**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, 2005





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
              (Address
                of principal executive
                offices)
            17318
              (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:  $7,586,000





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). o  Yes x  No




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
      February 13, 2007.




**DOCUMENTS
      INCORPORATED BY REFERENCE**




None.





Transitional
      Small Business Disclosure Format (Check one):  o  Yes  x  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
              
              F-1ITEM
                  8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                  AND
                  FINANCIAL DISCLOSURE
              
              44ITEM
                  8A. CONTROLS AND PROCEDURES
              
              44ITEM
                  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, 2005 ("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 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. This Annual Report
      covers the year ended December 31, 2005 and includes audited financial
      statements for the year then ended but also includes information through a
      recent practicable date with respect to certain topics we believe are of
      particular importance to readers, such as information with respect to the
      business of Transderm and its directors, executive officers and principal
      stockholders. To the extent this Annual Report references financial information
      relating to 2006, said information is drawn from internally prepared financial
      statements and has not been audited, as noted in each case where reference
      to
      that information is made.





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, is 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 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 have increased in 4 of the last 5 years
      during the period 2001 through 2005 (the financial information for the years
      2001 and 2002 is unaudited), net revenues decreased significantly during the
      2005 period as a result of a decline in orders 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,
      2005 had total liabilities of nearly $40 million and an accumulated deficit
      of
      $32.8 million.





At
      December 31, 2005, the
      Company liabilities included approximately (i) $ 6.1
      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 six years
      (the “Key Royalty”), and (ii) $29 million owed to Health Chem, including $13.5
      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 $8.3 million related to a long-term
      payable (each of which items is more fully described under “Management
      Discussion and Analysis of Financial Condition and Results of Operations” and in
      the notes to the Financial Statements and are herein collectively referred
      to as
      the “Intercompany Obligations”). At December 31, 2006, the Group’s total
      outstanding debts
      and
      liabilities (excluding
      the Intercompany Obligations) were
      estimated at approximately $22.3 million (unaudited).





Transderm’s
      current financial condition negatively impacts its day-to-day operations and
      undermines its ability to grow its business. In addition, Health-Chem’s
      outstanding total liabilities at December 31, 2005 of approximately $21.9
      million, including $10.8 million of principal and interest due under certain
      debentures under which it has been in default since April 1999, also bear on
      Transderm’s current and future prospects because Transderm’s financing options
      will be limited by Health-Chem’s debt. Accordingly, Transderm’s ability to
      return to profitability from the precarious financial condition which it has
      suffered 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 financial condition leaves them vulnerable because:





·
            the
                capital deficiency prevents the Group from diversifying operations
                by
                developing new products and reducing reliance on revenues generated
                from
                sales of a single product;





·
            their
                obligations and liabilities do not allow them to obtain financing
                for
                operations;





·
            the
                condition makes 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




-6-




·
            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, 2005 and 2006 we owed aggregate royalties to Key of approximately
      $6,108,000 and $7,315,000 (unaudited), respectively. 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 cash sufficient to resume our research and development
      activities, we expect that our primary strategy will be to identify generic
      drugs which
      can
      be delivered
      transdermally, which
      are
      suitable for transdermal delivery, 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 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, 2005, 2004 and 2003, we spent $438,000, $414,000
      and $418,000, 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 because we
      do
      not possess the appropriate equipment or outsourcing is more economically
      efficient if the test is not of a routine nature.




-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. Any interruption of supply could have a material
      adverse effect on the Company's ability to manufacture its
      products.





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,
      2003, 2004 and 2005, 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 pending or 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 two 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 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, 2005 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, 2005:**





·
            **Transderm
                had aggregate liabilities of approximately $39 million comprised
                of $10
                million to unrelated parties, including $6.1 million of royalties
                due
                under the Key License of which we are in breach (the “Key Royalty”) and
                $29 million owed to Health-Chem in respect of intercompany accounts
                (the
                “Intercompany Obligations” and collectively with of Transderm’s
                liabilities, the “Transderm
                Liabilities”);**





·
            **Transderm
                had a working capital deficiency of approximately $24.2 million;
                and**





·
            **the
                Group had aggregate debts and liabilities of approximately $21,901,000
                (the “Group Liabilities”), including $10,830,000 under the Debentures
                under which Health-Chem currently is in
                default.**





**As
      of December 31, 2006, we estimate:**





·
            **Transderm
                had aggregate liabilities of approximately $41.3 million, including
                $10.1
                million to unrelated parties and $31.2 million of intercompany
                liabilities; and**





·
            **the
                Group had aggregate liabilities of approximately $22.3 million, including
                $11,463,000 under the Debentures.**





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.*




-18-





Transderm’s
      audited consolidated financial statements for the year ended December 31, 2005
      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, 2005, particularly
                the amounts due to Health-Chem and Key, which it is unable to
                satisfy;





·
            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 $32.8 million at
      December 31, 2005 .
      In
      addition, we had a working capital deficit of approximately $24.2 million at
      December 31, 2005.





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 the conditions cited by the auditor
      in its report, 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.




-19-





*Health-Chem’s
      ability to achieve financial stability will bear on Transderm’s financial
      condition, ability to continue to operate as a going concern and achieve
      profitability. 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.*





As
      stated
      in the footnotes to the audited consolidated financial statement included in
      Health-Chem’s annual report for the year ended December 31, 2005 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 $10.8 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 the Trustee has not
      pursued legal redress to obtain the payment due. Health-Chem has approached the Trustee to negotiate a payment plan 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 Trustee, it 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 additional 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.




-20-




*Even
      if the Group concludes favorable agreements to pay its, 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.





*Transderm’s
      Intercompany Obligations to Health-Chem are approximately $29 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 $29 million in intercompany obligations 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. We do not expect to file any quarterly reports for the years
      1999
      through 2006, though we expect to file an annual report for 2006 as soon as
      practicable after the preparation of audited financial information for such
      period. 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 shareholders. 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 security holders 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 shareholders 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.




-21-





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





**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 six 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, 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 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 shareholders in our company may lose all or part of their
      investment.




-22-





*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. 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.





*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, 2005 and 2004, a significant portion
      of
      our revenues were derived from a small number of customers. In 2005, two
      customers accounted for approximately 55% of our revenues and these customers
      accounted for approximately 53% of our revenues during fiscal 2004. During
      2005,
      orders from one of our principal customers decreased by 44% 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 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
      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 was not as successful in its sales
      efforts, our business and results of operations would be adversely
      affected.*





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
      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 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 such product at levels anticipated prior to embarking on such development,
      our business, financial condition and results of operations would be materially
      adversely affected.




-24-




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 generic
      drugs, 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.





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 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 and product candidates could limit our
      potential product revenue.*




-25-





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.





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 receive
      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.*




-26-


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.





*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.*




-27-





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.





*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.*




-28-





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.





*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.




-29-





*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.





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.


Quarter
              
              2006
              
              2005
              
              2004High
              
              Low
              
              High
              
              Low
              
              High
              
              Low1st
              
              $
              0.0001
              
              $
              0.0001
              
              $
              0.0001
              
              $
              0.0001
              
              $
              0.0001
              
              $
              0.00012nd
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.00013rd
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.001
              
              
              0.00014th
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001
              
              
              0.0001


-30-




As
      of
      February 13, 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 AND RESULTS
                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 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$6,1
                million at December 31, 2005 and $7.3 million at December 31, 2006
                (unaudited);





·
            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, 2005, we had a working capital deficiency of $24.2
                million;





·
            as
                of December 31, 2005, we had aggregate liabilities of approximately
                $39
                million, comprised of liabilities of $10 million to third parties
                (including $6.1 million under the Key License) and liabilities in
                favor of
                Health-Chem of $29 million; and





·
            as
                of December 31, 2005, Health-Chem had aggregate liabilities of
                approximately $21.9 million, including $10.8 million under the
                Debentures,
                which cast doubt on its ability to continue to operate as a going
                concern.





During
      the year ended December 31, 2005, our operating results declined over the prior
      year. When comparing 2005 to 2004, net sales decreased by 17% from nearly $9.2
      million to $7.6 million. Management attributes the decrease in net sales for
      the
      years 2004 to 2005 to a decline in orders from our largest customer. The
      decrease in net sales reduced our gross profit from $2.9 million to $1.1
      million. As a result, we experienced a net loss of $2.5 million during 2005
      compared to a net loss of $598,000 in 2004.





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.




-32-





Intercompany
      Accounts .





As
      of
      December 31, 2005, Transderm owed Health-Chem an aggregate of $29 million,
      representing nearly 75% 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 redeemd 150,000 of the shares as required by their
                terms and
                currently remains obligated to redeem the remaining outstanding 850,000
                shares. As of December 31, 2005, the preferred stock has an aggregate
                liability of $13.5 million, which consists of $8.5 million of principal
                and accumulated dividends of $5
                million.





·
            Transderm
                participates in Health-Chem’s cash management practices, wherein all cash
                requirements are borrowed from Health-Chem and all excess cash is
                advanced
                to Health-Chem. The intercompany balance was $8,280,000 at December
                31,
                2005. Transderm pays interest on the amount due at a rate 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
                2005. 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 the note since March 2002 (after giving effect to
                Health-Chem’s extension of the note). As of December 31, 2005 and 2006,
                Transderm carried on its books an amount due to Health-Chem under
                the
                terms of this promissory note $7,000,000 and $7,000,000, respectively.
                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 $348,000 and $229,000
                for the
                years ended December 31, 2005 and 2004, 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.




-33-





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.





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
      company .




-34-





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.





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 5 years, the Company has reported a net
      loss in each of those years. Moreover, at December 31, 2005 the Company had
      a
      capital deficiency of $32.8
      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;




-35-




·
            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





·
            other
                events or general economic conditions 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.




-36-





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 55% of the sales volume of our patch
      during 2005. 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.





Results
      of Operations .





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 17% during
      the
      2005 period. This decrease is due primarily to a single customer who purchased
      approximately 44% less transdermal nitroglycerin patches in 2005 as compared
      to
      the quantity purchased in 2004.





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 $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 $.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 $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.





Year
      ended December 31, 2004 versus December 31, 2003




-37-





For
      the
      year ended December 31, 2004, our net sales were $9.2 million consisting
      solely of transdermal nitroglycerin patches. For the 2003 year, our net sales
      were $7.9 million, comprised solely of net sales of transdermal nitroglycerin
      patches. Net sales of transdermal nitroglycerin patches increased 16% during
      the
      2004 period. This increase is due primarily to a single customer who purchased
      approximately 84% more transdermal nitroglycerin patches in 2004 as compared
      to
      the quantity purchased in 2003.





Product
      development income was $239,000 for the twelve months ended December 31, 2004
      as
      compared to $31,000 for the same period in 2003. The $208,000 increase is due
      primarily to additional development work income associated with a contract
      signed in June 2004.





Gross
      profit increased $1.0 million, or 54%, to $2.9 million for the twelve months
      ended December 31, 2004 as compared to $1.9 million for the same period in
      2003.
      Gross profit as a percent of sales increased from 24% during 2003 to 32% during
      2004. The increase in gross profit was due primarily to increased sales volumes
      of higher margin products.





Selling,
      general and administrative expenses decreased $.2 million, or 12%, to $1.7
      million for the twelve months ended December 31, 2004 as compared to $1.9
      million for the same period in 2003. The decrease is due primarily to lower
      factor expenses.




Research
      and development expenses for the twelve months ended December 31, 2004 were
      $414,000, essentially the same as for the 2003 period.





Net
      interest expense for the twelve months ended December 31, 2004 was $1.1 million,
      virtually unchanged from the 2003 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
      2005, we incurred a net loss applicable to common stockholders of $2,482,000
      whereas during 2004 our net loss applicable to common stockholders was $598,000.
      Our total capital deficiency at December 31, 2005 was $32.8 million as compared
      to December 31, 2004 when our total capital deficiency was $30.3 million. As
      of
      December 31, 2005, we had an accumulated deficit of approximately $32.8
      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, 2005, our available cash totaled approximately $759,000 compared
      to
      $851,000 at December 31, 2004. We have no borrowing capacity and as
      of
      December 31, 2005 we had debts and liabilities to third parties of approximately
      $10 million (including $6.1 million under the Key License) and to Health-Chem
      (which owns 90% of our outstanding shares of common stock) of approximately
      $29
      million.





Our
      working capital deficit increased by approximately $2.3 million to $24.2 million
      from December 31, 2004 to December 31, 2005 due principally to a decrease of
      $.4
      million in current assets, consisting primarily of decreases in cash, accounts
      receivable, amounts due from financing agency and inventory, of $.1 million,
      $.1
      million, $.1 million and $.1 million, respectively, and to an increase of $1.9
      million in current liabilities, consisting primarily of increases in royalties
      payable, preferred stock dividends payable and other liabilities, of $1.6
      million, $.6 million and $.5 million, respectively, partially offset by a
      decrease in accounts payable of $.8 million. The decrease in accounts receivable
      resulted from a decrease in sales in the month of December 2005 as compared
      to
      the month of December 2004 and also reflects the timing of customer payments.
      The decrease in due from financing agency is due to the Company terminating
      its
      relationship with the financing agency in April 2005. 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 increase is due primarily to increases in accrued
      chargebacks and trade show discounts.




-38-





Cash
      used
      for operating activities for the twelve months ended December 31, 2005 was
      $154,000, as compared to cash provided by operating activities of $101,000
      for
      the same period in 2004. The decrease is due primarily 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 as compared
      to
      the $.6 million net loss applicable to common stockholders and increasing
      accounts receivable, inventory, accounts payable, royalties payable and other
      liabilities of $2.1 million, $.5 million, $.4 million, $1.6 million and $.4
      million, respectively, in 2004. Investing activities for the twelve months
      ended
      December 31, 2005 used cash of $87,000 as compared to the same period in 2004
      which used cash of $279,000. This decrease in use of cash is due to lower
      additions to property, plant and equipment for 2005. Financing activities for
      the twelve months ended December 31, 2005 provided $149,000 of cash as compared
      to the same period in 2004 which provided $566,000 of cash.





As
      of
      December 31, 2005, we owed an aggregate of $6.1 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 2006 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. At December
      31,
      2006, the Company estimates that it had expended approximately $125,000 for
      capital expenditures for property, plant and equipment in 2006.





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, 2005
      (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)
              
              $
              8,280
              
              
              
              
              
              
              
              
              
              
              $
              8,280Note
                  Payable toSubsidiary
                  of Health-Chem(2)
              
              
              7,000
              
              $
              7,000Amount
                  due to holderof
                  preferred stock(3)
              
              
              13,544
              
              
              13,544Royalties
                  owed to Key(4)
              
              
              6,108
              
              
              6,108Sale/Leaseback
                (Operating
                  Lease)(5)
              
              
              2,974
              
              
              212
              
              $
              425
              
              $
              425
              
              
              1,912Long-term
                  Debt(6)
              
              
              167
              
              
              
              
              
              
              
              
              167Total
              
              $
              38,073
              
              $
              26,864
              
              $
              425
              
              $
              592
              
              $
              10,192


(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% and 11.34% during 2005 and 2004, respectively.





(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 $13,544,000 consists of
      $8,500,000 required to redeem the preferred stock and $5,044,000 of accrued
      dividends.




-40-





(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.





(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 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 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;





·
            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 $1,745,000 and $1,267,000 at December 31,
      2005 and 2004, respectively, 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 will no longer be 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 will be 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. Management is currently assessing the
      impact that adoption of this Statement will have 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.





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




Index
        to
        Consolidated Financial Statements.
 
 PAGEReport
                  of Independent Registered Public Accounting Firm
              
              F-2Consolidated
                  Balance Sheets - December 31, 2005 and 2004
              
              F-3Consolidated
                  Statements of OperationsYears
                  Ended December 31, 2005, 2004 and 2003
              
              F-4Consolidated
                  Cash Flow StatementsYears
                  Ended December 31, 2005, 2004 and 2003
              
              F-5Consolidated
                  Statements of Stockholders’ DeficiencyYears
                  Ended December 31, 2005, 2004 and 2003
              
              F-6Notes
                  to Consolidated Financial Statements
              
              F-7
                  to F-25
  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, 2005 and 2004 and the related consolidated statements
      of operations, cash flows, and stockholders’ deficiency for each of
      the years in the three-year period ended December 31, 2005. 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, 2005 and 2004, and the consolidated
          results of their operations and their cash flows for each of the years
          in the
          three-year period ended December 31, 2005, 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/s
          DEMETRIUS & COMPANY, L.L.C.
 Wayne,
          New Jersey
 February
          27, 2007
 F-2
 TRANSDERM
        LABORATORIES CORPORATION
 CONSOLIDATED
        BALANCE SHEETS
 (In
        thousands)
  December
                  31,2005
              
              2004ASSETSCURRENT
                  ASSETSCash
              
              $
              759
              
              $
              851Accounts
                  receivable - net
              
              
              2,908
              
              
              2,962Due
                  from financing agency
              
              
              0
              
              
              110Inventories
              
              
              1,168
              
              
              1,302Other
                  current assets
              
              
              24
              
              
              23Total
                  Current Assets
              
              
              4,859
              
              
              5,248PROPERTY,
                  PLANT AND EQUIPMENT, net
              
              
              1,718
              
              
              1,947MORTGAGE
                  ESCROW DEPOSIT
              
              
              200
              
              
              0OTHER
                  NON-CURRENT ASSETS
              
              
              0
              
              
              44TOTAL
                  ASSETS
              
              $
              6,777
              
              $
              7,239LIABILITIES
                  AND STOCKHOLDERS’ DEFICIENCYCURRENT
                  LIABILITIESAccounts
                  payable
              
              $
              280
              
              $
              1,101Royalties
                  payable
              
              
              6,108
              
              
              4,522Other
                  liabilities
              
              
              2,119
              
              
              1,597Current
                  portion of long-term debt
              
              
              42
              
              
              0Subordinated
                  promissory note
              
              
              7,000
              
              
              7,000Redeemable
                  preferred stock
              
              
              8,500
              
              
              8,500Preferred
                  stock dividends payable
              
              
              5,044
              
              
              4,449Total
                  Current Liabilities
              
              
              29,093
              
              
              27,169LONG-TERM
                  LIABILITIES
              
              
              10,471
              
              
              10,245COMMITMENTSMINORITY
                  INTEREST
              
              
              0
              
              
              130PREFERRED
                  STOCK
              
              
              0
              
              
              0STOCKHOLDERS’
                  DEFICIENCYCommon
                  stock, par value $.001 per share;60,000,000
                  shares authorized; 40,000,000shares
                  issued and outstanding in 2005 and 2004
              
              
              40
              
              
              40Accumulated
                  deficit
              
              
              <32,827>
              
              
              <30,345>Total
                  Stockholders’ Deficiency
              
              
              <32,787>
              
              
              <30,305>TOTAL
                  LIABILITIES AND STOCKHOLDERS’ DEFICIENCY
              
              $
              6,777
              
              $
              7,239
 
 See
        Notes to Consolidated Financial
        Statements.
 
 F-3
  TRANSDERM
        LABORATORIES CORPORATION
 CONSOLIDATED
        STATEMENTS OF OPERATIONS
 (In
        thousands, except per share amounts)
 
 Years
                    Ended December 31,2005
                
                2004
                
                2003REVENUE:Net
                    sales
                
                $
                7,586
                
                $
                9,192
                
                $
                7,896Cost
                    of goods sold - royalties
                
                
                1,586
                
                
                1,594
                
                
                1,518Cost
                    of goods sold - other
                
                
                4,861
                
                
                4,654
                
                
                4,469Total
                    cost of goods sold
                
                
                6,447
                
                
                6,248
                
                
                5,987Gross
                    profit
                
                
                1,139
                
                
                2,944
                
                
                1,909OPERATING
                    EXPENSES:Selling,
                    general and administrative
                
                
                1,822
                
                
                1,706
                
                
                1,933Research
                    and development
                
                
                438
                
                
                414
                
                
                418Interest
                
                
                1,126
                
                
                1,121
                
                
                1,124Total
                    operating expenses
                
                
                3,386
                
                
                3,241
                
                
                3,475LOSS
                    FROM OPERATIONS
                
                
                <2,247
                >
                
                <297
                >
                
                <1,566
                >Product
                    development income
                
                
                349
                
                
                239
                
                
                31Other
                    income <expense> - net
                
                
                0
                
                
                55
                
                
                0LOSS
                    FROM OPERATIONS BEFORE TAXESAND
                    MINORITY INTEREST
                
                
                <1,898
                >
                
                <3
                >
                
                <1,535
                >Minority
                    interest
                
                
                11
                
                
                0
                
                
                0Income
                    tax benefit
                
                
                0
                
                
                0
                
                
                0NET
                    LOSS
                
                
                <1,887
                >
                
                <3
                >
                
                <1,535
                >PREFERRED
                    DIVIDENDS
                
                
                595
                
                
                595
                
                
                595NET
                    LOSS APPLICABLE TO COMMON STOCKHOLDERS
                
                $
                <2,482
                >
                $
                <598
                >
                $
                <2,130
                >Loss
                    per common share (basic & diluted):LOSS
                    PER COMMON SHARE
                
                $
                <.06
                >
                $
                <.01
                >
                $
                <.05
                >Average
                    number of common sharesoutstanding:
                    (in thousands)Basic
                
                
                40,000
                
                
                40,000
                
                
                40,000Diluted
                
                
                40,000
                
                
                40,000
                
                
                40,000
 See
        Notes
        to Consolidated Financial Statements.
 
 F-4
  TRANSDERM
        LABORATORIES CORPORATION
 CONSOLIDATED
        CASH FLOW STATEMENTS
 (In
        thousands)
 Years
                    Ended December 31,2005
                
                2004
                
                2003**CASH
                    FLOWS FROM OPERATING ACTIVITIES:**Net
                    loss applicable to common stockholders
                
                $
                <2,482
                >
                $
                <598
                >
                $
                <2,130
                >Adjustments
                    to reconcile net loss to net cashprovided
                    by operating activities:Depreciation
                    and amortization
                
                
                316
                
                
                326
                
                
                381Preferred
                    stock dividends payable
                
                
                595
                
                
                595
                
                
                595Loss
                    on disposal of property, plant & equipment
                
                
                0
                
                
                0
                
                
                5Minority
                    interest
                
                
                <11
                >
                
                0
                
                
                0Changes
                    in:Accounts
                    receivable
                
                
                54
                
                
                <2,095
                >
                
                <649
                >Due
                    from financing agency
                
                
                110
                
                
                59
                
                
                <36
                >Inventories
                
                
                134
                
                
                <536
                >
                
                <170
                >Other
                    current assets
                
                
                <1
                >
                
                2
                
                
                <3
                >Mortgage
                    escrow deposit
                
                
                <200
                >
                
                0
                
                
                0Other
                    non-current assets
                
                
                44
                
                
                <44
                >
                
                0Accounts
                    payable
                
                
                <821
                >
                
                428
                
                
                155Royalties
                    payable
                
                
                1,586
                
                
                1,594
                
                
                1,518Other
                    liabilities
                
                
                522
                
                
                370
                
                
                431Net
                    cash <used for> provided by operatingactivities
                
                
                <154
                >
                
                101
                
                
                97**CASH
                    FLOWS FROM INVESTING ACTIVITIES:**Additions
                    to property, plant and equipment
                
                
                <87
                >
                
                <279
                >
                
                <38
                >Net
                    cash used for investing activities
                
                
                <87
                >
                
                <279
                >
                
                <38
                >**CASH
                    FLOWS FROM FINANCING ACTIVITIES:**Borrowings
                    from affiliates, net
                
                
                <62
                >
                
                500
                
                
                158Long-term
                    debt proceeds
                
                
                1,400
                
                
                1,903
                
                
                0Long-term
                    debt payments
                
                
                <1,200
                >
                
                <1,967
                >
                
                <150
                >Minority
                    interest contributions
                
                
                11
                
                
                130
                
                
                0Net
                    cash provided by financing activities
                
                
                149
                
                
                566
                
                
                8**NET
                    <DECREASE> INCREASE IN CASH**
                
                
                <92
                >
                
                388
                
                
                67Cash
                    at beginning of year
                
                
                851
                
                
                463
                
                
                396Cash
                    at end of year
                
                $
                759
                
                $
                851
                
                $
                463Supplemental
                    Disclosures of Cash Flow Information:Cash
                    paid during the year for:Interest
                
                $
                248
                
                $
                359
                
                $
                260Income
                    taxes
                
                
                0
                
                
                0
                
                
                0Supplemental
                    Disclosures of Non-Cash FinancingActivities:Conversion
                    of members’ capital to long-termdebt
                
                $
                130
                
                $
                0
                
                $
                0
 
 See
        Notes
        to Consolidated Financial Statements.
  F-5
  TRANSDERM
        LABORATORIES CORPORATION
 CONSOLIDATED
        STATEMENTS OF STOCKHOLDERS’ DEFICIENCY
 YEARS
        ENDED DECEMBER 31, 2005, 2004 AND 2003
 (In
        thousands)
 Common
                    Stock
                
                Accumulated
                    Deficit
                
                TotalBalance,
                    January 1, 2003
                
                $
                40
                
                $
                <27,617
                >
                $
                <27,577
                >Net
                    loss
                
                
                
                
                
                <1,535
                >
                
                <1,535
                >Preferred
                    dividends
                
                
                
                
                
                <595
                >
                
                <595
                >Balance,
                    December 31, 2003
                
                
                40
                
                
                <29,747
                >
                
                <29,707
                >Net
                    loss
                
                
                
                
                
                <3
                >
                
                <3
                >Preferred
                    dividends
                
                
                
                
                
                <595
                >
                
                <595
                >Balance,
                    December 31, 2004
                
                
                40
                
                
                <30,345
                >
                
                <30,305
                >Net
                    loss
                
                
                
                
                
                <1,887
                >
                
                <1,887
                >Preferred
                    dividends
                
                
                
                
                
                <595
                >
                
                <595
                >Balance,
                    December 31, 2005
                
                $
                40
                
                $
                <32,827
                >
                $
                <32,787
                >
 See
        Notes
        to Consolidated Financial Statements.
 
 F-6
  TRANSDERM
        LABORATORIES CORPORATION
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 YEARS
        ENDED DECEMBER 31, 2005, 2004 AND 2003
 
 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 80% and 78% of the accounts receivable balances
        represent amounts due from two customers at December 31, 2005 and 2004,
        respectively.
 
 The
        percentage of sales to each major customer who was responsible for 10% or
        more
        of the total revenues is as follows:
 Years
                    Ended December 31,2005
                
                2004
                
                2003Customer
                    A
                
                
                13
                %
                
                23
                %
                
                15
                %Customer
                    B
                
                
                42
                %
                
                30
                %
                
                34
                %
 
 At
        December 31, 2005 and 2004, accounts receivable of approximately $2,340,000
        and
        $2,333,000, respectively were 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, 2005, 2004 and 2003.
 
 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.
 
 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.
 
 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.
  F-8
 
 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 2005, 2004 and 2003.
  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
        agreement, as amended, provided for a maximum amount of financing availability
        of $1.5 million. Under this agreement, the Company sold, on a revolving basis,
        an undivided percentage ownership in certain accounts receivable. As existing
        receivables were collected, undivided interests in new eligible receivables
        were
        sold. The Company sold accounts receivable of $0 and $3,091,000 to Bay View
        Funding during 2005, and 2004, respectively. The amounts due from the factor
        were $0 and $110,000 at December 31, 2005 and 2004, respectively. Accounts
        that
        became 90 days past due were no longer eligible to be sold and the Company
        had
        to repurchase the receivable. The Company addresses the risk of loss associated
        with these repurchased receivables in its allowance for doubtful accounts.
        Expenses incurred under this factoring program totaling $43,000, $132,000
        and
        $243,000 for 2005, 2004 and 2003, respectively, are included on the selling,
        general and administrative expense line in the Consolidated Statements of
        Operations. 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.
 
 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 approximately $8,280,000 and
        $8,342,000 at December 31, 2005 and 2004, respectively. 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% and 11.34%
        during 2005 and 2004, respectively. 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.
  F-10
 
 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 $348,000, $229,000
        and
        $393,000 for 2005, 2004 and 2003, 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.
 
 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, 2005, 2004 and 2003 is presented below
        (in
        thousands, except per share amounts):
 
 F-11
 
 2005
                
                2004
                
                2003Income
                  (Numer-
                    ator)
                
                Shares
                  (Denom-
                    inator)
                
                Per
                    Amount Share
                
                Income
                  (Numer-
                    ator)
                
                Shares
                  (Denom-
                    inator)
                
                Per
                    Share Amount
                
                Income(Numer-
                    ator)
                
                Shares
                  (Denom-
                    inator)
                
                Per
                  Share
                  AmountNet
                    loss
                
                $
                <1,887
                >
                
                
                
                
                
                
                $
                <3
                >
                
                
                
                
                
                
                $
                <1,535
                >Preferred
                    stock dividends
                
                
                <595
                >
                
                
                
                
                
                
                
                <595
                >
                
                
                
                
                
                
                
                <595
                >**Basic
                    Earnings Per Common Share**Net
                    loss applicable to common stock- holders
                
                
                <2,482
                >
                
                40,000
                
                $
                <.06
                >
                
                <598
                >
                
                40,000
                
                $
                <.01
                >
                
                <2,130
                >
                
                40,000
                
                $
                <.05
                >**Effect
                    of Dilutive Securities**Stock
                    options
                
                
                0
                
                
                0
                
                
                
                
                
                0
                
                
                0
                
                
                
                
                
                0
                
                
                0**Diluted
                    Earnings Per Common Share**Net
                    loss applicable to common stock- holders
                
                $
                <2,482
                >
                
                40,000
                
                $
                <.06
                >
                $
                <598
                >
                
                40,000
                
                $
                <.01
                >
                $
                <2,130
                >
                
                40,000
                
                $
                <.05
                >
 
 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):
 
 
 F-12
  Years
                    Ended December 31,2005
                
                2004
                
                2003Net
                    loss applicable to common stockholders,as
                    reported:
                
                $
                <2,482
                >
                $
                <598
                >
                $
                <2,130
                >Add:
                    Stock-based compensation expenserecognized
                    under the intrinsic value method
                
                
                0
                
                
                0
                
                
                0Deduct:
                    Stock-based compensation expensedetermined
                    under fair value based method
                
                
                0
                
                
                0
                
                
                0Pro
                    forma net loss applicable to commonstockholders
                
                $
                <2,482
                >
                $
                <598
                >
                $
                <2,130
                >Net
                    loss per common share:Basic
                    – as reported
                
                $
                <.06
                >
                $
                <.01
                >
                $
                <.05
                >Basic
                    – pro forma
                
                $
                <.06
                >
                $
                <.01
                >
                $
                <.05
                >Diluted
                    – as reported
                
                $
                <.06
                >
                $
                <.01
                >
                $
                <.05
                >Diluted
                    – pro forma
                
                $
                <.06
                >
                $
                <.01
                >
                $
                <.05
                >
  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-13
 
 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 will no longer be 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 will be 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. Management is currently assessing the
        impact that adoption of this Statement will have 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.
 
 q.
        Reclassifications
 
 The
        Company reclassified certain prior period financial statement balances to
        conform to current presentations.
 
 3. Going
        Concern
 
 As
        of
        December 31, 2005, the Company had aggregate debts and liabilities of
        $39,564,000 and had a working capital deficiency of $24,234,000. It has also
        sustained operating losses in each of the last three years. These debts and
        liabilities include $13,544,000 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 $8,280,000
        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 $6,108,000 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, 2005
        includes $595,000 of preferred dividends expense, $853,000 of Health-Chem
        interest expense and $1,586,000 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.
  F-14
 
 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.
 
 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
                    31,2005
                
                2004Raw
                    materials
                
                $
                630
                
                $
                525Finished
                    goods and work in process
                
                
                538
                
                
                777$
                1,168
                
                $
                1,302
  F-15
  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 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: 2006 - $212,400; 2007 - $212,400; 2008 - $212,400; 2009 - $212,400;
        2010 - $212,400; and 2011 and thereafter - $1,911,600. In December 2002,
        the
        Company had 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.
 
 The
        Company's property, plant and equipment balances are as follows (in
        thousands):
 December
                    31,2005
                
                2004Land
                
                $
                120
                
                $
                120Buildings
                
                
                2,734
                
                
                2,734Equipment
                    and leasehold improvements
                
                
                8,572
                
                
                8,323Construction-in-progress
                
                
                92
                
                
                254Total
                    Property, Plant and Equipment
                
                
                11,518
                
                
                11,431Less
                    accumulated depreciation and amortization
                
                
                9,800
                
                
                9,484Net
                    Property, Plant and Equipment
                
                $
                1,718
                
                $
                1,947
  Depreciation
        expense for the years ended December 31, 2005, 2004 and 2003 was $316,000,
        $326,000 and $381,000, respectively.
 
 F-16
  6. Other
        Liabilities (In
        thousands)
 December
                    31,2005
                
                2004Accrued
                    chargebacks
                
                $
                1,067
                
                $
                682Accrued
                    rebates & allowances
                
                
                367
                
                
                454Accrued
                    trade show discounts
                
                
                196
                
                
                73Allowance
                    for returns
                
                
                115
                
                
                59Accrued
                    audit fees
                
                
                120
                
                
                83Accrued
                    interest – Health-Chem
                
                
                158
                
                
                158Accrued
                    interest on the second mortgage
                
                
                0
                
                
                32Accrued
                    interest on other related party debt
                
                
                35
                
                
                0Accrued
                    interest on other debt
                
                
                5
                
                
                2Other
                
                
                56
                
                
                54$
                2,119
                
                $
                1,597
 
 7. Long-Term
        Debt
 
 The
        Company's long-term debt balances are as follows (in thousands):
 December
                    31,2005
                
                2004Long-term
                    payable – Health-Chem
                
                $
                8,280
                
                $
                8,342Subordinated
                    promissory note – Health-Chem
                
                
                7,000
                
                
                7,000Mortgage
                    payable
                
                
                1,400
                
                
                0Payable
                    to York Realty Leasing LLC members
                
                
                666
                
                
                1,736Note
                    payable
                
                
                167
                
                
                167Subtotal
                
                
                17,513
                
                
                17,245Less
                    current portion
                
                
                7,042
                
                
                7,000Total
                    Long-Term Debt
                
                $
                10,471
                
                $
                10,245
 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 $8,280,000 and $8,342,000 at December
        31, 2005 and 2004, respectively. 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% and 11.34% during 2005 and 2004,
        respectively. 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.
 
 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,
        2005 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 would not have to be repaid until
        January 15, 2007. 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.
  F-17
 
 In
        August
        2001, the Company obtained a $367,500 loan from Zackfoot Investments, LLC
        at
        12.5% interest per annum secured by a mortgage on the Company’s Pennsylvania
        facility. This loan was repaid during 2004. Of the nine initial investors
        in
        Zackfoot Investments, LLC, five were current or former members of Health-Chem’s
        Board of Directors and one investor was a former officer of Health-Chem
        Corporation. Each investor received eight shares of the Health-Chem’s common
        stock for each dollar invested.
 
 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%. As of December 31, 2005, 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:
        2006
        - $42,000; 2007 - $40,000; 2008 - $43,000; 2009 - $47,000 and 2010 - $51,000.
        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, 2005
        was
        $200,000.
 
 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.
 
 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 $14,000,
        $13,000 and $16,000 in 2005, 2004 and 2003, respectively.
  F-18
 
 9. Commitments
        & Contingencies
 
 In
        December 2004, the Company entered into a sale/leaseback agreement with York
        Realty Leasing LLC for the land, buildings, improvements and equipment at
        the
        Company’s previously-owned manufacturing facility in Emigsville, Pennsylvania.
        The term of the lease is for fifteen years, expiring in December 2019, can
        be
        extended an additional five years and contains a repurchase option. The selling
        price was $1.9 million and annual lease payments are $212,400. 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 $367,000 second mortgage. The effects
        of
        this sale/leaseback agreement have been eliminated in consolidation as a
        result
        of York Realty Leasing LLC being considered a Variable Interest
        Entity.
 
 Approximately
        thirty-two 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.
  F-19
 
 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.
  10. 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. 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.
 
 F-20
  11. Stock
        Options
 
 Options
        granted under the Company’s stock option plan are exercisable for up to ten
        years from the grant date. A summary of the status of the Company's plan
        as of
        December 31, 2005, 2004 and 2003 and changes during the years ended on those
        dates is presented below:
 2005
                
                2004
                
                2003Shares
                
                Weighted
                          Average
                          Exercise
                          Price
                
                Shares
                
                Weighted
                          Average
                          Exercise
                          Price
                
                Shares
                
                Weighted
                          Average
                          Exercise
                          PriceOutstanding
                    atbeginning
                    of year
                
                
                0
                
                $
                .00
                
                
                150,000
                
                $
                .125
                
                
                1,150,000
                
                $
                .125Granted
                
                
                0
                
                
                
                
                
                0
                
                
                
                
                
                0Exercised
                
                
                0
                
                
                
                
                
                0
                
                
                
                
                
                0Forfeited
                
                
                0
                
                
                
                
                
                <150,000
                >
                
                
                
                
                <1,000,000
                >Outstanding
                    at endof
                    year
                
                
                0
                
                $
                .00
                
                
                0
                
                $
                .00
                
                
                150,000
                
                $
                .125Options
                    exercisableat
                    year-end
                
                
                0
                
                
                
                
                
                0
                
                
                
                
                
                150,000Weighted-averagefair
                    value ofoptions
                    grantedduring
                    the year
                
                
                
                
                $
                .00
                
                
                
                
                $
                .00
                
                
                
                
                $
                .00
 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, 2005, 2004 and 2003 and no stock options
        were outstanding at December 31, 2005 and December 31, 2004.
  12. Taxes
        on Income (In
        thousands)
 Years
                    Ended December 31,2005
                
                2004
                
                2003Taxes
                    on income include provision <benefit> for:Federal
                    income taxes
                
                $
                0
                
                $
                0
                
                $
                0State
                    and local income taxes
                
                
                0
                
                
                0
                
                
                0Total
                
                $
                0
                
                $
                0
                
                $
                0Taxes
                    on income are comprised of:Current
                
                $
                0
                
                $
                0
                
                $
                0Deferred
                
                
                0
                
                
                0
                
                
                0Total
                
                $
                0
                
                $
                0
                
                $
                0
 
 F-21
  A
        reconciliation of taxes on income to the federal statutory rate is as
        follows:
 Years
                    Ended December 31,2005
                
                2004
                
                2003Tax
                    benefit at statutory rate
                
                $
                <595
                >
                $
                <1
                >
                $
                <522
                >Increase
                    <decrease> resulting from:Net
                    operating and other tax losscarryforwards
                    that expired
                
                
                844
                
                
                0
                
                
                0State
                    and local taxes, net of federaltax
                    benefit
                
                
                <88
                >
                
                0
                
                
                <77
                >Other
                
                
                11
                
                
                <205
                >
                
                0Change
                    in valuation allowance
                
                
                <172
                >
                
                206
                
                
                599Tax
                    provision <benefit>
                
                $
                0
                
                $
                0
                
                $
                0
 At
        December 31, 2005 and 2004, the deferred tax assets and liabilities result
        from
        the following temporary differences and carryforwards:
 2005
                
                2004Deferred
                    tax assets:Net
                    operating and other tax losscarryforwards
                
                $
                4,807
                
                $
                4,900Accumulated
                    depreciation
                
                
                0
                
                
                78Total
                    deferred tax assets
                
                
                4,807
                
                
                4,978Deferred
                    tax liabilities:Accelerated
                    depreciation
                
                
                1
                
                
                0Total
                    deferred tax liabilities
                
                
                1
                
                
                0Net
                    deferred tax asset before valuationallowance
                
                
                4,806
                
                
                4,978Valuation
                    Allowance
                
                
                <4,806
                >
                
                <4,978
                >Net
                    deferred tax asset
                
                $
                0
                
                $
                0
 
 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
        $4.8 million at December 31, 2005 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 $4.8 million at December 31, 2005. Therefore,
        no asset is shown as a deferred tax asset as of December 31, 2005 as a result
        of
        the losses not being used by the Company’s parent to offset any taxes due for
        2005 since the consolidated group showed a loss for 2005 and has net operating
        loss carryforwards. These net operating loss carryforwards expire in various
        years through 2025. The Company and its subsidiary file a stand-alone return
        for
        state purposes. At December 31, 2005, the Company had approximately $15.2
        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 2025. At December 31,
        2005,
        valuation allowance relating to tax loss carryforwards was
        $4,806,000.
 
 F-22
 
 13. Interest (In
        thousands)
 Years
                    ended December 31,2005
                
                2004
                
                2003Interest
                    expense
                
                $
                1,126
                
                $
                1,121
                
                $
                1,124Interest
                    income
                
                
                0
                
                
                0
                
                
                0$
                1,126
                
                $
                1,121
                
                $
                1,124
  14. Related
        Party Transactions
 
 The
        consolidated financial statements include the following items applicable
        to
        related parties (in thousands):
 December
                    31,2005
                
                2004Balance
                    Sheets:Property,
                    plant and equipment, net
                
                $
                1,610
                
                $
                1,693Payable
                    to York Realty Leasing LLC members(See
                    Note 7)
                
                
                666
                
                
                1,736Accrued
                    interest on the second mortgage
                
                
                0
                
                
                32Accrued
                    interest on other related party debt
                
                
                35
                
                
                0
 Years
                    Ended December 31,2005
                
                2004
                
                2003Income
                    Statements:Interest
                
                $
                267
                
                $
                50
                
                $
                46
  Accrued
        interest on the second mortgage
 
 In
        August
        2001, the Company obtained a $367,500 loan from Zackfoot Investments, LLC
        at
        12.5% interest secured by a mortgage on the Company’s Pennsylvania facility.
        This loan was repaid during 2004. At December 31, 2005 and 2004, the following
        related parties were owed interest with respect to this loan:
 2005
                
                2004Manfred
                    Mayerfeld (Director)
                
                $
                0
                
                $
                21,000Andrew
                    Levinson (Director)
                
                
                0
                
                
                11,000$
                0
                
                $
                32,000
  F-23
  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, 2005 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.
 
 Interest
 
 Interest
        expense with respect to related parties for the years ended December 31,
        2005,
        2004 and 2003 is presented below:
 Years
                    ended December 31,2005
                
                2004
                
                2003Second
                    mortgage
                
                $
                0
                
                $
                36,000
                
                $
                46,000York
                    Realty Leasing LLC members
                
                
                267,000
                
                
                14,000
                
                
                0$
                267,000
                
                $
                50,000
                
                $
                46,000
  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, 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.
 
 F-24
  16. Quarterly
        Results of Operations (Unaudited)
 First
                    Quarter
                
                Second
                  Quarter
                
                Third
                  Quarter
                
                Fourth
                    Quarter(in
                      thousands, except per share data)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
                >2004Net
                    sales
                
                $
                1,975
                
                $
                2,128
                
                $
                2,290
                
                $
                2,798Net
                    income <loss> applicableto
                    common stockholders
                
                $
                <372
                >
                $
                <37
                >
                $
                151
                
                $
                <340
                >Net
                    income <loss> per commonshare
                
                $
                <.009
                >
                $
                <.001
                >
                $
                .004
                
                $
                <.009
                >Diluted
                    net income <loss>per
                    common share
                
                $
                <.009
                >
                $
                <.001
                >
                $
                .004
                
                $
                <.009
                >
  The
        above
        financial data may not total to the results indicated on the Company’s financial
        statements.
 
 F-25




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.




-44-





ITEM
      8B.  OTHER
      INFORMATION





None





PART
      III




ITEM
              9.
            DIRECTORS,
                EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; 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 February 20, 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





The
      Company's directors are elected to hold office until the next annual meeting
      of
      shareholders 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.




-45-





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, 2005, none of the
      reports required to be filed were filed on a timely basis.





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*





-46-





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. The Board of Directors did not meet
      or otherwise take action by written consent during 2005.





*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 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.




-47-




*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 shareholders 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 hold a shareholders meeting at which directors will
      be
      elected after it files its annual report for the year ended December 31, 2006
      and to adopt a process for security holders to send communications to the Board
      of Directors prior to the annual shareholders meeting after the 2007 fiscal
      year
      which it will make available to shareholders in a report it will file with
      the
      SEC after the adoption of such process.





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. Effective January 1, 2006, non-employee
      directors receive $1,250 per month, an additional fee of $1,000 for each board
      meeting attended in person and $500 for each board meeting attended
      telephonically. During the period January 2000 through December 2005,
      non-employee directors received no fees.





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
                andPrinciple
                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
            
            
            2005
              
              2004
            
            $
              
              $
            180,000
              
              145,974
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
                606Ronald
                J. Burghauser,
              Chief
                Financial
              Officer,
                Secretary and
              Treasurer
            
            
            2005
              
              
              2004
            
            $
              
              
              $
            133,827
              
              
              117,036
            
            $
            4,600
            
            
            
            
            
            
            
            
            
            
            
            
            
            $1,994
              
              $1,583Kenneth
                Brody,
              Former
                Chief Financial
              Officer
                and Former
              Manager
                - Sales,
              Marketing
                & Business
              Development
            
            
            2005
            
            $
            130,769
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $2,659Donald
                E. Kauffman,
              Former
                Vice President
            
            
            2004
            
            $
            112,800
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $1,613Richard
                L. Bulwicz,
              Manager
                - Quality
              Operations
            
            
            2005
              
              2004
            
            $
                $
            101,600
                97,575
            
            $
            3,900
            
            
            
            
            
            
            
            
            
            
            
            
            $
              
              $
            1,503
              
              1,412






(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 years ended December 31, 2005 and 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 years ended December 31, 2005 and 2006, there were no options to
      purchase shares of common stock outstanding.





Equity
      Compensation Plan Information .





Not
      applicable.





ITEM
      11.
      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL


OWNERS
      AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS .





The
      following table sets forth information, as of February 13, 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.





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
      February 13, 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 February 13, 2007 and the total number of shares
      that various people then had the right to acquire within 60 days of said
      date.




-49-





Name
                and Addressof
                Beneficial Owner(1)
            
            Number
                of SharesBeneficially
                Owned(2)
            
            Percentof
                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 executive
              officers
                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 February 13,
                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.


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ITEM
      13.  EXHIBITS
      AND REPORTS ON FORM 8-K




(a)
      EXHIBITS




ExhibitNo.
            
            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. 1.10.5
            
            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.




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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, 1999.10.13
            
            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”).




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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.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.




-53-




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.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.




-54-




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.





(b)
      REPORTS ON FORM 8-K





During
      the quarter ended December 31, 2005 the Company did not file any reports on
      Form
      8-K.




-55-





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, 2004 and 2005 were $80,000.





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, 2004 or 2005.





Tax
      Fees





There
      were no fees billed by Demetrius & Company, L.L.C. for tax services during
      the fiscal years ended December 31, 2004 or 2005.





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, 2004 or
      2005.




-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)
            
            February
                27, 2007/s/
                Ronald J. Burghauser
              
              By:
                Ronald J. Burghauser
              Chief
                Financial Officer,
              Treasurer
                and Secretary
              (Principal
                Financial Officer)
              (Principal
                Accounting Officer)
            
            February
                27, 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
            
            February
                27, 2007/s/
                Ronald J. Burghauser
              
              Ronald
                J. Burghauser
            
            Chief
                Financial Officer,
              Treasurer
                and Secretary
              (Principal
                Financial Officer)
              (Principal
                Accounting Officer)
            
            February
                27, 2007/s/
                Andrew J. Levinson
              
              Andrew
                J. Levinson
            
            Director
            
            February
                27, 2007/s/
                Manfred Mayerfeld
              
              Manfred
                Mayerfeld
            
            Director
            
            February
                27, 2007





-57-