Years
            
            More
                than
              5
                YearsAmount
                due to Health-Chemunder
                Corporate ServicesAgreement(1)
            
            $
            9,231
            
            
            
            
            
            
            
            
            
            
            $
            9,231Note
                Payable toSubsidiary
                of Health-Chem(2)
            
            
            7,000
            
            $
            7,000Amount
                due to holderof
                preferred stock(3)
            
            
            14,139
            
            
            14,139Royalties
                owed to Key(4)
            
            
            7,321
            
            
            7,321Sale/Leaseback(Operating
                Lease)(5)
            
            
            2,761
            
            
            212
            
            $
            425
            
            $
            425
            
            
            1,699Long-term
                Debt(6)
            
            
            167
            
            
            
            
            
            167Total
            
            $
            40,619
            
            $
            28,672
            
            $
            592
            
            $
            425
            
            $
            10,930




(1)  Represents
      the amount due by the Company to Health-Chem under the Group’s cash management
      practices, wherein the Company borrows all of its cash requirements from
      Health-Chem and advances all excess cash to Health-Chem. Interest on the balance
      is calculated based upon the average outstanding intercompany balance and
      interest rate on Health-Chem’s debt. The average interest rate charged was
      10.375% during 2006.





(2)  Represents
      the amount due, including accrued interest, on a 9% Subordinated Promissory
      Note
      issued by Hercon to Health-Chem on August 31, 1995 in payment of outstanding
      borrowings under the Group’s cash management practices. The Company is required
      to make semi-annual interest payments on this promissory note in each March
      and
      September. The Note was originally due in March 1999 and was extended by the
      Board of Health-Chem to March 2002. **** The
      Company currently is in default on its obligation to repay amount due under
      this
      promissory note.





(3)  Represents
      the amount required to (i) redeem the current outstanding portion (850,000
      shares) of the 1,000,000 shares of the Company’s redeemable preferred stock,
      $10.00 par value, originally issued by the Company to Herculite Products, Inc.,
      a wholly-owned subsidiary of Health-Chem, on August 31, 1995 in payment for
      the
      manufacturing facility in which the Company’s operations are conducted and (ii)
      to pay the aggregate of the accrued annual preferred dividends of $.70 payable
      in each year during which the preferred stock is outstanding. The preferred
      stock provided for an annual sinking fund payment of $500,000 in 1996,
      $1,000,000 in each of the years 1997 through 2004 and a final redemption payment
      of $1,500,000 due in March 2005. The Company made the required redemption
      payments of $500,000 and $1,000,000 in 1996 and 1997, respectively, but has
      made
      no subsequent required redemption payments. The Company has not made any
      dividend payments since 1998. The 850,000 shares of preferred stock currently
      outstanding accrue annual dividends of $595,000. The $14,139,000 consists of
      $8,500,000 required to redeem the preferred stock and $5,639,000 of accrued
      dividends.





(4)  Royalties
      consist of the amount due to Key for royalties under the Key License. We are
      uncertain as to what arrangements we can make for the payment of these
      royalties. Because the Key License provides for payments based upon products
      sold, we have excluded future royalty payments from the above
      table.





-40-


(5)  The
      sale/leaseback (operating lease) consists solely of the December 2004
      sale/leaseback agreement with York Realty Leasing LLC, the terms of which are
      described in Item 12, below.





(6)  Other
      long-term debt consists of a $167,000 note related to the purchase of certain
      fixed assets. The purchase of these fixed assets was pursuant to a development,
      manufacturing and supply agreement that the Company entered into with a client
      company. Payment terms of the note are contingent upon certain performance
      criteria under the agreement. One such performance criteria applicable to the
      client company may result in the note being forgiven. We estimate the earliest
      that the note may need to be repaid is in 2008.





Liquidity
      and Operations Going Forward .





The
      Company intends to continue its efforts to complete the necessary steps to
      meet
      its future cash flow requirements and to continue its pursuit of the development
      of new products and contract manufacturing opportunities. Management’s plans in
      this regard include, but are not limited to, the following:





·
            continue
                with preliminary negotiations with Key with respect to devising a
                plan to
                pay the royalties due under the Key License and possibly negotiate
                a new
                license agreement;





·
            continue
                with existing projects whereby the Company is developing other transdermal
                products for client companies and where the Company will be the contract
                manufacturer of these products, if, among other things, FDA approval
                is
                obtained, of which no assurance can be
                given;





·
            form
                business alliances with other pharmaceutical companies in connection
                with
                the development and/or manufacture of new
                products;





·
            raise
                additional working capital through borrowing or by issuing equity;
                and





·
            evaluate
                new directions for the Company’s
                operations.





Management
      believes that actions presently being taken will need to be further realigned
      or
      otherwise amended so that the Company will be in a position to generate
      sufficient revenues to provide positive cash flows from operations and meet
      its
      obligations as they become due. However, there can be no assurance that this
      will occur.





Given
      our
      current financial condition and outstanding obligations, we are uncertain as
      to
      our future sources of cash as we expect to encounter difficulty either accessing
      capital markets or obtaining financing from traditional lenders. We expect
      that
      our liquidity position and ability to obtain cash from outside sources will
      be
      materially impacted by the terms of the agreements we may enter into with the
      holders of the Debentures and Key and the other factors enumerated above under
      the heading “Factors which
      Affect or May Impact Our Current and Future Operations .”





Off-Balance
      Sheet Arrangements .





We
      have
      not entered into any off-balance sheet arrangements.





-41-


Critical
      Accounting Policies .





Our
      significant accounting policies are described in Note 2 of the Notes to
      Consolidated Financial Statements, which were prepared in accordance with
      accounting principles generally accepted in the United States of America.
      Included within these policies are certain policies which contain critical
      accounting estimates and, therefore, have been deemed to be “critical accounting
      policies.” Critical accounting estimates are those which require management to
      make assumptions about matters that were uncertain at the time the estimate
      was
      made and for which the use of different estimates, which reasonably could have
      been used, or changes in the accounting estimates that are reasonably likely
      to
      occur from period to period, could have a material impact on the presentation
      of
      our financial condition, changes in financial condition or results of
      operations. The Company has identified revenue recognition and legal matters
      as
      its critical accounting policies.





Revenue
      Recognition .





Revenue
      is recognized for product sales upon shipment when title and risk of loss have
      transferred to the customer and when provisions for estimates, including
      discounts, 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 reductions to net revenues and within other current liabilities.
      Other current liabilities include $902,000 at December 31, 2006 for certain
      rebates and other adjustments that are paid to customers.





Provisions
      for estimated discounts, rebates, promotional and other credits are estimated
      based on historical payment experience, historical relationship to revenues
      and
      contract terms. Such provisions are determinable due to the limited number
      of
      assumptions and consistency of historical experience. Others, such as price
      adjustments, returns and chargebacks, require management to make more subjective
      judgments and evaluate current market conditions. These provisions are discussed
      in further detail below.





Price
      Adjustments — Price adjustments, which include shelf stock adjustments, are
      credits issued to reflect decreases in the selling prices of our products.
      Shelf
      stock adjustments are based upon the amount of product that our customers have
      remaining in their inventories at the time of the price reduction. Decreases
      in
      our selling prices are discretionary decisions made by us to reflect market
      conditions. Amounts recorded for estimated price adjustments are based upon
      specified terms with direct customers, and in the case of shelf stock
      adjustments, estimates of inventory held by the customer.





Returns
—
      Consistent with industry practice, we maintain a return policy that allows
      our
      customers to return product within a specified period prior to and subsequent
      to
      the expiration date. Our estimate of the provision for returns is based upon
      our
      historical experience with actual returns, which is applied to the level of
      sales for the period that corresponds to the period during which our customers
      may return product. This period is known by us based on the shelf lives of
      our
      products at the time of shipment.





Chargebacks
      — The provision for chargebacks is the most significant estimate used in the
      recognition of revenue. The Company markets products directly to wholesalers,
      distributors, retail pharmacy chains, mail order pharmacies and group purchasing
      organizations. The Company also markets products indirectly to independent
      pharmacies, managed care organizations, hospitals, nursing homes and pharmacy
      benefit management companies, collectively referred to as “indirect customers.”
The Company enters into agreements with its indirect customers to establish
      contract pricing for certain products. The indirect customers then independently
      select a wholesaler whom they actually purchase the products at these contracted
      prices. Alternatively, certain wholesalers may enter into agreements with
      indirect customers which establish contract pricing for certain products which
      the wholesalers provide. Under either arrangement, the Company will provide
      credit to the wholesaler for any difference between the contracted price with
      the indirect party and the wholesaler’s invoice price. Such credit is called a
      chargeback, while the difference between the contracted price and the
      wholesaler’s invoice price is referred to as the chargeback rate. The provision
      for chargebacks is based on expected sell-through levels by our wholesaler
      customers to indirect customers. Additionally, internal estimates are prepared
      based upon historical buying patterns and estimated end user demand. Such
      information allows us to estimate the potential chargeback that we may
      ultimately owe to our customers given the quantity of inventory on hand. We
      continually monitor our provision for chargebacks and evaluate our reserve
      and
      estimates as additional information becomes available.





-42-


Legal
      Matters .





The
      Company is not involved in any legal proceedings. However, Health-Chem is
      involved in one legal matter that, if a significant adverse outcome results,
      may
      have an impact on the Company





Recent
      Accounting Pronouncements .





In
      January 2003, the
      Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46
      (revised December 2003), *Consolidation
      of Variable Interest Entities* (“FIN
      46(R)”). FIN 46(R) addresses the consolidation of business enterprises to which
      the usual condition (ownership of a majority voting interest) of consolidation
      does not apply. FIN 46(R) focuses on controlling financial interests that may
      be
      achieved through arrangements that do not involve voting interests. It concludes
      that in the absence of clear control through voting interests, a company’s
      exposure (variable interest) to the economic risks and potential rewards from
      the variable interest entity’s assets and activities are the best evidence of
      control. If an enterprise holds a majority of the variable interests of an
      entity, it would be considered the primary beneficiary. Upon consolidation,
      the
      primary beneficiary is generally required to include assets, liabilities and
      non-controlling interests at fair value and subsequently account for the
      variable interest as if it were consolidated based on majority
      voting interest. As a result of FIN 46(R), effective as of December 31, 2004, the
      Company’s consolidated balance sheet includes the assets and liabilities of York
      Realty Leasing LLC, which is a related party.





In May
      2004,
      the FASB issued FASB Staff Position No. 106-2, *Accounting
      and Disclosure Requirements Related to the Medicare Prescription Drug,
      Improvement and Modernization Act of 2003* (FSP
      106-2)in response to a new law regarding prescription drug benefits under
      Medicare as well as a federal subsidy to sponsors of retiree healthcare benefit
      plans. We expect that the impact of this Act will not be material.





In
      November 2004, the FASB
      issued Statement of Financial Accounting Standards (“SFAS”) No. 151, *Inventory
      Costs - an Amendment of ARB No. 43, Chapter 4.* SFAS
      151
      clarifies the accounting for abnormal amounts of idle facility expense, freight,
      handling costs and spoilage. SFAS 151 also requires that allocation of fixed
      production overhead costs be based on normal production activity. The provisions
      of SFAS 151 are effective for inventory costs incurred beginning in January
      2006, with adoption permitted for inventory costs incurred beginning in January
      2005. Adoption of this Statement is not expected to have a material effect
      on
      the Company’s Consolidated Financial Statements.





-43-


In
      December 2004, the FASB
      issued SFAS No. 123(R), *Share-Based
      Payment.* SFAS
      123(R) establishes standards for the accounting for transactions in which an
      entity exchanges its equity instruments for goods and services. Under SFAS
      123(R), companies are no longer able to account for share-based compensation
      transactions using the intrinsic method in accordance with APB No. 25, *Accounting
      for Stock Issued to Employees* .
      Instead, companies are required to account for such transactions using a
      fair-value method and to recognize compensation expense over the period during
      which an employee is required to provide services in exchange for the award.
      In
      April 2005, the SEC delayed the effective date of SFAS 123(R) to fiscal
      years beginning after June 15, 2005. Adoption of this Statement is not
      expected to have a material effect on the Company’s Consolidated Financial
      Statements.





In
      May
      2005, the FASB
      issued SFAS No. 154, *Accounting
      Changes and Error Corrections - a Replacement of APB Opinion No. 20 and SFAS
      No.
      3.* SFAS
      154
      changes the requirements for the accounting for and reporting of a change in
      accounting principle. This Statement applies to all voluntary changes in
      accounting principle. SFAS 154 also applies to changes required by an accounting
      pronouncement in the usual instance that the pronouncement does not include
      specific transition provisions. The provisions of SFAS 154 are effective for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. Adoption of this Statement is not expected to have
      a
      material effect on the Company’s Consolidated Financial Statements.





In
      June
      2006, the FASB
      issued FASB Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,
      Accounting for Income Taxes* (“FIN
      48”), effective for the Company beginning on January 1, 2007. FIN 48 clarifies
      the recognition threshold a tax position is required to meet before being
      recognized in the financial statements. FIN 48 also provides guidance on
      disclosure and other matters. Currently, the Company does not expect this
      guidance to have a material impact on its financial statements.





In
      September 2006, the FASB
      issued SFAS No. 157, *Fair
      Value Measurements* ,
      effective for the Company beginning on January 1, 2008. SFAS 157 defines fair
      value, establishes a framework for measuring fair value, and expands disclosures
      about fair value measurements. This statement establishes a fair value hierarchy
      that distinguishes between valuations obtained from sources independent of
      the
      entity and those from the entity’s own unobservable inputs that are not
      corroborated by observable market data. SFAS 157 expands disclosures about
      the
      use of fair value to measure assets and liabilities in interim and annual
      periods subsequent to initial recognition. The disclosures focus on the inputs
      used to measure fair value and for recurring fair value measurements using
      significant unobservable inputs, the effect of the measurements on earnings
      or
      changes in net assets for the period. The Company is currently assessing the
      impact of this guidance on its financial statements.





Inflation .





We
      believe that our results of operations are not dependent upon moderate changes
      in inflation rates.





ITEM
      7.  FINANCIAL
      STATEMENTS





Transderm
      submits with this Annual Report the financial statements and related information
      listed in the Index to Consolidated Financial Statements on page F-1 following
      this Annual Report's signature page.





-44-
 
 ITEM
                    8.
                  CHANGES
                      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND
                      FINANCIAL DISCLOSURE


On
      February 4, 2005, we retained the services of Demetrius & Company, L.L.C. to
      serve as our independent accountant to audit our financial statements. We had
      not retained an independent auditor since 2000. The engagement of Demetrius
      & Company was approved by our Board of Directors.





Prior
      to
      its engagement, we had not consulted with Demetrius & Company, L.L.C.
      regarding the application of accounting principles to a specific completed
      or
      contemplated transaction, or the type of audit opinion that would be rendered
      on
      our financial statements. Moreover, we did not seek, and Demetrius &
Company, L.L.C. did not furnish, written or oral advice on any matter that
      we
      considered an important factor in reaching a decision as to an accounting,
      auditing or financial reporting issue.





Demetrius
      & Company's offices are located at Wayne Interchange Plaza II, 155 Route 46,
      Wayne, New Jersey 07470.





ITEM
      8A.  CONTROLS
      AND PROCEDURES





We
      maintain disclosure controls and procedures designed to ensure that information
      required to be disclosed in our reports filed or submitted under the Securities
      Exchange Act of 1934 is recorded, processed, summarized and reported within
      the
      time periods specified in the SEC’s rules and forms. As of the end of the period
      covered by this Annual Report on Form 10-KSB, we carried out an evaluation,
      under the supervision and with the participation of management, including our
      Chief Executive Officer and Chief Financial Officer, of the effectiveness of
      the
      design and operation of our disclosure controls and procedures pursuant to
      Exchange Act Rule 13a-15. Based upon that evaluation, management and our Chief
      Executive Officer and Chief Financial Officer concluded that our disclosure
      controls and procedures are effective. During the periods covered by this Annual
      Report on Form 10-KSB, there was no change in our internal control over
      financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that
      materially effected, or is reasonably likely to materially effect, our internal
      control over financial reporting.





ITEM
      8B.  OTHER
      INFORMATION





None





PART
      III




ITEM
                9.
              DIRECTORS,
                  EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE GOVERNANCE;
                  COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE
                  ACT





Directors
      and Executive Officers .





The
      following table sets forth certain information about our directors and executive
      officers as of March 30, 2007:





Name
            
            Age
            
            Position
            
            Year
                First
              Became
              a
                DirectorAndy
                E. Yurowitz
            
            71
            
            Chairmanof
                the Board, President,
              Chief
                Executive Officer and Director
            
            2000Ronald
                J. Burghauser
            
            46
            
            Chief
                Financial Officer, Treasurer
              and
                SecretaryAndrew
                J. Levinson
            
            58
            
            Director
            
            2000Manfred
                Mayerfeld
            
            75
            
            Director
            
            2000





-45-





The
      Company's directors are elected to hold office until the next annual meeting
      of
      stockholders and until their respective successors have been elected and
      qualified. The Company's officers serve at the pleasure of the Board of
      Directors.





Set
      forth
      below is biographical information concerning our directors and executive
      officers for at least the past five years. All of the following persons who
      are
      executive officers are also full-time employees.





Andy
      E.
      Yurowitz has served as Chairman of the Board of Directors, President, Chief
      Executive Officer of Transderm since February 2000. Mr. Yurowitz has also served
      as Chairman of the Board of Directors, President, Chief Executive Officer of
      Health-Chem and all of the Group’s subsidiaries since February
      2000.





Ronald
      J.
      Burghauser, a certified public accountant, has served as Chief Financial
      Officer, Treasurer and Secretary of the Company since November 2003. From May
      2002 through October 2003, Mr. Burghauser was Controller of the Company. From
      April 1999 through September 2001, Mr. Burghauser was Chief Financial Officer
      for Oakworks, Inc., a manufacturer of therapeutic equipment. Mr. Burghauser
      serves as the chief financial officer, treasurer and secretary of each of the
      Group’s subsidiaries, positions which he has held since November
      2003.





Andrew
      J.
      Levinson has been a practicing attorney for more than twenty-nine years. From
      September 2002 to the present, Mr. Levinson has been counsel to Greenberg &
Kahr in New York City. Previously he was a partner in Phillips Nizer, LLP from
      March 2001 to August 2002. Mr. Levinson serves as a member of the Board of
      Transderm and each of the Group’s subsidiaries, positions which he has held
      since February 2000. Mr. Levinson has also served on the Board of Directors
      of
      Health-Chem and all of the Group’s subsidiaries since February
      2000.





Manfred
      Mayerfeld retired from teaching in 1991. Since then he has been active in real
      estate investing and property management. Mr. Mayerfeld serves as a member
      of
      the Board of Transderm and each of the Group’s subsidiaries, positions which he
      has held since February 2000. Mr. Mayerfeld has also served on the Board of
      Directors of Health-Chem and all of the Group’s subsidiaries since February
      2000.





Section
      16(a) Beneficial Ownership Reporting Compliance





Section
      16(a) of the Securities Act of 1934 requires the Company's officers and
      directors, and greater than 10% stockholders, to file reports of ownership
      and
      changes in ownership of its securities with the SEC. Copies of the reports
      are
      required by SEC regulation to be furnished to the Company. Based on management's
      review of these reports during the year ended December 31, 2006, all of the
      reports required to be filed have been filed.





-46-


Code
      of Ethics





Our
      Board
      of Directors has adopted a Code of Ethics that applies to our Chief Executive
      Officer, our Chief Financial Officer and to the other senior management and
      senior financial staff of our company. Our Code of Ethics complies with the
      requirements imposed by the Sarbanes-Oxley Act of 2002 and the rules and
      regulations issued thereunder for codes of ethics applicable to such officers.
      Our Board of Directors has reviewed and will continue to evaluate its role
      and
      responsibilities with respect to the new legislative and other requirements
      of
      the SEC. Interested persons can obtain a copy of our Code of Ethics, without
      charge and upon request, by writing to the
      Company’s Secretary at: Transderm Laboratories Corporation, 101 Sinking Springs
      Lane, Emigsville, PA 17318.





Corporate
      Governance





*General*





We
      believe that good corporate governance is important to ensure that Transderm
      is
      managed for the long-term benefit of our stockholders. This section describes
      key corporate governance practices.





*Board
      Determination of Independence*





As
      of the
      date hereof, the Company has no policy with respect to independence requirements
      for its Board members or that a majority of its board be comprised of
“independent directors.” In determining whether a Board member is “independent,”
the Company applies the standards of “independence” prescribed by rules set
      forth by the American Stock Exchange (“AMEX”). Under said rules, a director will
      only qualify as an “independent director” if, in the opinion of our Board of
      Directors, that person does not have a relationship with our company which
      would
      interfere with the exercise of independent judgment in carrying out the
      responsibilities of a director. A director who is, or at any time during the
      past three years, was employed by the Company or by any parent or subsidiary
      of
      the Company, shall not be considered independent. Accordingly, Manfred Mayerfeld
      and Andrew Levinson meet the definition of “independent director” under Section
      121 of the American Stock Exchange Company Guide; Andy Yurowitz does
      not.





*Board
      of Directors Meetings and Attendance*





The
      Board
      of Directors has responsibility for establishing broad corporate policies and
      reviewing our overall performance rather than day-to-day operations. The primary
      responsibility of our Board of Directors is to oversee the management of our
      company and, in doing so, serve the best interests of the Company and our
      stockholders. The Board of Directors selects, evaluates and provides for the
      succession of executive officers and, subject to stockholder election,
      directors. It reviews and approves corporate objectives and strategies, and
      evaluates significant policies and proposed major commitments of corporate
      resources. Our Board of Directors also participates in decisions that have
      a
      potential major economic impact on our Company. Management keeps the directors
      informed of Company activity through regular communication.





We
      have
      no formal policy regarding director attendance at the annual meeting of
      stockholders, although all directors are expected to attend the annual meeting
      of stockholders if they are able to do so. During 2006, the Board of Directors
      held eight meetings, each of which was attended by all members of the Board
      either in person or telephonically.





-47-


*Board
      of Directors Committees*





We
      do not
      currently have a standing audit, nominating or compensation committee of the
      Board of Directors, or any committee performing similar functions. Our Chairman
      of the Board, Andy Yurowitz, and our remaining directors, Manfred Mayerfeld
      and
      Andrew Levinson, perform the functions of audit, nominating and compensation
      committees. As of the date of this Annual Report, no member of our Board of
      Directors qualifies as an “audit committee financial expert” as defined in
      Item 401(e) of Regulation S-B promulgated under the Securities
      Act of 1933, as amended. Since the Board of Directors currently consists of
      three members, it does not believe that establishing a separate nominating
      committee is necessary for effective governance. If and when additional members
      of the Board of Directors are appointed or elected, we will consider creating
      a
      nominating committee. Given the Company’s financial condition, management does
      not anticipate hiring any additional executives in the foreseeable future and
      for this reason it does not believe that establishing a separate compensation
      committee is necessary for effective governance. The Board will consider
      establishing a compensation committee if and when it becomes necessary or
      required.





*Shareholder
      Communications*





The
      Company does not presently provide a process for security holders to send
      communications to the Board of Directors. The Company does not provide such
      process because it has not held a stockholders meeting at which directors were
      elected since 1999, as it has not had the funds to cover the cost of preparing
      and filing a proxy statement in connection with such meeting. All of the current
      members of the Board of Directors have served as directors since 2000. The
      Board
      of Directors expects to call a stockholders meeting at which directors will
      be
      elected after it files this Annual Report and to adopt a process for security
      holders to send communications to the Board of Directors prior to such
      stockholders meeting, which process it will disclose in the proxy statement
      to
      be mailed to all stockholders prior to the stockholders meeting.





ITEM
      10.  EXECUTIVE
      COMPENSATION





Directors’
      Compensation





The
      Company does not compensate its employee directors for services rendered as
      directors. The Company reimburses non-employee directors for travel and related
      expenses for attending board meetings.





Executive
      Compensation





The
      following Summary Compensation Table sets forth certain information
      concerning the annual and long-term compensation of the person serving as the
      Company’s chief executive officer and each other executive officer who received
      annual compensation in excess of $100,000 during the last two fiscal years
      (collectively, the “Named Executives”) .





**SUMMARY
                COMPENSATION TABLE**Long
                Term CompensationAnnual
                Compensation
            
            Awards
            
            PayoutsName
                and
              Principle
                Position
            
            Year
            
            Salary
              ($)
            
            Bonus
              ($)
            
            Other
                Annual
              Compensation
              ($)
            
            Restricted
              Stock
              Award(s)
              ($)
            
            Securities
              Underlying
              Options/SARs
              (#)
            
            LTIP
              Payouts
                ($)
            
            All
                Other
              Compensation
              ($)(1)Andy
                Yurowitz,
              President,
                Chief
              Executive
                Officer
              and
                Chairman
            
            
            2006
              
              
              2005
            
            $
              
              
              $
            197,999
              
              
              180,000
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
              
              $
            4,860
              
              606Ronald
                J. Burghauser,
              Chief
                Financial
              Officer,
                Secretary and
              Treasurer
            
            
            2006
              
              
              2005
            
            $
              
              
              $
            154,000
              
              
              133,827
            
            $
            2,033
            
            
            
            
            
            
            
            
            
            
            
            
            $
              
              $
            2,192
              
              1,994Kenneth
                Brody,
              Former
                Chief Financial
              Officer
                and Former
              Manager
                - Sales,
              Marketing
                & Business
              Development
            
            
            2005
            
            $
            130,769
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            2,659Richard
              L.
              Bulwicz,Manager
              -
              Quality
            
            
            2006
            
            $
            111,500
            
            $
            1,467
            
            
            
            
            
            
            
            
            
            
            
            
            $
            1,577Operations
            
            
            2005
            
            $
            101,600
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            1,503






(1)
            Consists
                of the Company matching contributions under our 401(K) plan and the
                term
                cost value of all excess group life insurance policies on behalf
                of the
                Named Executives.





-48-


Option
      Grants in the Last Fiscal Year .





During
      the fiscal year ended December 31, 2006, Transderm did not grant any options
      to
      purchase any securities.





As
      of the
      date hereof, there are no options to purchase any securities
      outstanding.




Fiscal
      Year-End Option Numbers and Values .




During
      the fiscal year ended December 31, 2006, there were no options to purchase
      shares of common stock outstanding.





Equity
      Compensation Plan Information .





Not
      applicable.





ITEM
                  11.
                SECURITY
                    OWNERSHIP OF CERTAIN BENEFICIALOWNERS
                    AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.





The
      following table sets forth information, as of March 30, 2007 with respect to
      the
      beneficial ownership of our common stock by each person known by us to be the
      beneficial owner of more than 5% of the outstanding common stock, by each of
      our
      officers and directors, and by all of our officers and directors as a
      group.





-49-


For
      the
      purpose of this table, the beneficial ownership of a person includes shares
      as
      to which that person has sole or shared voting or investment power as well
      as
      shares that the person has the right to acquire within 60 days (such as upon
      conversion of convertible securities or exercise of warrants or options) as
      of
      March 30, 2007. For the purpose of calculating the ownership percentages for
      each person listed, we have considered to be outstanding both the total number
      shares actually outstanding on March 30, 2007 and the total number of shares
      that various people then had the right to acquire within 60 days of said
      date.





Name
                and Address
              of
                Beneficial Owner(1)
            
            Number
                of Shares
              Beneficially
                Owned(2)
            
            Percent
              of
                Class(3)Andy
                E. Yurowitz
            
            
            227,350
            (4)
            
            *Manfred
                Mayerfeld
            
            
            0
            
            
            -Andrew
                J. Levinson
            
            
            0
            
            
            -Ronald
                J. Burghauser
            
            
            424
            (4)
            
            *Laura
                G. Speiser(5)
            
            
            2,520,362
            
            
            6.30
            %All
                directors and executiveofficers
                as a group (4 persons)
            
            
            227,774
            
            
            *





*
            Indicates
                ownership of less than one percent (1%) of
                class.


(1)
            Address
                is c/o Transderm Laboratories Corporation, 101 Sinking Springs Lane,
                Emigsville, PA 17318.


(2)
            The
                information concerning security holders is based upon information
                furnished to the Company by such security holder. Except as otherwise
                indicated, all of the shares are owned of record and beneficially
                and the
                persons identified have sole voting and dispositive power with respect
                thereto.


(3)
            Based
                upon 40,000,000 shares of common stock outstanding on March 30,
                2007.


(4)
            Voting
                and/or dispositive power is shared with another
                individual.


(5)
            Includes
                188,475 shares of common stock owned by Lauralei Investors, Inc.
                ("Lauralei"), of which Laura G. Speiser was the sole stockholder.
                The
                Company was made aware of Ms. Speiser’s demise in May 2006 and has been
                unable to ascertain the current owner of these
                shares.




ITEM
      12.  CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS





In
      December 2004, Transderm sold its real property, buildings, improvements and
      equipment located in Emigsville, Pennsylvania to York Realty Leasing LLC for
      a
      sale price of $1.9 million. Concurrent with the sale, Transderm entered into
      a
      15-year lease for the property expiring in December 2019, which can be extended
      by the Company for an additional five years. The agreement provides for a
      Company repurchase option at a price of $1,995,000. The annual lease cost during
      the initial 15 year term is $212,400. In December 2002, Transderm had received
      an appraisal for the real property, including the structures and appurtenances,
      by Weinstein Realty Advisors, an independent real estate agent located in York,
      Pennsylvania, which appraised the market value of the real property and
      structures at $1,850,000. The proceeds from the sale were used to satisfy a
      $1.6
      million first mortgage associated with the property and to substantially pay
      off
      a $367,500 Second Mortgage (the “Second Mortgage”). Mr. Andy E. Yurowitz, the
      Chairman of the Board, President, Chief Executive Officer and a member of the
      Board of Directors of each of Transderm and Health-Chem, is a 50% owner of
      York
      Realty Leasing LLC. Transderm entered into the sale/leaseback arrangement with
      York Realty Leasing LLC because it required cash and was unable to obtain a
      loan
      or any other financing from an unaffiliated party on any basis. In December
      2005, York Realty Leasing LLC obtained a $1.4 million mortgage from Fulton
      Bank.
      Proceeds from the mortgage were used to pay down York Realty Leasing LLC member
      loans.





-50-


ITEM
      13.  EXHIBITS
      AND REPORTS ON FORM 8-K





(a)
      EXHIBITS




Exhibit
              No.
            
            Exhibit
                Description
            
            Location
                Reference2
            
            Plan
                of Reorganization and Asset Exchange Agreement dated as of June 30,
                1995,
                by and among Health-Chem Corporation, ("Health-Chem") Herculite Products,
                Inc. ("HPI") and Transderm Laboratories Corporation
                ("Transderm").
            
            Previously
                filed as Exhibit 2 to Transderm’s Registration Statement on Form S-1 No.
                33-95080 filed with the Commission on July 28, 1995 ("Registration
                Statement").3.1
            
            Restated
                Certificate of Incorporation dated April 27, 1995.
            
            Previously
                filed as Exhibit 3.1 to the Registration Statement.3.2
            
            Amendment
                to Restated Certificate of Incorporation dated July 13,
                1995.
            
            Previously
                filed as Exhibit 3.2 to the Registration Statement.3.3
            
            By-Laws.
            
            Previously
                filed as Exhibit 3.3 to the Registration Statement.10.1
            
            Asset
                Acquisition Agreement dated April 28, 1995 between Hercon Environmental
                Corporation (“HEC”) and Hercon Laboratories Corporation
                (“HLC”).
            
            Previously
                filed as Exhibit 10.7 to the Registration Statement.10.2
            
            $7,000,000
                principal amount Subordinated Promissory Note of HLC.
            
            Previously
                filed as Exhibit 10.8 to Amendment No. 1 to the Registration Statement
                (“Amendment No. 1”) .10.3
            
            Corporate
                Services Agreement between Health-Chem and Transderm, dated as of
                August
                31, 1995.
            
            Previously
                filed as Exhibit 10.9 to Amendment No. 1.10.4
            
            Tax
                Sharing Agreement between Health Chem and Transderm, dated as of
                August
                31, 1995
            
            Previously
                filed as Exhibit 10.10 to Amendment No.
                1.




-51-




10.5
            
            Second
                Modification Agreement dated as of October 11, 1995 by and among
                Health-Chem, HLC, HPI, Pacific Combining Corporation (“PCC”), HEC and
                Transderm.
            
            Previously
                filed as Exhibit 10.5 to the Registrant’s
              Quarterly
                Report for the Quarter ended September 30, 1995.10.6
            
            Revolving
                Credit, Term Loan and Security Agreement dated as of January 9, 1997
                by
                and between HCH, HPI, HEC, PCC, HLC and Transderm and IBJ Schroder
                Bank
                & Trust Company,
            
            Previously
                filed as Exhibit 1 to Health-Chem's Current Report on Form 8-K filed
                with
                the Commission on January 22, 1997.10.7
            
            First
                Amendment to Revolving Credit, Term Loan and Security Agreement dated
                as
                of January 21, 1998 by and between HCH, HPI, HEC, PCC, HLC and Transderm
                and IBJ Schroder Business Credit Corporation.
            
            Previously
                filed as Exhibit 10.18(b) to Health-Chem's Report on Form 10-K for
                the
                year ended December 31, 1997.10.8
            
            Second
                Amendment to Revolving Credit, Term Loan and Security Agreement dated
                as
                of July 31, 1998 by and between HCH, HPI, HEC, PCC, HLC and Transderm
                and
                IBJ Schroder Business Credit Corporation.
            
            Previously
                filed as an exhibit to Health-Chem's Report on Form 10-Q for the
                quarter
                ended September 30, 1998.10.9
            
            Waiver
                and Third Amendment to Revolving Credit, Term Loan and Security Agreement
                dated as of January 11, 1999 by and between Health-Chem, HPI, HEC,
                PCC,
                HLC and Transderm and IBJ Whitehall Business Credit
                Corporation.
            
            Previously
                filed as Exhibit 10.18(d) to Health-Chem's Report on Form 10-K for
                the
                year ended December 31, 1998.10.10
            
            Consent
                and Fourth Amendment to Revolving Credit, Term Loan and Security
                Agreement
                dated as of March 24, 1999 by and between HCH, HPI, HEC, PCC, HLC
                and
                Transderm and IBJ Whitehall Business Credit Corporation.
            
            Previously
                filed as Exhibit 10.18(e) to Health-Chem's Report on Form 10-K for
                the
                year ended December 31, 1998.10.11
            
            Amendment
                and Forbearance Agreements to Revolving Credit, Term Loan and Security
                Agreement dated as of April 14, 1999, May 14, 1999, June 21, 1999,
                July
                15, 1999 and August 15, 1999 by and between Health-Chem, HPI, HEI,
                PCC,
                HLC and Transderm and IBJ Whitehall
              Business
                Credit Corporation.
            
            Previously
                filed as Exhibit 10.18 (f) to Health-Chem's Report on Form 10-K for
                the
                year ended December 31, 1998.10.12
            
            Asset
                Purchase Agreement dated as of July 20, 1999 by and among HPI, HEC
                and
                Aberdeen Road Company.
            
            Previously
                filed as Exhibit 2.1 to Health-Chem's Current Report on Form 8-K
                dated
                September 2, 1999.




-52-




10.13
            
            License
                Agreement dated March 13, 2000 between HLC and Key Pharmaceuticals,
                Inc.
            
            Previously
                filed as Exhibit 10.18 to Health-Chem’s Annual Report on Form 10-KSB for
                the year ended December 31, 2004 as filed with the SEC on July 31,
                2006
                (the “HC 2004 10-KSB”).10.14
            
            Mortgage
                and Security Agreement dated May 23, 2000 between Transderm and Mercury
                Capital Corp.
            
            Previously
                filed as Exhibit 10.19 to the HC 2004 10-KSB.10.15
            
            Mortgage
                Note dated May 23, 2000 made by Transderm in favor of Mercury Capital
                Corp.
            
            Previously
                filed as Exhibit 10.20 to the HC 2004 10-KSB.10.16
            
            Guaranty
                of Transderm in favor of Mercury Capital Corp. dated May 23,
                2000.
            
            Previously
                filed as Exhibit 10.21 to HC 2004 10-KSB.10.17
            
            Assignment
                of Leases and Rents from Transderm to Mercury Capital Corp. dated
                May 23,
                2000.
            
            Previously
                filed as Exhibit 10.22 to the HC 2004 10-KSB.10.18
            
            Mortgage
                Modification Agreement dated June 30, 2000 between Transderm and
                Mercury
                Capital Corp.
            
            Previously
                filed as Exhibit 10.23 to the HC 2004 10-KSB.10.19
            
            Mortgage
                Modification Agreement dated July 10, 2000 between Transderm and
                Mercury
                Capital Corp.
            
            Previously
                filed as Exhibit 10.24 to the HC 2004 10-KSB.10.20
            
            Assignment
                of Leases and Rents from Transderm to Mercury Capital Corp. dated
                July 13,
                2000.
            
            Previously
                filed as Exhibit 10.25 to the HC 2004 10-KSB.10.21
            
            Guaranty
                of Transderm in favor of Mercury Capital Corp. dated July 13,
                2000.
            
            Previously
                filed as Exhibit 10.26 to the HC 2004 10-KSB.10.22
            
            Sales
                Representative Agreement dated July 25, 2000 between HLC and Granard
                Pharmaceutical, LLP.
            
            Previously
                filed as Exhibit 10.27 to the HC 2004 10-KSB.10.23
            
            Product
                Purchase Agreement dated February 28, 2001 between HLC and Ranbaxy
                Pharmaceuticals Inc. (portions of this Exhibit have been omitted
                pursuant
                to a request for confidential treatment and have been filed separately
                with the Commission).
            
            Previously
                filed as Exhibit 10.28 to the HC 2004
                10-KSB.




-53-




10.24
            
            Development
                Assistance Agreement dated February 28, 2001 between HLC and Ranbaxy
                Pharmaceuticals Inc. (portions of this Exhibit have been omitted
                pursuant
                to a request for confidential treatment and have been filed separately
                with the Commission).
            
            Previously
                filed as Exhibit 10.29 to the HC 2004 10-KSB.10.25
            
            Finished
                Goods Supply Agreement dated February 28, 2001 between HLC and Ranbaxy
                Pharmaceuticals Inc. (portions of this Exhibit have been omitted
                pursuant
                to a request for confidential treatment and have been filed separately
                with the Commission).
            
            Previously
                filed as Exhibit 10.30 to the HC 2004 10-KSB.10.26
            
            Amendment
                No. 1 to Sales Representative Agreement between HLC and Granard
                Pharmaceutical, LLP dated July 24, 2001.
            
            Previously
                filed as Exhibit 10.31 to the HC 2004 10-KSB.10.27
            
            Mortgage
                Note in the principal amount of $367,500 dated August 7, 2001 among
                Transderm and certain creditors, including affiliates of
                Transderm.
            
            Previously
                filed as Exhibit 10.32 to the HC 2004 10-KSB.10.28
            
            Agreement
                dated May 22, 2002 among Zackfoot Investments, LLC, the holders of
                the
                Mortgage Note dated August 7, 2001 and Transderm.
            
            Previously
                filed as Exhibit 10.34 to the HC 2004 10-KSB.10.29
            
            Promissory
                Note in the principal amount of $164,692.50 dated May 22, 2002 among
                Transderm and Zackfoot Investments, LLC and certain other lenders
                to
                Transderm.
            
            Previously
                filed as Exhibit 10.35 to the HC 2004 10-KSB.10.30
            
            Mortgage
                Note in the principal amount of $150,000 dated June 22, 2002 made
                by
                Transderm Laboratories Corporation in favor of Albert
                David.
            
            Previously
                filed as Exhibit 10.36 to the HC 2004 10-KSB.10.31
            
            Outline
                of Agreement between the Registrant and Jack Aronowitz, Leon Services
                LLC
                and Health-Chem Diagnostics, LLC, effective October 31,
                2003.
            
            Previously
                filed as Exhibit 10.37 to the HC 2004 10-KSB.10.32
            
            Development,
                Manufacturing and Supply Agreement dated June 10, 2004 between Hercon
                Laboratories Corporation and Ranbaxy Pharmaceuticals Inc. (portions
                of
                this Exhibit have been omitted pursuant to a request for confidential
                treatment and have been filed separately with the
                Commission).
            
            Previously
                filed as Exhibit 10.38 to the HC 2004
                10-KSB.




-54-




10.33
            
            Deed
                dated December 7, 2004 selling and transferring ownership of the
                land and
                building owned by Transderm Laboratories Corporation to York Realty
                Leasing LLC.
            
            Previously
                filed as Exhibit 10.39 to the HC 2004 10-KSB.10.34
            
            Warranty
                Bill of Sale dated December 7, 2004 selling and transferring ownership
                of
                machinery and equipment owned by Hercon Laboratories Corporation
                to York
                Realty Leasing LLC.
            
            Previously
                filed as Exhibit 10.40 to the HC 2004 10-KSB.10.35
            
            Commercial
                Lease Agreement dated December 7, 2004 by
              and
                between York Realty Leasing LLC and Transderm.
            
            Previously
                filed as Exhibit 10.41 to the HC 2004 10-KSB.10.36
            
            Development,
                Manufacturing and Supply Agreement dated April 28, 2006 between HLC
                and
                Cure Therapeutics, Inc. (portions of this Exhibit have been omitted
                pursuant to a request for confidential treatment and have been filed
                separately with the Commission).
            
            Previously
                filed as Exhibit 10.42 to the HC 2004 10-KSB.14
            
            Code
                of Ethics
            
            Previously
                filed in Transderm’s Annual Report on Form 10-KSB for the years ended
                December 31, 2003 and 2004.21
            
            Subsidiaries
                of the Registrant.
            
            Filed
                herewith.31.1
            
            Certification
                of Chief Executive Officer pursuant to Rule
              13a-14(a)
                or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002.
            
            Filed
                herewith.31.2
            
            Certification
                of Chief Financial Officer pursuant to Rule
              13a-14(a)
                or Rule 15d-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002.
            
            Filed
                herewith.32.1
            
            Certification
                of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
            
            Filed
                herewith.32.2
            
            Certification
                of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
            
            Filed
                herewith.




-55-




(b)
      REPORTS ON FORM 8-K





During
      the quarter ended December 31, 2006 the Company did not file any reports on
      Form
      8-K.





ITEM
      14 . PRINCIPAL
      ACCOUNTANT FEES AND SERVICES





Audit
      Fees





The
      aggregate fees billed by Demetrius & Company, L.L.C. for professional
      services related to the audit of the Company's consolidated financial statements
      for the fiscal years ended December 31, 2005 and 2006 were
      $123,000.





Audit-Related
      Fees





There
      were no fees billed by Demetrius & Company, L.L.C. for audit-related
      services for the fiscal years ended December 31, 2005 or 2006.





Tax
      Fees





There
      were no fees billed by Demetrius & Company, L.L.C. for tax services during
      the fiscal years ended December 31, 2005 or 2006.





All
      Other Fees





There
      were no fees billed by Demetrius & Company, L.L.C. for any other
      professional services during the fiscal years ended December 31, 2005 or
      2006.




-56-





SIGNATURES





In
      accordance with Section 13 or 15(d) 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.





TRANSDERM
      LABORATORIES CORPORATION





Name
                and Capacity
            
            
            Date/s/
                Andy E. Yurowitz
              By:
                Andy E. Yurowitz
              Chairman
                of the Board,
              President
                and Chief Executive
              Officer
                (Principal Executive Officer)
            
            
            April
                17, 2007/s/
                Ronald J. Burghauser
              By:
                Ronald J. Burghauser
              Chief
                Financial Officer,
              Treasurer
                and Secretary
              (Principal
                Financial Officer)
              (Principal
                Accounting Officer)
            
            
            April
                17, 2007





In
      accordance with the Securities Exchange Act of 1934, this report has been signed
      below by the following persons on behalf of the Registrant and in the capacities
      and on the dates indicated.





Person
            
            Capacity
            
            Date/s/
                Andy E. Yurowitz
              Andy
                E. Yurowitz
            
            Chairman
                of the Board, President
              and
                Chief Executive Officer
              (Principal
                Executive Officer)and
              Director
            
            April
                17, 2007/s/
                Ronald J. Burghauser
              Ronald
                J. Burghauser
            
            Chief
                Financial Officer,
              Treasurer
                and Secretary
              (Principal
                Financial Officer)
              (Principal
                Accounting Officer)
            
            April
                17, 2007/s/
                Andrew J. Levinson
              Andrew
                J. Levinson
            
            Director
            
            April
                17, 2007/s/
                Manfred Mayerfeld
              Manfred
                Mayerfeld
            
            Director
            
            April
                17, 2007





-57-


ITEM
      7.  FINANCIAL
      STATEMENTS





Index
      to
      Consolidated Financial Statements.




PAGEReport
                of Independent Registered Public Accounting Firm
            
            F-2Consolidated
                Balance Sheet - December 31, 2006
            
            F-3Consolidated
                Statements of OperationsYears
                Ended December 31, 2006 and 2005
            
            F-4Consolidated
                Cash Flow StatementsYears
                Ended December 31, 2006 and 2005
            
            F-5Consolidated
                Statements of Stockholders’ DeficiencyYears
                Ended December 31, 2006 and 2005
            
            F-6Notes
                to Consolidated Financial Statements
            
            F-7
                to F-23




F-1


**REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
  To
        the
        Board of Directors and Stockholders
 Transderm
        Laboratories Corporation and Subsidiaries
 
 We
        have
        audited the accompanying consolidated balance sheet of Transderm Laboratories
        Corporation and Subsidiaries (“Transderm” or the ”Company”) as of December 31,
        2006 and the related consolidated statements of operations, cash flows, and
        stockholders’ deficiency for each of the years in the two year period ended
        December 31, 2006. These financial statements are the responsibility of
        Transderm’s management. Our responsibility is to express an opinion on these
        financial statements based on our audits.
 
 We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. The Company is not required
        to
        have, nor were we engaged to perform, an audit of its internal control over
        financial reporting. Our audit included consideration of internal control
        over
        financial reporting as a basis for designing audit procedures that are
        appropriate in the circumstances, but not for the purpose of expressing an
        opinion on the effectiveness of the Company’s internal control over financial
        reporting. Accordingly, we express no such opinion. An audit also includes
        examining, on a test basis, evidence supporting the amounts and disclosures
        in
        the financial statements, assessing the accounting principles used and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audits provide a
        reasonable basis for our opinion.
 
 In
        our
        opinion, the financial statements referred to above present fairly, in all
        material respects, the consolidated financial position of Transderm Laboratories
        Corporation and Subsidiaries at December 31, 2006, and the consolidated results
        of their operations and their cash flows for each of the years in the two
        year
        period ended December 31, 2006, in conformity with accounting principles
        generally accepted in the United States of America.
 
 The
        accompanying financial statements have been prepared assuming that the Company
        will continue as a going concern. As more fully described in Note 3, the
        Company
        is in default of payments to its bondholders and licensors, and has working
        capital deficiencies that raise substantial doubt about its ability to continue
        as a going concern. Management’s plans concerning these matters are also
        described in Note 3. The financial statements do not include any adjustments
        that might result from the outcome of this uncertainty.
 
  /s/
        DEMETRIUS & COMPANY, L.L.C.
 Wayne,
        New Jersey
 April
        16,
        2007


F-2




TRANSDERM
      LABORATORIES CORPORATION


CONSOLIDATED
      BALANCE SHEET


DECEMBER
      31, 2006


(In
      thousands, except share amounts)


ASSETSCURRENT
                  ASSETSCash
              
              $
              1,145Accounts
                  receivable - net
              
              
              1,885Inventories
              
              
              937Other
                  current assets
              
              
              20Total
                  Current Assets
              
              
              3,987PROPERTY,
                  PLANT AND EQUIPMENT, net
              
              
              1,528MORTGAGE
                  ESCROW DEPOSIT
              
              
              201TOTAL
                  ASSETS
              
              $
              5,716LIABILITIES
                  AND STOCKHOLDERS’ DEFICIENCYCURRENT
                  LIABILITIESAccounts
                  payable
              
              $
              147Royalties
                  payable
              
              
              7,321Other
                  liabilities
              
              
              1,291Current
                  portion of long-term debt
              
              
              40Subordinated
                  promissory note
              
              
              7,000Redeemable
                  preferred stock
              
              
              8,500Preferred
                  stock dividends payable
              
              
              5,639Total
                  Current Liabilities
              
              
              29,938LONG-TERM
                  LIABILITIESLong-term
                  payable - Health-Chem
              
              
              9,231Mortgage
                  payable
              
              
              1,318Payable
                  to affiliate
              
              
              666Note
                  payable
              
              
              167Total
                  Long-Term Liabilities
              
              
              11,382COMMITMENTSPREFERRED
                  STOCK
              
              
              0STOCKHOLDERS’
                  DEFICIENCYCommon
                  stock, par value $.001 per share;60,000,000
                  shares authorized; 40,000,000shares
                  issued and outstanding
              
              
              40Accumulated
                  deficit
              
              
              <35,644
              >Total
                  Stockholders’ Deficiency
              
              
              <35,604
              >TOTAL
                  LIABILITIES AND STOCKHOLDERS’ DEFICIENCY
              
              $
              5,716




See
      Notes
      to Consolidated Financial Statements.





F-3




TRANSDERM
      LABORATORIES CORPORATION


CONSOLIDATED
      STATEMENTS OF OPERATIONS


(In
      thousands, except per share amounts)


Years
                  Ended
                December
                  31,2006
              
              2005REVENUE:Net
                  sales
              
              $
              5,940
              
              $
              7,586Cost
                  of goods sold - royalties
              
              
              1,213
              
              
              1,586Cost
                  of goods sold - other
              
              
              4,144
              
              
              4,861Total
                  cost of goods sold
              
              
              5,357
              
              
              6,447Gross
                  profit
              
              
              583
              
              
              1,139OPERATING
                  EXPENSES:Selling,
                  general and administrative
              
              
              1,782
              
              
              1,822Research
                  and development
              
              
              491
              
              
              438Interest,
                  net
              
              
              1,046
              
              
              1,126Total
                  operating expenses
              
              
              3,319
              
              
              3,386LOSS
                  FROM OPERATIONS
              
              
              <2,736
              >
              
              <2,247
              >Product
                  development income
              
              
              509
              
              
              349Other
                  income <expense> - net
              
              
              5
              
              
              0LOSS
                  FROM OPERATIONS BEFORE TAXESAND
                  MINORITY INTEREST
              
              
              <2,222
              >
              
              <1,898
              >Minority
                  interest
              
              
              0
              
              
              11Income
                  tax benefit
              
              
              0
              
              
              0NET
                  LOSS
              
              
              <2,222
              >
              
              <1,887
              >PREFERRED
                  DIVIDENDS
              
              
              595
              
              
              595NET
                  LOSS APPLICABLE TO COMMON STOCKHOLDERS
              
              $
              <2,817
              >
              $
              <2,482
              >Loss
                  per common share (basic & diluted):LOSS
                  PER COMMON SHARE
              
              $
              <.07
              >
              $
              <.06
              >Average
                  number of common sharesoutstanding:
                  (in thousands)Basic
              
              
              40,000
              
              
              40,000Diluted
              
              
              40,000
              
              
              40,000


See
      Notes
      to Consolidated Financial Statements.




F-4




TRANSDERM
      LABORATORIES CORPORATION


CONSOLIDATED
      CASH FLOW STATEMENTS


(In
      thousands)


Years
                  Ended
                December
                  31,2006
              
              2005**CASH
                  FLOWS FROM OPERATING ACTIVITIES:**Net
                  loss applicable to common stockholders
              
              $
              <2,817
              >
              $
              <2,482
              >Adjustments
                  to reconcile net loss to net cashprovided
                  by operating activities:Depreciation
                  and amortization
              
              
              316
              
              
              316Preferred
                  stock dividends payable
              
              
              595
              
              
              595Minority
                  interest
              
              
              0
              
              
              <11
              >Changes
                  in:Accounts
                  receivable
              
              
              1,023
              
              
              54Due
                  from financing agency
              
              
              0
              
              
              110Inventories
              
              
              231
              
              
              134Other
                  current assets
              
              
              4
              
              
              <1
              >Mortgage
                  escrow deposit
              
              
              <1
              >
              
              <200
              >Other
                  non-current assets
              
              
              0
              
              
              44Accounts
                  payable
              
              
              <133
              >
              
              <821
              >Royalties
                  payable
              
              
              1,213
              
              
              1,586Other
                  liabilities
              
              
              <828
              >
              
              522Net
                  cash used for operating activities
              
              
              <397
              >
              
              <154
              >**CASH
                  FLOWS FROM INVESTING ACTIVITIES:**Additions
                  to property, plant and equipment
              
              
              <126
              >
              
              <87
              >Net
                  cash used for investing activities
              
              
              <126
              >
              
              <87
              >**CASH
                  FLOWS FROM FINANCING ACTIVITIES:**Borrowings
                  from affiliates, net
              
              
              951
              
              
              <62
              >Long-term
                  debt proceeds
              
              
              0
              
              
              1,400Long-term
                  debt payments
              
              
              <42
              >
              
              <1,200
              >Minority
                  interest contributions
              
              
              0
              
              
              11Net
                  cash provided by financing activities
              
              
              909
              
              
              149**NET
                  INCREASE <DECREASE> IN CASH**
              
              
              386
              
              
              <92
              >Cash
                  at beginning of year
              
              
              759
              
              
              851Cash
                  at end of year
              
              $
              1,145
              
              $
              759Supplemental
                  Disclosures of Cash Flow Information:Cash
                  paid during the year for:Interest
              
              $
              191
              
              $
              248Income
                  taxes
              
              
              0
              
              
              0Supplemental
                  Disclosures of Non-Cash FinancingActivities:Conversion
                  of members’ capital to long-termdebt
              
              $
              0
              
              $
              130





See
      Notes
      to Consolidated Financial Statements.




F-5




TRANSDERM
      LABORATORIES CORPORATION


CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ DEFICIENCY


YEARS
      ENDED DECEMBER 31, 2006 AND 2005


(In
      thousands)


Common
                Stock
              
              Accumulated
                Deficit
              
              Total
                  .Balance,
                  January 1, 2005
              
              $
              40
              
              $
              <30,345
              >
              $
              <30,305
              >Net
                  loss
              
              
              
              
              
              <1,887
              >
              
              <1,887
              >Preferred
                  dividends
              
              
              
              
              
              <595
              >
              
              <595
              >Balance,
                  December 31, 2005
              
              
              40
              
              
              <32,827
              >
              
              <32,787
              >Net
                  loss
              
              
              
              
              
              <2,222
              >
              
              <2,222
              >Preferred
                  dividends
              
              
              
              
              
              <595
              >
              
              <595
              >Balance,
                  December 31, 2006
              
              $
              40
              
              $
              <35,644
              >
              $
              <35,604
              >




See
      Notes
      to Consolidated Financial Statements.




F-6


TRANSDERM
      LABORATORIES CORPORATION


NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


YEARS
      ENDED DECEMBER 31, 2006 AND 2005




1. Nature
      of Operations





Transderm
      Laboratories Corporation (“Transderm”) and its subsidiary, Hercon Laboratories
      Corporation (“Hercon”) (collectively the “Company”) are engaged in the
      development, manufacture and marketing of transdermal drug delivery systems.
      Since 1986, the Company has manufactured a transdermal nitroglycerin patch
      which
      was the first
      such product introduced for the generic market in the United States. The product
      is used for transdermal relief of vascular and cardiovascular symptoms related
      to angina pectoris. The Company sells the transdermal nitroglycerin patch to
      distributors and wholesalers who distribute it in the United
      States.





In
      addition to its transdermal nitroglycerin products, the Company is developing
      other transdermal products for client companies and will be the contract
      manufacturer of these products if United States Food and Drug Administration
      (“FDA”) approval is obtained. The Company is also conducting a number of
      feasibility studies on drugs to be developed independently or for client
      companies and pursuing additional contract manufacturing opportunities. There
      is
      no assurance that FDA filings for additional products will be submitted or
      that
      FDA approval for any additional products will be obtained.




2. Summary
      of Significant Accounting Policies





a.
      Principles of Consolidation





The
      accompanying consolidated financial statements include the accounts of Transderm
      and Hercon. As of December 31, 2004, the consolidated financial statements
      also
      include a Variable Interest Entity (“VIE”), York Realty Leasing LLC, of which
      Transderm is the primary beneficiary as further described in Note 5. All
      significant intercompany accounts and transactions, including those involving
      the VIE, have been eliminated in consolidation. The Company is a 90% owned
      subsidiary of Health-Chem Corporation (“Health-Chem”).





b.
      Cash
      Equivalents





Money
      market funds and investment instruments with original maturities of ninety
      days
      or less are considered cash equivalents.





c.
      Fair
      Value of Financial Instruments and Concentrations of Credit Risk





Management
      believes that the carrying amounts of the Company’s financial instruments,
      including cash and cash equivalents, accounts receivable, accounts payable,
      and
      accrued liabilities approximate fair value due to the short-term nature of
      these
      instruments. The carrying amount of the Company’s long-term debt also
      approximates fair value. Management believes that determining a fair value
      for
      the Company’s redeemable preferred stock is impractical due to the closely-held
      nature of these securities.




F-7




Financial
      instruments that potentially subject the Company to concentrations of credit
      risk consist primarily of cash, cash equivalents and accounts receivable.
      Periodically, the Company has cash balances at certain financial institutions
      in
      excess of federally insured limits. However, the Company does not believe that
      it is subject to unusual credit risk beyond the normal credit risk associated
      with commercial banking relationships. The Company mitigates this risk by
      depositing its cash in high quality financial institutions. To reduce credit
      risk related to accounts receivable, the Company performs ongoing credit
      evaluations of its customers’ financial condition but does not generally require
      collateral. Approximately 62% of the December 31, 2006 accounts receivable
      balance represents amounts due from two customers.





The
      percentage of sales to each major customer who was responsible for 10% or more
      of the total revenues is as follows:


Years
                  EndedDecember
                  31,2006
              
              2005Customer
                  A
              
              
              23
              %
              
              13
              %Customer
                  B
              
              
              20
              %
              
              42
              %


At
      December 31, 2006, accounts receivable of approximately $1,178,000 was from
      such
      customers.





d.
      Revenue Recognition and Accounts Receivable





The
      Company recognizes revenue for product sales upon shipment when title and risk
      of loss pass to its customers and when provisions for estimates, including
      trade
      discounts, rebates, promotional adjustments, price adjustments, returns,
      chargebacks, and other potential adjustments are reasonably determinable. No
      revisions were made to the methodology used in determining these provisions
      during the years ended December 31, 2006 and 2005.





The
      Company has historically provided financial terms to customers in accordance
      with what management views as industry norms. Financial terms, for
      credit-approved customers, are generally on a net 30-61 day basis, though most
      customers are entitled to a prompt payment discount. Management periodically
      and
      regularly reviews customer account activity in order to assess the adequacy
      of
      allowances for doubtful accounts, considering factors such as economic
      conditions and each customer’s payment history and creditworthiness. If the
      financial condition of our customers were to deteriorate, or if they were
      otherwise unable to make payments in accordance with management’s expectations,
      we might have to increase our allowance for doubtful accounts, modify their
      financial terms and/or pursue alternative collection methods. When accounts
      receivable are considered uncollectible, they are charged against the allowance.
      Quarterly, the Company reviews its accounts receivable for potential
      uncollectible accounts. At December 31, 2006, the allowance was a nominal amount
      and is considered adequate.





The
      following briefly describes the nature of each provision and how such provisions
      are estimated.





Trade
      discounts are charged to operations when taken by customers.




F-8




Rebates
      are offered to key customers to promote customer loyalty and encourage greater
      product sales. These rebate programs provide that upon the attainment of
      pre-established volumes or the attainment of revenue milestones for a specified
      period, the customer receives credit against purchases. Other promotional
      programs are incentive programs periodically offered to our customers. The
      Company is able to estimate provisions for rebates and other promotional
      programs based on the specific terms in each agreement at the time of
      shipment.





Consistent
      with industry practices, customers may return short-dated or expired product
      within a specified period prior to and subsequent to the expiration date. The
      Company’s estimate of the provision for returns is based upon historical
      experience with actual returns.





Price
      adjustments, which include shelf stock adjustments, are credits issued to
      reflect decreases in the selling prices of products. Shelf stock adjustments
      are
      based upon the amount of product which the customer has remaining in its
      inventory at the time of the price reduction. Decreases in selling prices are
      discretionary decisions made by the Company to reflect market conditions.
      Amounts recorded for estimated price adjustments are based upon specified terms
      with direct customers, and in the case of shelf stock adjustments, estimates
      of
      inventory held by the customer.





The
      Company has agreements with certain indirect customers, such as independent
      pharmacies, managed care organizations, hospitals, nursing homes, governmental
      agencies and pharmacy benefit management companies, which establish contract
      prices for certain products. The indirect customers then independently select
      a
      wholesaler from whom they purchase the products at these contracted prices.
      The
      Company will provide credit to the wholesaler for any difference between the
      contracted price with the indirect party and the wholesaler’s invoice price.
      Such credit is called a chargeback. The provision for chargebacks is based
      on
      expected sell-through levels by our wholesaler customers to indirect
      customers.





Costs
      incurred for shipping and handling are recorded in cost of sales.





e.
      Inventories





Inventories
      are stated at lower of cost (first-in, first-out basis) or market.





f.
      Property, Plant and Equipment





Property,
      plant and equipment are recorded at cost. Maintenance and repairs are charged
      to
      expense as incurred, and costs of improvements are capitalized. Depreciation
      and
      amortization are provided using the straight-line method by charges to
      operations over estimated useful lives of five to twenty-five years. The cost
      and related accumulated depreciation of disposed assets are removed from the
      applicable accounts and any gain or loss is included in income in the period
      of
      disposal.





g.
      Impairment of Long-Lived Assets





The
      Company reviews long-lived assets, such as property and equipment, and purchased
      intangibles subject to amortization, for impairment whenever events or changes
      in circumstances indicate that the carrying amount of an asset may not be
      recoverable, in accordance with Statement of Financial Accounting Standards
      (“SFAS”) No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets* .
      Recoverability of assets to be held and used is measured by a comparison of
      the
      carrying amount of an asset to estimated undiscounted future cash flows expected
      to be generated by the asset. If the carrying amount of an asset exceeds its
      estimated future cash flows, an impairment charge is recognized by the amount
      by
      which the carrying amount of the asset exceeds the fair value of the asset.
      There were no impairment charges in 2006 and 2005.




F-9




h .
      Accounts Receivable Financing





In
      January 2001, the Company entered into an agreement to sell certain of its
      accounts receivable with full recourse to a factor, Bay View Funding. The
      Company terminated its agreement with Bay View Funding in April 2005 because
      management believed that the Company no longer needed the services of a factor.
      The Company did not sell any accounts receivable to Bay View Funding during
      2005. Expenses incurred under this factoring program totaling $43,000 for 2005
      are included on the selling, general and administrative expense line in the
      Consolidated Statements of Operations.





i.
      Research and Development





Research
      and development costs are charged to operations as incurred.





j.
      Income
      Taxes





The
      Company is included in the consolidated federal income tax return of its parent,
      Health-Chem, and is party to a Tax Sharing Agreement. Deferred tax assets and
      liabilities are provided by the Company on a stand-alone basis for differences
      between the financial statement and tax bases of assets and liabilities that
      will result in future taxable or deductible amounts. The deferred tax assets
      and
      liabilities are measured using the enacted tax laws and rates applicable to
      the
      periods in which the differences are expected to affect taxable income. Income
      tax expense is computed as the tax payable or refundable for the period plus
      or
      minus the change during the period in deferred tax assets and liabilities.
      Deferred tax assets are reduced by a valuation allowance when, in the opinion
      of
      management, it is more likely than not that some portion or all of the deferred
      tax assets will not be realized.





k.
      Cash
      Management





The
      Company participates in Health-Chem’s cash management practice, wherein all cash
      requirements are borrowed from Health-Chem and all excess cash is advanced
      to
      Health-Chem. The intercompany balance was $9,231,000 at December 31, 2006.
      Interest is charged based upon the average outstanding intercompany balance
      and
      interest rate on Health-Chem’s debt. The average interest rate charged was
      10.375% during both 2006 and 2005.





l.
      Expenses Charged by Health-Chem





Pursuant
      to a Corporate Services Agreement between the Company and Health-Chem,
      Health-Chem pays for certain administrative expenses on behalf of the Company
      for which Health-Chem is reimbursed. These expenses are comprised primarily
      of
      an allocation of corporate services including executive, professional, legal
      and
      accounting. The allocation of these costs, approximately $459,000 and $348,000
      for 2006 and 2005, respectively, reflect Health-Chem’s estimate of their cost
      for these services based upon a method (allocation based upon the Company’s net
      sales as a percentage of Health-Chem’s consolidated net sales) which is
      considered by the Company to be reasonable. The Company estimates that these
      expenses, on a stand-alone basis, would not have been materially different
      from
      the costs allocated.




F-10




m.
      Per
      Share Information





Basic
      and
      diluted earnings per share are computed based upon the weighted average number
      of common shares outstanding during each year after adjustment for any dilutive
      effect of the Company's stock options.





A
      reconciliation of the basic and diluted earnings per common share computations
      for the years ended December 31, 2006 and 2005 is presented below
      (in
      thousands, except per share amounts):


2006
              
              2005Income
                  (Numerator)
              
              Shares
                  (Denominator)
              
              PerShare
                  Amount
              
              Income
                  (Numerator)
              
              Shares
                  (Denominator)
              
              PerShare
                  AmountNet
                  loss
              
              $
              <2,222
              >
              
              
              
              
              
              
              $
              <1,887
              >Preferred
                  stock dividends
              
              
              <595
              >
              
              
              
              
              
              
              
              <595
              >**Basic
                  Earnings Per****Common
                  Share**Net
                  loss applicable tocommon
                  stockholders
              
              
              <2,817
              >
              
              40,000
              
              $
              <.07
              >
              
              <2,482
              >
              
              40,000
              
              $
              <.06
              >**Effect
                  of Dilutive****Securities**Stock
                  options
              
              
              0
              
              
              0
              
              
              
              
              
              0
              
              
              0**Diluted
                  Earnings Per****Common
                  Share**Net
                  loss applicable tocommon
                  stockholders
              
              $
              <2,817
              >
              
              40,000
              
              $
              <.07
              >
              $
              <2,482
              >
              
              40,000
              
              $
              <.06
              >




n.
      Stock
      Options





In
      accordance with SFAS No. 123, *Accounting
      for Stock-Based Compensation* and SFAS
      No. 148, *Accounting
      for Stock-Based Compensation-Transition and Disclosure* ,
      the
      Company accounts for its stock option plans under the intrinsic-value-based
      method as defined in APB No. 25, *Accounting
      for Stock Issued to Employees* .
      The
      following table illustrates the effect on net earnings and earnings per share
      if
      the Company had applied the fair value recognition provisions of SFAS No. 123
      to
      stock-based employee compensation (in thousands, except per share
      amounts):




Years
                  EndedDecember
                  31,2006
              
              2005Net
                  loss applicable to common stockholders,as
                  reported:
              
              $
              <2,817
              >
              $
              <2,482
              >Add:
                  Stock-based compensation expenserecognized
                  under the intrinsic value method
              
              
              0
              
              
              0Deduct:
                  Stock-based compensation expensedetermined
                  under fair value based method
              
              
              0
              
              
              0Pro
                  forma net loss applicable to commonstockholders
              
              $
              <2,817
              >
              $
              <2,482
              >Net
                  loss per common share:Basic
                  - as reported
              
              $
              <.07
              >
              $
              <.06
              >Basic
                  - pro forma
              
              $
              <.07
              >
              $
              <.06
              >Diluted
                  - as reported
              
              $
              <.07
              >
              $
              <.06
              >Diluted
                  - pro forma
              
              $
              <.07
              >
              $
              <.06
              >




F-11




o.
      Use of
      Estimates in the Preparation of Financial Statements





The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities and disclosure of
      contingent assets and liabilities at the date of the financial statements and
      the reported amounts of revenues and expenses during the reporting period.
      Actual results could differ from those estimates.





p.
      Recent
      Accounting Pronouncements





In
      January 2003, the
      Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46
      (revised December 2003), *Consolidation
      of Variable Interest Entities* (“FIN
      46(R)”). FIN 46(R) addresses the consolidation of business enterprises to which
      the usual condition (ownership of a majority voting interest) of consolidation
      does not apply. FIN 46(R) focuses on controlling financial interests that may
      be
      achieved through arrangements that do not involve voting interests. It concludes
      that in the absence of clear control through voting interests, a company’s
      exposure (variable interest) to the economic risks and potential rewards from
      the variable interest entity’s assets and activities are the best evidence of
      control. If an enterprise holds a majority of the variable interests of an
      entity, it would be considered the primary beneficiary. Upon consolidation,
      the
      primary beneficiary is generally required to include assets, liabilities and
      noncontrolling interests at fair value and subsequently account for the variable
      interest as if it were consolidated based on majority voting interest. As a result of FIN 46(R), effective as of December 31, 2004, the
      Company’s consolidated balance sheet includes the assets and liabilities of York
      Realty Leasing LLC.





In
      May
      2004, the FASB issued FASB Staff Position No. 106-2, *Accounting
      and Disclosure Requirements Related to the Medicare Prescription Drug,
      Improvement and Modernization Act of 2003* (FSP
      106-2)in response to a new law regarding prescription drug benefits under
      Medicare as well as a federal subsidy to sponsors of retiree healthcare benefit
      plans. We expect that the impact of this Act will not be material.




F-12







In
      November 2004, the FASB
      issued SFAS No. 151, *Inventory
      Costs - an Amendment of ARB No. 43, Chapter 4.* SFAS
      151
      clarifies the accounting for abnormal amounts of idle facility expense, freight,
      handling costs and spoilage. SFAS 151 also requires that allocation of fixed
      production overhead costs be based on normal production activity. The provisions
      of SFAS 151 are effective for inventory costs incurred beginning in January
      2006, with adoption permitted for inventory costs incurred beginning in January
      2005. Adoption of this Statement is not expected to have a material effect
      on
      the Company’s Consolidated Financial Statements.





In
      December 2004, the FASB
      issued SFAS No. 123(R), *Share-Based
      Payment.* SFAS
      123(R) establishes standards for the accounting for transactions in which an
      entity exchanges its equity instruments for goods and services. Under SFAS
      123(R), companies are no longer able to account for share-based compensation
      transactions using the intrinsic method in accordance with APB No. 25, *Accounting
      for Stock Issued to Employees* .
      Instead, companies are required to account for such transactions using a
      fair-value method and to recognize compensation expense over the period during
      which an employee is required to provide services in exchange for the award.
      In
      April 2005, the SEC delayed the effective date of SFAS 123(R) to fiscal
      years beginning after June 15, 2005. Adoption of this Statement is not
      expected to have a material effect on the Company’s Consolidated Financial
      Statements.





In
      May
      2005, the FASB
      issued SFAS No. 154, *Accounting
      Changes and Error Corrections - a Replacement of APB Opinion No. 20 and SFAS
      No.
      3.* SFAS
      154
      changes the requirements for the accounting for and reporting of a change in
      accounting principle. This Statement applies to all voluntary changes in
      accounting principle. SFAS 154 also applies to changes required by an accounting
      pronouncement in the usual instance that the pronouncement does not include
      specific transition provisions. The provisions of SFAS 154 are effective for
      accounting changes and corrections of errors made in fiscal years beginning
      after December 15, 2005. Adoption of this Statement is not expected to have
      a
      material effect on the Company’s Consolidated Financial Statements.





In
      June
      2006, the FASB
      issued FASB Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,
      Accounting for Income Taxes* (“FIN
      48”), effective for the Company beginning on January 1, 2007. FIN 48 clarifies
      the recognition threshold a tax position is required to meet before being
      recognized in the financial statements. FIN 48 also provides guidance on
      disclosure and other matters. Currently, the Company does not expect this
      guidance to have a material impact on its financial statements.





In
      September 2006, the FASB
      issued SFAS No. 157, *Fair
      Value Measurements* ,
      effective for the Company beginning on January 1, 2008. SFAS 157 defines fair
      value, establishes a framework for measuring fair value, and expands disclosures
      about fair value measurements. This statement establishes a fair value hierarchy
      that distinguishes between valuations obtained from sources independent of
      the
      entity and those from the entity’s own unobservable inputs that are not
      corroborated by observable market data. SFAS 157 expands disclosures about
      the
      use of fair value to measure assets and liabilities in interim and annual
      periods subsequent to initial recognition. The disclosures focus on the inputs
      used to measure fair value and for recurring fair value measurements using
      significant unobservable inputs, the effect of the measurements on earnings
      or
      changes in net assets for the period. The Company is currently assessing the
      impact of this guidance on its financial statements.




F-13





q.
      Reclassifications





The
      Company reclassified certain prior period financial statement balances to
      conform to current presentations.





3. Going
      Concern





As
      of
      December 31, 2006, the Company had aggregate debts and liabilities of
      $41,320,000 and had a working capital deficiency of $25,951,000. It has also
      sustained operating losses in each of the last three years. These debts and
      liabilities include $14,139,000 related to redeemable preferred stock under
      which the Company is currently in default, $7,158,000 related to a subordinated
      promissory note under which the Company is currently in default and $9,231,000
      related to a long-term payable, with all three of these amounts being owed
      to
      Health-Chem. Also included in these debts and liabilities is $7,321,000 of
      royalties due under a license agreement with Key Pharmaceuticals, Inc. (“Key”)
      which allows the Company to utilize certain technology incorporated into our
      current transdermal patch which has been accumulating since 2000. The
      Consolidated Statement of Operations for the years ended December 31, 2006
      includes $595,000 of preferred dividends expense, $875,000 of Health-Chem
      interest expense and $1,213,000 of Key royalty expense. The Company has been
      able to continue to operate by not having paid these creditors. The Company
      has
      been paying its debts and liabilities not related to Health-Chem or the license
      on a current basis from cash flow generated from operations. The Company does
      not have cash on hand to repay any of the amounts due Health-Chem or the royalty
      payment owed under the license agreement. The Company’s financial condition has
      prevented it from securing financing or obtaining loans from which it could
      repay all or a portion of the amounts due.





The
      Company is also in
      breach of the Key license agreement for failing to pay royalties as they became
      due. The Company’s default under and breach of this license agreement entitles
      the licensor to terminate the agreement. If this creditor took legal action
      against the Company, the Company would not be able to continue as a going
      concern unless there was an increase in profitability and/or an infusion of
      additional funds in order to meet these obligations for both the past amounts
      due and ongoing amounts as they became due.





The
      Company intends to continue its efforts to complete the necessary steps in
      order
      to meet its future cash flow requirements and to continue its pursuit of new
      products and contract manufacturing opportunities. Management’s plans in this
      regard include, but are not limited to, the following:




·
            Continue
                with the preliminary negotiations entered into with Key with respect
                to
                devising a plan to pay the royalties due, including possibly negotiating
                a
                new royalty agreement.





·
            Continue
                with existing projects where the Company is developing other transdermal
                products for client companies and where the Company will be the contract
                manufacturer of these products if FDA approval is
                obtained.





·
            Form
                business alliances with other pharmaceutical companies on the development
                and/or manufacturing of new
                products.





·
            Raise
                additional working capital through borrowing or through issuing
                equity.





·
            Evaluate
                new directions for the Company.




F-14




Management
      believes that actions presently being taken will need to be further realigned
      or
      otherwise amended so that the Company will be in a position to generate
      sufficient revenues to provide positive cash flows from operations and meet
      its
      obligations as they become due. However, there can be no assurance that this
      will occur. The accompanying consolidated financial statements do not include
      any adjustments that might result from the outcome of these
      uncertainties.





4. Inventories (In
      thousands)


December
                  31,2006
              
              2005Raw
                  materials
              
              $
              434
              
              $
              630Finished
                  goods and work in process
              
              
              503
              
              
              538$
              937
              
              $
              1,168





5. Property,
      Plant and Equipment





In
      December 2004, the Company sold its real property, buildings, improvements
      and
      equipment located in Emigsville, Pennsylvania to York Realty Leasing LLC, an
      affiliated company, for a sale price of $1.9 million. Concurrent with the sale,
      the Company entered into a 15-year net lease with York Realty Leasing LLC for
      the property expiring in December 2019, which can be extended by the Company
      for
      an additional five years. The agreement provides for a Company repurchase option
      at a price of $1,995,000. The base annual lease cost during the initial 15
      year
      term is $212,400, and the base lease expense for the remaining term of the
      lease
      is as follows: 2007 - $212,400; 2008 - $212,400; 2009 - $212,400; 2010 -
      $212,400; 2011 - $212,400; and 2012 and thereafter - $1,699,200. In December
      2002, the Company received an appraisal for the real property, including the
      structures and appurtenances, which appraised the market value of the property
      at $1,850,000. The proceeds from the sale were used to satisfy a $1.6 million
      first mortgage associated with the property and to substantially pay off a
      $367,500 second mortgage, a portion of which was held by related parties. Andy
      Yurowitz, the Company’s Chairman of the Board, President, Chief Executive
      Officer and a member of the Board of Directors, is a 50% owner of York Realty
      Leasing LLC. As a result of Financial Interpretation 46(R), effective as of
      December 31, 2004, the Company’s consolidated balance sheet includes the assets
      and liabilities of York Realty Leasing LLC. In December 2005, York Realty
      Leasing LLC obtained a $1.4 million mortgage on this property with a financial
      institution.




F-15





The
      Company's property, plant and equipment balances at December 31, 2006 are as
      follows (in thousands):


Land
              
              $
              120Buildings
              
              
              2,734Equipment
                  and leasehold improvements
              
              
              8,698Construction-in-progress
              
              
              92Total
                  Property, Plant and Equipment
              
              
              11,644Less
                  accumulated depreciation and amortization
              
              
              10,116Net
                  Property, Plant and Equipment
              
              $
              1,528





Depreciation
      expense for the years ended December 31, 2006 and 2005 was $316,000 and
      $316,000, respectively.





6. Other
      Liabilities (In
      thousands)





The
      Company's other liabilities balances at December 31, 2006 are as follows (in
      thousands):


Accrued
                  chargebacks
              
              $
              608Accrued
                  rebates & allowances
              
              
              194Allowance
                  for returns
              
              
              100Accrued
                  audit fees
              
              
              97Accrued
                  interest - Health-Chem
              
              
              158Accrued
                  interest on other related party debt
              
              
              59Accrued
                  interest on other debt
              
              
              9Other
              
              
              66$
              1,291





7. Long-Term
      Debt





The
      Company's long-term debt balances at December 31, 2006 are as follows (in
      thousands):


Long-term
                  payable - Health-Chem
              
              $
              9,231Subordinated
                  promissory note - Health-Chem
              
              
              7,000Mortgage
                  payable
              
              
              1,358Payable
                  to York Realty Leasing LLC members-affiliate
              
              
              666Note
                  payable
              
              
              167Subtotal
              
              
              18,422Less
                  current portion
              
              
              7,040Total
                  Long-Term Debt
              
              $
              11,382





The
      Company participates in Health-Chem’s cash management practice, wherein all cash
      requirements are borrowed from Health-Chem and all excess cash is advanced
      to
      Health-Chem. The intercompany balance was $9,231,000 at December 31, 2006.
      Interest is charged based upon the average outstanding intercompany balance
      and
      interest rate on Health-Chem’s debt. There are no provisions in place for
      repayment of these advances. Advances under this program are included in
      long-term liabilities. The average interest rate charged was 10.375% during
      2006. On August 31, 1995, Hercon issued to Health-Chem a $7,000,000, 9%
      Subordinated Promissory Note in exchange for the then outstanding borrowings
      from affiliates. The Company is required to make semi-annual interest payments
      each March and September on this note. The principal amount of $7,000,000 was
      due on March 31, 2002. In March, 2002 the Company defaulted on its obligation
      to
      repay the principal amount of $7,000,000. At December 31, 2006, the Company
      had
      accrued $157,500 with respect to the semi-annual interest payment due March
      31,
      2007.




F-16





In
      the
      spring of 2000, the Company obtained a $1.6 million loan from Mercury Capital
      Corporation at 15% interest per annum secured by a mortgage on the Company’s
      Pennsylvania facility. In December 2003, Mercury Capital Corporation assigned
      this mortgage to William Robbins. In December 2004, the Company sold its real
      property, buildings, improvements and equipment located in Emigsville,
      Pennsylvania to York Realty Leasing LLC for a sale price of $1.9 million. The
      proceeds from the sale were used to satisfy the $1.6 million first mortgage
      noted above and to substantially pay off a $367,500 second mortgage. The Company
      entered into the sale/leaseback arrangement with York Realty Leasing LLC because
      it was unable to negotiate a like transaction with an unaffiliated party. In
      December 2005, York Realty Leasing LLC obtained a $1.4 million mortgage from
      Fulton Bank. Proceeds from the mortgage were used to pay down the $1.2 million
      of member loans from William Robbins. Andy Yurowitz, the Company’s Chairman of
      the Board, President, Chief Executive Officer and a member of the Board of
      Directors, is a 50% owner of York Realty Leasing LLC. William Robbins is also
      a
      50% owner of York Realty Leasing LLC. In addition to capital contributions
      that
      Messrs. Yurowitz and Robbins made to York Realty Leasing LLC, as of December
      31,
      2006 each had loans outstanding to York Realty Leasing LLC totaling $201,000
      and
      $465,000, respectively. York Realty Leasing LLC has classified these two member
      loans of $666,000 as long-term and is accruing interest of 15% per annum on
      both
      loans. The members of York Realty Leasing LLC have provided the Company with
      documentation indicating that these loans will not have to be repaid until
      January 15, 2008. As a result of Financial Interpretation 46(R), effective
      as of
      December 31, 2004, the Company’s consolidated balance sheet includes the assets
      and liabilities of York Realty Leasing LLC, including the $666,000 member
      loans.





The
      York
      Realty Leasing LLC mortgage with Fulton Bank has payment terms of eighty three
      (83) consecutive monthly installments of principal and interest of $13,065
      commencing January 1, 2006, with one final payment of all unpaid principal
      and
      interest payable on December 1, 2012. The interest rate associated with this
      mortgage is one-half (1/2) percent over Fulton Bank’s prime rate. The average
      interest rate charged during 2006 was 8.36%. The mortgage is collateralized
      by
      the building owned by York Realty Leasing LLC. As of December 31, 2006, the
      approximate aggregate annual maturities of long-term debt for the next five
      years, which consists solely of the York Realty Leasing LLC mortgage, were:
      2007
      - $40,000; 2008 - $43,000; 2009 - $47,000; 2010 - $51,000 and 2011 - $56,000.
      Terms of the mortgage require York Realty Leasing LLC to maintain an escrow
      account at Fulton Bank. The balance in this account at December 31, 2006 was
      $201,000. Additionally, Fulton Bank does not have recourse to the Company in
      the
      event of a default on this mortgage.





The
      $167,000 note relates to the purchase of certain fixed assets. The purchase
      of
      these fixed assets was pursuant to a development, manufacturing and supply
      agreement that the Company entered into with a client company. Payment terms
      of
      the note are contingent upon certain performance criteria under the agreement.
      One such performance criteria applicable to the client company may result in
      the
      note being forgiven. We estimate the earliest that the note may need to be
      repaid is in 2008.




F-17





8. Employee
      Benefit Plan





All
      permanent, full-time non-union employees of the Company are eligible to
      participate in Health-Chem’s 401(k) Plan (the “Plan”) following six months of
      employment. The Plan allows eligible employees to defer up to 20% of their
      compensation on a pre-tax basis through contributions to the Plan. The Company
      may contribute for each participant a matching contribution equal to a
      percentage of the elective contributions made by the participants. The decision
      to make matching contributions and the amount of such contributions will be
      made
      each year by the Company. These Company matching contributions were $15,000
      and
      $14,000 in 2006 and 2005, respectively.





9. Commitments
      & Contingencies





Approximately
      thirty percent of the Company’s employees are covered by a collective bargaining
      agreement with a local unit of the Retail Wholesale and Department Store Union,
      AFL-CIO (“R.W.D.S.U.”). The R.W.D.S.U. agreement is for a three year period
      ending December 10, 2007. The contract is subject to annual renewal thereafter
      and acknowledges that the R.W.D.S.U. is the exclusive bargaining agent for
      the
      Company’s regular production employees, excluding all other employees including
      but not limited to supervisors, foremen, clerical employees, time-keepers,
      watchmen, guards, maintenance personnel and part-time employees.





Certain
      raw materials and components used in the manufacture of our products are
      available from limited sources, and, in some cases, a single source. Generally,
      regulatory authorities must approve raw material sources for transdermal
      products. Without adequate approved supplies of raw materials or packaging
      supplies, our manufacturing operations could be interrupted until another
      supplier is identified, our products approved and trading terms with it
      negotiated. We may not be able to identify an alternative supplier and any
      supplier that we do identify may not be able to obtain the requisite regulatory
      approvals in a timely manner, or at all. Furthermore, we may not be able to
      negotiate favorable terms with an alternative supplier. Any disruptions in
      our
      manufacturing operations from the loss of an approved supplier may cause us
      to
      incur increased costs and lose revenues and may have an adverse effect on our
      relationships with our partners and customers, any of which could have adverse
      effects on our business and results of operations. Our business also faces
      the
      risk that third party suppliers may supply us with raw materials that do not
      meet required specifications, which, if undetected by us, could cause our
      products to test out of specification and require us to recall the affected
      product.





We
      market
      all of our products through a single marketing representative. If we were to
      lose the services of such marketing agent for any reason or said entity does
      not
      maintain a steady demand for our product, and we are unable to identify an
      adequate replacement, our business, results of operations and financial
      condition would be materially adversely affected.





We
      rely
      on insurance to protect us from many business risks, including product
      liability, business interruption, property and casualty loss and employment
      practices liability. The cost of insurance has risen significantly in recent
      years. In response, we may increase deductibles and/or decrease certain
      coverages to mitigate these costs. There can be no assurance that the insurance
      that we maintain and intend to maintain will be adequate, or that the cost
      of
      insurance and limitations in coverage will not adversely affect our business,
      financial position or results of operations. Furthermore, it is possible that,
      in some cases, coverage may not be available at any price.





F-18





10. Redeemable
      Preferred Stock





In
      April
      1995, Health-Chem’s Board of Directors approved a plan to realign certain of its
      business operations in order to separate its transdermal pharmaceutical business
      from its then other businesses. As part of such realignment, on August 31,
      1995
      the Company issued to Herculite Products, Inc. (“Herculite”), which is a
      wholly-owned subsidiary of Health-Chem, 1,000,000 shares of the Company’s
      redeemable preferred stock, $10.00 par value, in exchange for the manufacturing
      facility in which Hercon’s operations are conducted and the 985 shares of Hercon
      common stock owned by Herculite. The Company is required to make semi-annual
      preferred dividend payments out of funds legally available each March and
      September at the annual rate of $0.70 per share on the then-outstanding shares
      of its redeemable preferred stock. Legally available funds were not available
      to
      make the 1998 through 2006 preferred dividend payments, nor were they available
      to make the required $1,000,000 redemption payments in each March for the years
      1998 through 2004. An additional required redemption payment of $1,500,000
      due
      in March 2005 was also not made due to legally available funds not being
      available to make the redemption payment. At both December 31, 2005 and 2006,
      850,000 shares of the redeemable preferred stock were still outstanding.
      Dividend expense related to this preferred stock was $595,000 in each of 2005
      and 2006. The preferred stock dividends payable balance at December 31, 2006
      was
      $5,639,000.





The
      terms
      of the preferred stock provide that if either dividends payable on the preferred
      stock shall be in default in an amount equal to two full semi-annual dividend
      payments or a mandatory redemption payment is not made, the holder of all of
      the
      outstanding shares of the preferred stock shall be entitled to elect the
      smallest number of Directors necessary to constitute a majority of the Company’s
      Board of Directors until such time as the default is cured. Health-Chem waived
      this right since, as a practical matter, it already possessed such
      power.





11. Stock
      Options





Options
      granted under the Company’s stock option plan are exercisable for up to ten
      years from the grant date. The fair value of each option grant is estimated
      on
      the date of grant using the Black-Scholes option-pricing model. The Company
      did
      not award any option grants during the years ended December 31, 2006 and 2005
      and no stock options were outstanding at December 31, 2006.





F-19




12. Taxes
      on Income (In
      thousands)


Years
                  EndedDecember
                  31,2006
              
              2005Taxes
                  on income include provision <benefit> for:Federal
                  income taxes
              
              $
              0
              
              $
              0State
                  and local income taxes
              
              
              0
              
              
              0Total
              
              $
              0
              
              $
              0Taxes
                  on income are comprised of:Current
              
              $
              0
              
              $
              0Deferred
              
              
              0
              
              
              0Total
              
              $
              0
              
              $
              0





A
      reconciliation of taxes on income to the federal statutory rate is as
      follows:


Years
                  EndedDecember
                  31,2006
              
              2005Tax
                  benefit at statutory rate
              
              $
              <830
              >
              $
              <595
              >Increase
                  <decrease> resulting from:Net
                  operating and other tax losscarryforwards
                  that expired
              
              
              0
              
              
              844State
                  and local taxes, net of federaltax
                  benefit
              
              
              <272
              >
              
              <88
              >Other
              
              
              <1
              >
              
              11Change
                  in valuation allowance
              
              
              1,103
              
              
              <172
              >Tax
                  provision <benefit>
              
              $
              0
              
              $
              0





At
      December 31, 2006, the deferred tax assets and liabilities result from the
      following temporary differences and carryforwards:


Deferred
                  tax assets:Net
                  operating and other tax losscarryforwards
              
              $
              5,909Accumulated
                  depreciation
              
              
              0Total
                  deferred tax assets
              
              
              5,909Deferred
                  tax liabilities:Accelerated
                  depreciation
              
              
              0Total
                  deferred tax liabilities
              
              
              0Net
                  deferred tax asset before valuationallowance
              
              
              5,909Valuation
                  Allowance
              
              
              <5,909
              >Net
                  deferred tax asset
              
              $
              0




F-20




The
      Company is part of a consolidated group and included in the consolidated federal
      income tax return of its parent, Health-Chem. The Company is also party to
      a Tax
      Sharing Agreement with Health-Chem. Deferred tax assets and liabilities are
      provided by the Company on a stand-alone basis for differences between the
      financial statement and tax bases of assets and liabilities that will result
      in
      future taxable or deductible amounts. The Company had a deferred tax asset
      of
      $5.9 million at December 31, 2006 as a result of its losses which may be used
      in
      the future should the consolidated group have taxable income. This deferred
      tax
      asset had an allowance reserve of $5.9 million at December 31, 2006. Therefore,
      no asset is shown as a deferred tax asset as of December 31, 2006 as a result
      of
      the losses not being used by the Company’s parent to offset any taxes due for
      2006 since the consolidated group showed a loss for 2006 and has net operating
      loss carryforwards. These net operating loss carryforwards expire in various
      years through 2027. The Company and its subsidiary file a stand-alone return
      for
      state purposes. At December 31, 2006, the Company had approximately $17.9
      million of net operating loss carryforwards in various states in which the
      Company and its subsidiary operate which are available to absorb allocated
      portions of future taxable income for state tax purposes. The state operating
      loss carryforwards expire in various years through 2027. At December 31, 2006,
      valuation allowance relating to tax loss carryforwards was
      $5,909,000.





13. Interest,
      Net (In
      thousands)


Years
                  EndedDecember
                  31,2006
              
              2005Interest
                  expense:Subordinated
                  promissory note - Health-Chem
              
              $
              630
              
              $
              630Long-term
                  payable - Health-Chem
              
              
              245
              
              
              223York
                  Realty Leasing LLC mortgage
              
              
              115
              
              
              0York
                  Realty Leasing LLC members
              
              
              100
              
              
              267Other
              
              
              3
              
              
              6Total
                  interest expense
              
              
              1,093
              
              
              1,126Interest
                  income
              
              
              47
              
              
              0Interest,
                  net
              
              $
              1,046
              
              $
              1,126
 
 
 F-21


14. Related
      Party Transactions





The
      consolidated financial statements include the following items applicable to
      related parties at December 31, 2006 (in thousands):


Balance
                  Sheet:Property,
                  plant and equipment, net
              
              
              
              
              $
              1,101Payable
                  to York Realty Leasing LLC members(See
                  Note 7)
              
              
              
              
              
              666Accrued
                  interest on other related party debt
              
              
              
              
              
              59Due
                  to Parent - Health-Chem:Accrued
                  interest (See Note 7)
              
              
              
              
              
              158Subordinated
                  promissory note (See Note 7)
              
              
              
              
              
              7,000Redeemable
                  preferred stock (See Note 10)
              
              
              
              
              
              8,500Preferred
                  stock dividend payable (See Note 10)
              
              
              
              
              
              5,639Long-term
                  payable (See Note 7)
              
              
              
              
              
              9,231Years
                  EndedDecember
                  31,2006
              
              
              2005Income
                  Statements:Allocation
                  of Parent’s administrative costs(See
                  Note 2l)
              
              $
              459
              
              $
              348Interest
                  expense (See Note 13):Subordinated
                  promissory note - Health-Chem
              
              
              630
              
              
              630Long-term
                  payable - Health-Chem
              
              
              245
              
              
              223York
                  Realty Leasing LLC members
              
              
              100
              
              
              267Preferred
                  dividends (See Note 10)
              
              
              595
              
              
              595




Accrued
      interest on other related party debt





In
      December 2004, the Company sold its real property, buildings, improvements
      and
      equipment located in Emigsville, Pennsylvania to York Realty Leasing LLC for
      a
      sale price of $1.9 million. The Company entered into the sale/leaseback
      arrangement with York Realty Leasing LLC because it was unable to negotiate
      a
      like transaction with an unaffiliated party. Andy Yurowitz, the Company’s
      Chairman of the Board, President, Chief Executive Officer and a member of the
      Board of Directors, is a 50% owner of York Realty Leasing LLC. William Robbins
      is also a 50% owner of York Realty Leasing LLC. In addition to capital
      contributions that Messrs. Yurowitz and Robbins made to York Realty Leasing
      LLC,
      as of December 31, 2006 each had loans outstanding to York Realty Leasing LLC
      totaling $201,000 and $465,000, respectively. York Realty Leasing LLC has
      classified these two member loans of $666,000 as long-term and is accruing
      interest of 15% per annum on both loans. At December 31, 2006, the York Realty
      Leasing LLC members were owed interest of $59,000 with respect to these
      loans.





F-22




15. Minority
      Interest





As
      a
      result of Financial Interpretation 46(R), effective as of December 31, 2004,
      the
      Company’s consolidated balance sheet includes the assets and liabilities of York
      Realty Leasing LLC. Andy Yurowitz and William Robbins are each 50% owners of
      York Realty Leasing LLC. As of December 31, 2006 and 2005, each had contributed
      $5,500 in capital to York Realty Leasing LLC. In 2005, York Realty Leasing
      LLC
      sustained a loss of $147,000 of which $11,000 was allocated to the stockholders
      of the LLC. This eliminated their cash investment as of December 31,
      2005.





A
      former
      president of Hercon Laboratories Corporation maintains a 1.5% interest in Hercon
      Laboratories Corporation.





16. Quarterly
      Results of Operations (Unaudited)





First
            
            Second
            
            Third
            
            FourthQuarter
            
            Quarter
            
            Quarter
            
            Quarter(in
                thousands, except per share data)2006Net
                sales
            
            $
            1,619
            
            $
            1,300
            
            $
            1,792
            
            $
            1,229Net
                loss applicableto
                common stockholders
            
            $
            <454
            >
            $
            <448
            >
            $
            <689
            >
            $
            <1,226
            >Net
                loss percommon
                share
            
            $
            <.011
            >
            $
            <.011
            >
            $
            <.017
            >
            $
            <.031
            >Diluted
                net loss percommon
                share
            
            $
            <.011
            >
            $
            <.011
            >
            $
            <.017
            >
            $
            <.031
            >2005Net
                sales
            
            $
            1,474
            
            $
            2,224
            
            $
            1,893
            
            $
            1,995Net
                loss applicableto
                common stockholders
            
            $
            <182
            >
            $
            <402
            >
            $
            <326
            >
            $
            <1,572
            >Net
                loss percommon
                share
            
            $
            <.005
            >
            $
            <.010
            >
            $
            <.008
            >
            $
            <.039
            >Diluted
                net loss percommon
                share
            
            $
            <.005
            >
            $
            <.010
            >
            $
            <.008
            >
            $
            <.039
            >





The
      above
      financial data may not total to the results indicated on the Company’s financial
      statements.




F-23