**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

 

**Washington, D.C. 20549**

 

**FORM 10-QSB**

** **
| **ý**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                    |
| **For the  quarterly period ended June 30, 2005**                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                    |
| **OR**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                    |
| **o**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                    |
| **For the  transition period from                                       to                                         ** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       |                                                                                                    |
| **Commission  file number 1-7335**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

**LEEPHARMACEUTICALS**

(Exact name of smallbusiness issuer as specified in its charter)

 
| **California**                                                                      | ** ** | **95 - 2680312**                     |
|-------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation                                       |       | (I.R.S. Employer Identification No.) |
| or organization)                                                                    |       |                                 |
|                                                                                |       |                                 |
| **1444 Santa Anita Avenue, South El Monte,  California 91733**                      |
| (Address of principal executive offices)                                            |
|                                                                                |
| **(626) 442 - 3141**                                                                |
| (Issuer’s telephone number)                                                    |
|                                                                                |
| **N/A**                                                                             |
| (Former name, former address and former fiscal year,  if changed since last report) |

 

As of March 31,2005 there were outstanding 4,135,162 shares of common stock of the registrant.

 

TransitionalSmall Business Disclosure Format (check one):

Yes         o No         ý

 

 

----

 

**LEE PHARMACEUTICALS**

**BALANCE SHEET**

**JUNE 30, 2005**

**(Dollars in thousands)**

**(Unaudited)**

 
| **ASSETS**                                                                                     |       |       |       |       |       |
|------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
|                                                                                           |       |       |       |       |       |
| Cash                                                                                           | ** ** | ** ** | ** ** | **$**      | **22**     | ** ** |
|                                                                                           |       |       |       |       |       |
| Accounts and  notes receivable (net of allowances: $250)                                       | ** ** | ** ** | ** ** | **659**    | ** ** |
|                                                                                           |       |       |       |       |       |
| Inventories (net  of reserves: $813)                                                           |       |       |       |       |       |
| Raw materials                                                                                  | ** ** | **$**      | **1,520**  | ** ** | ** ** | ** ** |
| Work in process                                                                                | ** ** | **111**    | ** ** | ** ** | ** ** |
| Finished goods                                                                                 | ** ** | **532**    | ** ** | ** ** | ** ** |
|                                                                                           |       |       |       |       |       |
| Total  inventories                                                                             | ** ** | ** ** | ** ** | **2,163**  | ** ** |
|                                                                                           |       |       |       |       |       |
| Other current  assets                                                                          | ** ** | ** ** | ** ** | **257**    | ** ** |
|                                                                                           |       |       |       |       |       |
| Total current  assets                                                                          | ** ** | ** ** | ** ** | **3,101**  | ** ** |
|                                                                                           |       |       |       |       |       |
| Property, plant  and equipment (less accumulated depreciation and amortization: $5,798)        | ** ** | ** ** | ** ** | **820**    | ** ** |
|                                                                                           |       |       |       |       |       |
| Intangibles and  other assets (net of accumulated amortization: $1,549 and impairment: $2,237) | ** ** | ** ** | ** ** | **1,505**  | ** ** |
|                                                                                           |       |       |       |       |       |
| **TOTAL**                                                                                      | ** ** | ** ** | ** ** | **$**      | **5,426**  | ** ** |
|                                                                                                |            |            |            |            |            |  |  |

 

See Accompanying Notes to Financial Statements.

 

2

----

 

**LEE PHARMACEUTICALS**

**BALANCE SHEET**

**JUNE 30, 2005**

**(Dollars in thousands)**

**(Unaudited)**

 
| **LIABILITIES**                                                                                       |       |        |       |
|-------------------------------------------------------------------------------------------------------|------------|-------------|------------|
|                                                                                                  |       |        |       |
| Bank Overdraft                                                                                        | ** ** | **$**       | **31**     | ** ** |
| Notes payable -  finance company                                                                      | ** ** | **770**     | ** ** |
| Current portion  - notes payable, other                                                               | ** ** | **3,228**   | ** ** |
| Current portion  - note payable related party                                                         | ** ** | **1,506**   | ** ** |
| Accounts payable  - trade                                                                             | ** ** | **796**     | ** ** |
| Accounts payable - other                                                                              | ** ** | **238**     | ** ** |
| Accrued  liabilities                                                                                  | ** ** | **586**     | ** ** |
| Environmental  cleanup liability                                                                      | ** ** | **366**     | ** ** |
| Due to related  parties                                                                               | ** ** | **1,672**   | ** ** |
| Deferred income                                                                                       | ** ** | **139**     | ** ** |
|                                                                                                  |       |        |       |
| Total current  liabilities                                                                            | ** ** | **9,332**   | ** ** |
|                                                                                                  |       |        |       |
| Long-term notes  payable to related parties                                                           | ** ** | **1,373**   | ** ** |
| Long-term notes  payable, other                                                                       | ** ** | **160**     | ** ** |
| Environmental  cleanup liability - Casmalia Site                                                      | ** ** | **374**     | ** ** |
| Deferred income                                                                                       | ** ** | **28**      | ** ** |
|                                                                                                  |       |        |       |
| Total long-term  liabilities                                                                          | ** ** | **1,935**   | ** ** |
|                                                                                                  |       |        |       |
| Total  liabilities                                                                                    | ** ** | **11,267**  | ** ** |
|                                                                                                  |       |        |       |
| **COMMITMENTS  AND CONTINGENCIES**                                                                    |       |        |       |
|                                                                                                  |       |        |       |
| **STOCKHOLDERS’  (DEFICIT)**                                                                     |       |        |       |
|                                                                                                  |       |        |       |
| Common stock,  $.10 par value; authorized, 7,500,00 shares; issued and outstanding,  4,135,162 shares | ** ** | **413**     | ** ** |
|                                                                                                  |       |        |       |
| Additional  paid-in capital                                                                           | ** ** | **4,222**   | ** ** |
|                                                                                                  |       |        |       |
| Accumulated  (deficit)                                                                                | ** ** | **(10,476** | **)**      |
|                                                                                                  |       |        |       |
| Total  stockholders’ (deficit)                                                                   | ** ** | **(5,841**  | **)**      |
|                                                                                                  |       |        |       |
| **TOTAL**                                                                                             | ** ** | **$**       | **5,426**  | ** ** |

 

See Accompanying Notes to Financial Statements.

 

3

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**LEE PHARMACEUTICALS**

**STATEMENTS OF OPERATIONS**

**(Dollars in thousands, except per share amounts)**

**(Unaudited)**

** **
| ** **                     | ** **                                 | **For the Three Months** | ** ** | **For the Nine Months** | ** ** |
|--------------------------------|--------------------------------------------|--------------------------|------------|-------------------------|------------|
| ** **                     | ** **                                 | **Ended June 30,**  | ** ** | **Ended June 30,** | ** ** |
| ** **                     | ** **                                 | **2005**                 | ** ** | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|                           |                                       |                     |       |                    |       |   |   |   |   |
| Gross revenue                  | ** **                                 | **$**                    | **2,327**  | ** **              | $          | 1,810 |   | **$** | **7,128** | ** ** | $ | 7,183 |   |
| Other revenue                  | ** **                                 | **62**                   | ** ** | 39                      |       | **189** | ** ** | 186 |   |
| Less:                          | Sales returns                              |                     | **(127**   | **)**                   | (111       | ) | **(401** | **)** | (840 | ) |
|                           | Cash discounts  and others                 | ** **               | **(28**    | **)**                   | (19        | ) | **(80** | **)** | (78 | ) |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Net revenues                   | ** **                                 | **2,234**                | ** ** | 1,719                   |       | **6,836** | ** ** | 6,451 |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Costs and  expenses:           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
|                           | Cost of sales                              | ** **               | **1,268**  | ** **              | 979        |   | **4,336** | ** ** | 3,762 |   |
|                           | Selling and  advertising expense           | ** **               | **566**    | ** **              | 776        |   | **2,051** | ** ** | 2,136 |   |
|                           | General and  administrative expense        | ** **               | **248**    | ** **              | 322        |   | **769** | ** ** | 960 |   |
|                           | Intangible  impairment expense             | ** **               | **35**     | ** **              | (90        | ) | **135** | ** ** | 39 |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Total costs and  expenses      | ** **                                 | **2,117**                | ** ** | 1,987                   |       | **7,291** | ** ** | 6,897 |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Income (loss)  from operations | ** **                                 | **117**                  | ** ** | (268                    | )          | **(455** | **)** | (446 | ) |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Other income  (expense):       |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
|                           | Interest expense                           | ** **               | **(161**   | **)**                   | (219       | ) | **(461** | **)** | (647 | ) |
|                           | Gain on sale of  product line              |                     | **—** | ** **              | —     |   | **750** | ** ** | **—** |   |
|                           | Miscellaneous                              | ** **               | **45**     | ** **              | 55         |   | **148** | ** ** | 195 |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Total other  income (expense)  | ** **                                 | **(116**                 | **)**      | (164                    | )          | **437** | ** ** | (452 | ) |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Net income  (loss)             | ** **                                 | **$**                    | **1**      | ** **              | $          | (432 | ) | **$** | **(18** | **)** | $ | (898 | ) |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
| Per share:                     |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
|                           |                                       |                     | ** ** |                    |       |   | ** ** |   |   |
|                           | Basic and  diluted income (loss) per share | ** **               | **$**      | **00**                  | ** ** | $ | (.11 | ) | **$** | **.00** | ** ** | $ | (.22 | ) |

 

See Accompanying Notes to Financial Statements.

 

4

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**LEE PHARMACEUTICALS**

**STATEMENTS OF CASH FLOWS**

**(Dollars in thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **For the Nine Months** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                         | ** ** | **Ended June 30,** | ** ** |
| ** **                                                                         | ** ** | **2005**                | ** ** | **2004** | ** ** |
| Cash flows (used  in) provided by operating activities:                            |       |                    | ** ** |   |   |
| Net income  (loss)                                                                 | ** ** | **$**                   | **(18**    | **)** | $ | (898 | ) |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                    | ** ** |   |   |
| Depreciation                                                                       | ** ** | **171**                 | ** ** | 147 |   |
| Amortization of  intangibles                                                       | ** ** | **312**                 | ** ** | 195 |   |
| (Decrease) in  deferred income                                                     | ** ** | **(142**                | **)**      | (195 | ) |
| Gain on sale of  product line                                                      | ** ** | **(750**                | **)**      | — |   |
| Gain on sale of  equipment                                                         | ** ** | **(5**                  | **)**      | — |   |
| Change in  operating assets and liabilities:                                       |       |                    | ** ** |   |   |
| Decrease in  accounts receivable, net                                              | ** ** | **353**                 | ** ** | 330 |   |
| Decrease  (increase) in inventories                                                | ** ** | **16**                  | ** ** | (169 | ) |
| Decrease  (Increase) in deposits                                                   | ** ** | **136**                 | ** ** | (16 | ) |
| Decrease  (increase) in other current assets                                       | ** ** | **135**                 | ** ** | (27 | ) |
| (Decrease)  increase in accounts payable and accrued liabilities                   | ** ** | **(413**                | **)**      | 286 |   |
| Increase  (decrease) in due to related parties                                     | ** ** | **253**                 | ** ** | (112 | ) |
| Net cash  provided by (used in) operating activities                               | ** ** | **48**                  | ** ** | (459 | ) |
|                                                                               |       |                    | ** ** |   |   |
| Cash flows from  investing activities:                                             |       |                    | ** ** |   |   |
| Additions to  property, plant and equipment                                        | ** ** | **(166**                | **)**      | (181 | ) |
| Gain on sale of  product line                                                      | ** ** | **750**                 | ** ** | — |   |
| Gain on sale of  equipment                                                         | ** ** | **5**                   | ** ** | — |   |
| Acquisition of  product brands                                                     | ** ** | **(95**                 | **)**      | — |   |
| Net cash  provided by (used in) investing activities                               | ** ** | **494**                 | ** ** | (181 | ) |
|                                                                               |       |                    | ** ** |   |   |
| Cash flows from  financing activities:                                             |       |                    | ** ** |   |   |
| Proceeds from  notes payable to related party                                      | ** ** | **83**                  | ** ** | 218 |   |
| (Decrease)  increase in notes payable, finance company                             | ** ** | **(456**                | **)**      | (39 | ) |
| Proceeds from  notes payable, other                                                |       | **—**              | ** ** | 550 |   |
| (Payments on)  notes payable, other                                                | ** ** | **(193**                | **)**      | (84 | ) |
| Increase  (decrease) in bank overdraft                                             | ** ** | **18**                  | ** ** | (3 | ) |
| Net cash (used  in) provided by financing activities                               | ** ** | **(548**                | **)**      | 642 |   |
|                                                                               |       |                    | ** ** |   |   |
| Net (decrease)  increase in cash                                                   | ** ** | **(6**                  | **)**      | 2 |   |
| Cash, beginning  of period                                                         | ** ** | **28**                  | ** ** | 16 |   |
| Cash, end of  period                                                               | ** ** | **$**                   | **22**     | ** ** | $ | 18 |   |
|                                                                               |       |                    | ** ** |   |   |
| **Supplemental  disclosures of cash flow information:**                            |       |                    | ** ** |   |   |
|                                                                               |       |                    | ** ** |   |   |
| Cash paid during  the year for:                                                    |       |                    | ** ** |   |   |
| Interest                                                                           | ** ** | **$**                   | **342**    | ** ** | $ | 184 |   |
| Taxes                                                                              | ** ** | **$**                   | **1**      | ** ** | $ | 1 |   |

 

See Accompanying Notes to Financial Statements.

 

5

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LEE PHARMACEUTICALS

 

**Notes toFinancial Statements**

**(Unaudited)**

 

1.               Basisof presentation:

 

Thecondensed interim financial statements included herein have been prepared byLee Pharmaceuticals without audit, pursuant to the rules and regulationsof the Securities and Exchange Commission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with generally accepted accountingprinciples have been condensed or omitted pursuant to such rules andregulations, although the Company believes that the disclosures are adequate tomake the information presented not misleading.

 

Thesestatements reflect all adjustments, consisting of normal recurring adjustments(except as set forth in Note 5) which, in the opinion of management, arenecessary for fair presentation of the information contained herein.  It is suggested that these condensedfinancial statements be read in conjunction with the financial statements andnotes thereto included in the Company’s Annual Report on Form 10-KSB forthe year ended September 30, 2004. The Company follows the same accounting policies in preparation ofinterim reports.

 

Resultsof operations for the interim periods may not be indicative of annual results.

 

TheCompany is involved in various matters involving environmental cleanupissues.  See “Item 2. Management’sDiscussion and Analysis or Plan of Operations” and Note 13 of Notes toFinancial Statements included in the Company’s Form 10-KSB for the fiscalyear ended September 30, 2004.  Theultimate outcome of these matters cannot presently be determined.  Environmental expenditures that relate to anexisting condition caused by past operations, and which do not contribute tocurrent or future revenue generation, are expensed.  The Company’s proportionate share of theliabilities are recorded when environmental remediation and/or cleanups areprobable, and the costs can be reasonably estimated.  As of June 30, 2005, no settlements havebeen reached.

 

Shippingand handling expenses are included in selling expenses.  Shipping expenses for the three and ninemonths are set forth below:

 

| ** **                 | ** ** | **For the Three Months** | ** **  | **For the Nine Months** | ** ** |
|----------------------------|------------|--------------------------|-------------|-------------------------|------------|
| ** **                 | ** ** | **Ended June 30,**  | ** **  | **Ended June 30,** | ** ** |
| ** **                 | ** ** | **2005**                 | ** **  | **2004**                | ** ** | **2005** | ** ** | **2004** | ** ** |
|                       |       |                     |        |                    |       |   |   |   |   |
| Labor and fringe  benefits | ** ** | **$**                    | **18,000**  |                    | $          | 19,000 | ** ** | **$** | **57,000** |   | $ | 62,000 |   |
| Freight                    | ** ** | **83,000**               |        | 89,000                  | ** ** | **336,000** |   | 308,000 |   |
| Building rental            | ** ** | **15,000**               |        | 30,000                  | ** ** | **62,000** |   | 90,000 |   |
| Utilities and  supplies    | ** ** | **3,000**                |        | 5,000                   | ** ** | **9,000** |   | 14,000 |   |
|                       |       |                     |        |                    |       |   |   |   |   |
| Totals                     | ** ** | **$**                    | **119,000** |                    | $          | 143,000 | ** ** | **$** | **464,000** |   | $ | 474,000 |   |
|                            |            |                          |             |                         |            |  |  |  |  |  |  |  |  |  |

 

6

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TheCompany has a service agreement with Monticello Drug Company (MDC).  Under this agreement, the Company provides thewarehousing, shipping, billing and collection for several MDC owned andsupplied products.  Weekly, the net salesof these products minus certain agreed upon fees are calculated, and theproceeds are remitted to MDC six weeks later. MDC is responsible for all sales, returns, advertising and possibleliability claims for these products.

 

Theshipments and returns of MDC are compiled on a weekly basis.  From that net figure, a set percentage ofgross sales for cash discounts, freight and the Company’s fees are deducted,and the balance due MDC is recorded as a payable.  It is paid six weeks later.  At the end of a quarter, or year end, a worksheet entry is made, removing MDC’s net invoicing for that month from theCompany’s accounts receivable balance, and 85% of that figure is removed fromthe Company’s payable balance to MDC. The remaining 15%, which is the approximate amount of the abovementioned deductions, is set up as a current asset.

 

Thepolicy for sales return allowances is the same for all of the Company’sproducts, including private label.  Eachmonth the amount of actual returns is deducted from the allowances.  At the same time a provision forapproximately the same amount is added to the allowances.  If, from time to time, a customer indicates adesire to return a large amount, such as a discontinuance of a product line, anadditional provision is recorded.  As thereturns are received, the amount is deducted from the allowances, with nooffsetting provision.  The sales returnallowances at year end were $163,000.

 

InNOTE 1 Segment reporting, page 20, of the Company’s Form 10-KSBfor the year ended September 30, 2004, the Company reported two segmentsof business; namely, consumer personal care products and professional dentalproducts.  The consumer personal careproducts consists of approximately fifty (50) different brand names and manymore private label items.  Managementfeels that it is impracticable to report revenues from each of the products in theCompany’s two segments.

 

Cooperativeadvertising expenses are included in selling and advertising.  The Company’s customers accrue 5% of grosssales as a cooperative advertising allowance. This allowance can only be collected by running the ad or performing thepromotional event and by providing proof of performance.  The Company’s credit terms are 1% 20 days,net 30 days.  The Company does notparticipate in coupons or buydowns and does not use rebates.  Slotting fees are paid very infrequently.  Slotting expenditures in recent years have beenless than $25,000 per year.

 

2.               Continuedexistence:

 

Thefinancial statements have been prepared assuming that the Company will continueas a going concern.  The Company has anaccumulated deficit of $10,476,000.  TheCompany’s recurring losses from operations and inability to generate sufficientcash flow from normal operations to meet its obligations as they come due raisesubstantial doubt about the Company’s ability to continue as a goingconcern.  The Company’s ability tocontinue in existence is dependent upon future developments, includingretaining current financing and achieving a level of profitable operationssufficient to enable it to meet its obligations as they become due.  Management’s plans in regard to these mattersare to increase profitability by increasing sales, control expenses and seekadditional financing from outside lenders. The financial statements do not include any adjustments to reflect thepossible future effects of the recoverability and classification of assets orthe amounts and classification of liabilities that may result from the possibleinability of the Company to continue as a going concern.

 

7

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3.               Useof estimates:

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principals requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosures ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

4.               Reclassification:

 

Certainreclassifications have been made to the prior year financial statements to beconsistent with the 2005 presentation.

 

5.               Impairmentof intangible assets:

 

At June 30,2005, the Company had $5.2 million of product line and certain identifiableintangibles.  In assessing therecoverability of these intangibles, the Company must make assumptions regardingestimated future cash flows and other factors to determine the fair value ofthe respective assets.  If the estimatesor their related assumptions change in the future, the Company may be requiredto record impairment charges for these assets not previously recorded.  In connection with the adoption of SFAS 142issued in July 2001, the Company performed an impairment assessment as of December 31,2004 and June 30, 2005, using a twelve month moving average.  There was an impairment charge of $100,000 atDecember 31, 2004 and an impairment charge of $35,000 at June 30,2005.

 

6.               Debtmaturities schedule:

 

At June 30,2005, the Company was committed to the following minimum principal payments:

 
| **Year ending**        | ** ** | **Notes payable**   | ** ** | **Related** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------|------------|---------------------|------------|-------------|------------|------------|------------|------------|------------|
| **September 30,** | ** ** | **finance company** | ** ** | **parties** | ** ** | **Other**  | ** ** | **Total**  | ** ** |
|                   |       |                |       |        |       |       |       |       |       |
| 2005                   |       | $                   | 640,000    |        | $          | 1,417,000  |       | $          | 443,000    |   | $ | 2,500,000 |   |
| 2006                   |       | 130,000             |       | 120,000     |       | 2,800,000  |       | 3,050,000  |       |
| 2007                   |       | —              |       | 120,000     |       | 60,000     |       | 180,000    |       |
| 2008                   |       | —              |       | 120,000     |       | 60,000     |       | 180,000    |       |
| 2009                   |       | —              |       | 50,000      |       | 25,000     |       | 75,000     |       |
| 2010                   |       | —              |       | 1,052,000   |       | —     |       | 1,052,000  |       |
|                   |       |                |       |        |       |       |       |       |       |
| Total                  |       | $                   | 770,000    |        | $          | 2,879,000  |       | $          | 3,388,000  |   | $ | 7,037,000 |   |

 

7.               Earnings(loss) per share:

 

TheCompany has a simple capital structure, and there were no changes under theSFAS 128 methodology to the previously reported earnings (loss) per shareamounts for any of the fiscal years. Basic earnings (loss) per share under SFAS 128 were computed using theweighted average number of shares outstanding of 4,135,162 for the three monthsand nine months ended June 30, 2005 and June 30, 2004.

 

8

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8.               Otherincome:

 

Forthe nine months ended June 30, 2005, other income included realized gainsof approximately $142,000 related to the sale of three product lines.  These realized gains pertain to therecognition of the earned portion of the deferred income of the consultingagreements arising from the sale of these product lines.  Also included is $5,000 arising from the saleof equipment retired in prior years.  Forthe nine months ended June 30, 2004, other income consisted of realizedgains as described above of $195,000.

 

For the three months ended June 30, 2005, otherincome included realized gains of approximately $45,000 related to the sale ofthe three product lines as described above. For the three months ended June 30, 2004, other income includedapproximately $55,000 of realized gains as described above.

 

9.               Incometaxes:

 

At September 30,2004, the Company has a Federal net operating loss (NOL) carry forward ofapproximately $14,775,000 for which it has recorded a valuation allowance forthe entire NOL.

 

The expiration dates of the Company’s Federal netoperating loss carryforwards are:

 

| 2005            |   | $ | 2,567,104 |   |
|-----------------|--------|---|-----------|--------|
| 2006            |   | $ | 837,727   |   |
| 2007            |   | $ | 416,740   |   |
| 2008            |   | $ | 689,503   |   |
| 2009            |   | $ | 1,458,800 |   |
| 2010 thereafter |   | $ | 8,805,126 |   |

 

**Item 2.****                                    Management’sDiscussion and Analysis or Plan of Operations**

 

**Critical Accounting Policies**

 

Our discussion and analysis of our financial conditionand results of operations are based upon our financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America.  Thepreparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of liabilities, expenses and relateddisclosures of contingent assets and liabilities.  We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances. Actual results may differ from these estimates underdifferent assumptions or conditions; however, we believe that our estimates areresponsible.

 

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***Revenue and Expense Recognition***

 

Income and expenses are recorded on the accrual basisof accounting.  The Company recognizesrevenues from sales when goods have been shipped, there are no materialuncertainties regarding customer acceptance, collection of the resulting receivableis deemed probable and no other significant vendor obligations exist.  Expenses are recognized when services havebeen performed or inventory items have been used.  Chemical items are recognized as inventory onceQuality Control testing is in compliance with the Company specifications.

 

***Deferred Income***

 

Deferred income relates to certain consultingagreements arising from the sale of several product lines.  The deferred income is recognized over theterms of the contracts.

 

***Inventory Obsolescence Allowance***

 

Inventory allowances for obsolescence are recordedbased upon a periodic review by the Company’s management of its inventory.  The Company’s management will evaluateobsolete and slow moving inventory and determine their overall futuresalability and use in manufactured products. If the future salability and use in manufactured products of slow movinginventory are questionable, then an allowance is recorded based upon the lowerof cost or market.  If such inventory isdetermined to have no future salability or use, then such inventory will bewritten off.  Changes in customer demandfor certain products could impact the allowance for obsolete inventory.

 

***Intangible Assets***

 

Intangible assets consist of product lines andcovenants not to compete.  In accordancewith SFAS No. 142, “Goodwill and Other Intangible Assets,” we evaluateintangible assets and other long-lived assets for impairment, at least on anannual basis and whenever events or changes in circumstances indicate that thecarrying value may not be recoverable from its estimated future cashflows.  Recoverability of intangibleassets and other long-lived assets is measured by comparing their net bookvalue to the related undiscounted cash flows from these assets.  Any change in the  undiscounted cash flows from these assets, asa result of changes in the Company’s operations or prospects, could alter thisanalysis.  If the net book value of theasset exceeds the related undiscounted cash flows, the asset is consideredimpaired, and a second test is performed to measure the amount of impairmentloss.  Amortization is computed using thestraight-line method over the estimated useful life of the covenants not tocompete.

 

**MaterialChanges in Results of Operations**

**ThreeMonths Ended June 30, 2005, and June 30, 2004**

 

Grossrevenues for the three months ended June 30, 2005, were $2,327,000, anincrease of approximately $517,000, or 29%, from the comparable three monthsended June 30, 2004.  The Companyreported increased sales volume in several product line categories.  Specifically, the Lee® Lip-Ex® product lineincreased $246,000, while increases were also reported in depilatories($88,000), private label products ($74,000), personal care items ($72,000),over-the-counter (OTC) products ($12,000) and exports ($64,000).  Offsetting these increases were decreases indental products ($45,000) and the Lee Nails® category ($3,000).

 

Netrevenues increased approximately $515,000, or 30%, for the three months ended June 30,2005, as compared to the three months ended June 30, 2004.  The increase was due primarily to the factorsmentioned above.  In addition, theCompany’s income from the service agreement with Monticello Drug Companyincreased $23,000, while sales returns increased $16,000, or 14%, and cashdiscounts increased $9,000, or 47%.

 

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Thecost of sales line item consists of material (including a provision forobsolete inventory if required), direct and indirect labor (and related fringebenefits) and related manufacturing overhead expenses.  It also includes purchasing, receiving,inspection (quality control functions), warehousing costs and inbound freight.

 

Thecost of sales as a percentage of gross revenues was 54% for the three monthsended June 30, 2005, as well as for the three months ended June 30,2004.

 

Sellingand advertising expenses include salesmen’s and clerical salaries (and relatedfringe benefits) and commissions, commissions to outside representatives,travel, entertainment and expenses for various trade shows attended.  Also included are royalty expense on sale ofcertain products, coop advertising expenses, amortization of several covenantsnot to compete agreements and impairment of certain product lines ifapplicable.  Distribution costs are alsoincluded in this category.

 

Sellingand advertising expenses decreased $210,000, or 27%, when comparing the threemonths ended June 30, 2005 with the three months ended June 30,2004.  Included in selling andadvertising are shipping and handling expenses of $119,000 for the three monthsended June 30, 2005 and $143,000 for the three months ended June 30,2004.  The $210,000 decrease in expenseswas primarily due to: (1) lower advertising costs ($76,000), (2) lowerconvention expense ($43,000), (3) lower salary and related fringe benefits($43,000), (4) lower shipping and handling expenses mentioned above($26,000), (5) lower product liability premiums ($15,000) and (6) lowerroyalty expenses ($13,000).  Offsettingthese decreases was an increase in amortization expense of $21,000.

 

Generaland administrative expenses include executive and clerical salaries (andrelated fringe benefits), auditing and legal expenses, Management InformationSystem expenses and shareholder costs.

 

Generaland administrative expenses decreased $74,000, or 23%, when comparing the threemonths ended June 30, 2005, with the three months ended June 30,2004.  The decrease was primarily due to:(1) lower salary and related fringe benefit costs ($50,000), (2) lowercosts for supplies ($14,000), (3) lower dues and subscriptions ($10,000), (4) lowerMIS (Management Information Systems) consulting fees ($9,000) and (5) lowerauditing fees ($3,000).  Offsetting thesedecreases was an increase in legal fees of ($14,000).

 

Animpairment charge of $35,000 was made in the three months ended June 30,2005.  During the three months ended June 30,2004, the Company made a $90,000 adjustment to an impairment charge made in March 2004,which had been overstated due to the incorrect application of an impairmentformula.

 

Otherexpense was approximately $116,000 for the three months ended June 30,2005, as compared to other expense of $164,000 for the comparable three monthsended June 30, 2004.  Interestexpense for the three months ended June 30, 2005 was $161,000, a decreaseof $58,000, or 26%, when comparing the three months ended June 30, 2005,with the three months ended June 30, 2004. The primary reason for this decrease was that in September 2004,the Company reached an agreement with a non-related party to consolidate eleven(11) of its notes payable and related unpaid interest totaling $2,176,000 withinterest rates from 20% to 24% into one new note.  The interest rate on the new note is the onemonth LIBOR (London Interbank Offered Rate) rate.  The LIBOR rate at June 30, 2005 was3.08%.  Also included in other income is$45,000 pertaining to realized gains related to the sale of the Klutch® productline ($3,000), the sale of the Astring-o-Sol® product line ($10,000) and thesale of the iodex® product line ($32,000).  The realized gains pertain to the recognitionof the earned portion of the deferred income of the consulting agreementsarising from the sale of these product lines.

 

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Other expense for the three months ended June 30,2004, included interest expense of approximately $219,000 and other income ofapproximately $55,000 which pertains to realized gains related to the sale ofthe Klutch® product line ($13,000), the sale of the Astring-o-Sol® product line($10,000) and the sale of the iodex® product line ($32,000).

 

**MaterialChanges in Results of Operations**

**NineMonths Ended June 30, 2005, and June 30, 2004**

 

Grossrevenues for the nine months ended June 30, 2005, were $7,128,000, adecrease of $55,000, or 1%, from the comparable nine months ended June 30,2004.  The decrease was due to lowersales in over-the-counter products ($523,000), dental products ($87,000),private label items ($71,000) and personal care products ($60,000).  Offsetting these decreases was an increase of$686,000 in the Lee® Lip-Ex® category.

 

Netrevenues increased approximately $385,000, or 6%, for the nine months ended June 30,2005, as compared to the nine months ended June 30, 2004.  The increase in net revenues was due to themodest decline in gross revenues mentioned above, with a $439,000 decline insales returns. The Company experienced fewer returns of their SKU’s (stockkeeping units) at the retail store level during the nine months ended June 30,2005.  In addition, the Company increasedits allowance for sales returns by $272,000 during the nine months ended June 30,2004, with no corresponding adjustment for the nine months ended June 30,2005.

 

Costof sales as a percentage of gross revenues was 61% for the nine months ended June 30,2005, compared to 52% for the nine months ended June 30, 2004.  The continued change in the product mix tohigher cost of goods products resulted in lower gross margins on sales of theseproducts.  For the nine months ended June 30,2005, gross revenues of product categories with low gross margins representedapproximately 48% of the Company’s total gross revenues.  For the nine months ended June 30, 2004,gross revenues of product categories with low gross margins representedapproximately 36% of the Company’s total gross revenues.  In addition, the Company increased itsinventory obsolescence reserve $266,000 during the nine months ended June 30,2005, as compared to $156,000 in the corresponding period of 2004, and incurredincreased expenses in: (1) depreciation ($32,000), (2) workers’compensation insurance premiums ($13,000) and (3) increased labor andrelated fringe benefits ($12,000). Offsetting these increases was a decrease in analytical testing costs of$105,000.

 

Sellingand advertising expenses decreased $85,000, or 4%, when comparing the ninemonths ended June 30, 2005 with the nine months ended June 30,2004.  Included in selling andadvertising are shipping and handling charges of $464,000 for the nine monthsended June 30, 2005 and $474,000 for the nine months ended June 30,2004.  The lower expenses of $85,000consisted of: (1) lower labor and related fringe benefits ($82,000), (2) lowerconvention costs ($41,000),  (3) lowerproduct liability insurance premiums ($38,000), (4) lower royalty expenses($35,000) and (5) lower shipping and handling charges ($10,000).  Somewhat offsetting these decreases was anincrease of $99,000 in advertising costs and an increase in the allowance forbad debts ($18,000).

 

Generaland administrative expenses decreased $191,000, or 20%, when comparing the ninemonths ended June 30, 2005, with the nine months ended June 30,2004.  The decrease was primarily due to:(1) lower salaries and fringe benefits ($139,000), (2) lower MISconsulting fees ($46,000), (3) lower auditing fees ($23,000), (4) lowerdues, subscription fees ($11,000) and (5) lower supply expenses($9,000).  Offsetting these decreaseswere: (1) higher legal fees ($35,000) and higher travel and entertainmentexpenses ($6,000).

 

Anintangible impairment charge of $135,000 was recorded for the nine months endedJune 30, 2005, as compared to a $39,000 charge for the nine months ended June 30,2004.

 

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Forthe nine months ended June 30, 2005, the Company realized other income of$437,000, as compared to other expense of $452,000 for the nine months ended June 30,2004.  The primary reason for thisdifference is a $750,000 gain from the sale of the Nose Better® product line inOctober 2004 (fiscal 2005).  Interest expense for the nine months ended June 30,2005 was $461,000, a decrease of $186,000, or 29%, when comparing the ninemonths ended June 30, 2005 with the nine months ended June 30,2004.  The primary reason for thisdecrease is the same as outlined above for the three months period.  Also included for the nine months ended June 30,2005 is $148,000 pertaining to the realized gains related to the sale of theKlutch® product line ($15,000), the sale of the Astring-o-Sol® product line($32,000), the sale of the iodex® product line ($96,000) and $5,000 arisingfrom the sale of some equipment retired in prior years.

 

Otherexpense for the nine months ended June 30, 2004 included interest expenseof $647,000 and other income of $195,000 related to the sale of the Klutch®product line ($67,000), the sale of the Astring-o-Sol® product line ($32,000)and the sale of the iodex® product line ($96,000).

 

**Liquidityand Capital Resources**

 

At June 30, 2005, working capital was a negative$6,231,000, as compared with a negative $3,519,000 as of September 30,2004.  The ratio of current assets tocurrent liabilities was 0.3 to 1 at June 30, 2005 and 0.5 to 1 at September 30,2004.  The increase in currentliabilities was principally due to the maturity date of certain long-termliabilities becoming current in December 2004.

 

TheCompany has an accumulated deficit of $10,476,000.  Past recurring losses and inability togenerate sufficient cash flow from normal operations to meet its obligations asthey become due, raises substantial doubt about the Company’s ability tocontinue as a going concern.  The Company’sability to continue in existence is dependent upon future developments,including retaining current financing and achieving a level of profitableoperations sufficient to enable it to meet its obligations as they become due.

 

TheCompany expects to increase its source of cash by a combination of increasedsales, lower costs and perhaps additional financing from outside lenders.  Any increase in cash will be used to payaccrued interest and notes payable. Projected interest payments and capital expenditures will have an impacton the Company’s liquidity.

 

TheCompany implemented cost reduction programs since September 2004.  They include personnel layoffs, salary cuts,wage freezes, lower products liability premium, lower interest rate paid to alender and the vacating of a building. In addition, on March 8, 2005, a royalty expense expired.  The expiration of the royalty expense savesthe Company approximately $5,000 per month. Vacating one of the facilities, effective February 28, 2005, willsave the Company approximately $7,500 per month in rent and utilities combined.

 

Incomparing the nine months ended June 30, 2005 and June 30, 2004, thenumber of days’ sales were in average accounts receivable was 28 days versus 15days.  Due to the anticipation of a priceincrease, many customers were doing some hedge buying, which distorted thenumber of average days’ sales would normally be in accounts receivable.  Also, in June 2004, the allowance forreturned goods was increased in anticipation of large returns from acustomer.  This caused the netreceivables at June 30, 2004 to be lower than normal.

 

Itshould be noted that included in the Company’s total liabilities of$11,267,000, the Lee family affiliates constitute $4,551,000, environmental$740,000 (subject to negotiation) and deferred income $167,000, for a total of$5,458,000, which represents 48% of the total liabilities.  This liability gives the Company a certainamount of latitude as to when payment of principal and/or interest are made.

 

All ofthe Company’s building leases are with two individuals, one of whom is thePresident and Chairman of the Company. The Company is in the process of exercising its option to extend theterms of the leases, which currently expire in November 2005.  When the options are exercised, the leaseswill be extended to November 2010.

 

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**EnvironmentalMatters**

 

TheCompany owns a manufacturing facility located in South El Monte,California.  The California RegionalWater Quality Control Board (The “RWQCB”) ordered the Company in 1988 and 1989to investigate the contamination on its property (relating to soil andgroundwater contamination).  The Companyengaged a consultant who performed tests and reported to the then Chairman ofthe Company.  The Company resistedfurther work on its property until the property upgradient was tested ingreater detail since two “apparent source” lots had not been tested.  On August 12, 1991, the RWQCB issued a “Cleanupand Abatement Order” directing the Company to conduct further testing and cleanup the site.  In October 1991, theCompany received from an environmental consulting firm an estimate of $465,200for investigation and cleanup costs.  TheCompany believed that this estimate was inconclusive and overstated the contamination levels.  The Company believes that subsequentinvestigations will support the Company’s conclusions  about that estimate.  The Company did not complete the testing forthe reasons listed above as well as “financial constraints.”  In June 1992, the RWQCB requested thatthe EPA evaluate the contamination and take appropriate action.  At the EPA’s request, Ecology &Environment, Inc. conducted an investigation of soil and groundwater onthe Company’s property.  Ecology &Environment Inc.’s Final Site Assessment Report, which was submitted to the EPAin June 1994, did not rule out the possibility that some of thecontamination originated on-site, and resulted from either past or currentoperations on the property.

 

On April 24,2002, the RWQCB notified the Company that the detection of emergent chemicalsin groundwater, above State and Federal maximum containment levels or action levels,has caused the RWQCB and the EPA to reassess the threat posed to groundwaterresources used for domestic supply.  TheRWQCB directed the Company to test for the presence of emergent chemicals inits groundwater monitoring wells.  Thegroundwater monitoring analytical results were due by July 15, 2002.  On May 24, 2002, the Company informedRWQCB that it could not comply with the requirement to conduct groundwatersampling due to ongoing financial difficulties.

 

On July 8,2002, the RWQCB sent a “Second Notice of Violation” to the Company directingthe Company to comply with the requirement to prepare a groundwater remedialaction plan (RAP).  The Companypreviously notified the RWQCB that it could not comply with the requirement tosubmit a RAP because of ongoing financial difficulties.  The RWQCB requested that the Company submitcertain financial information by July 29, 2002 to “substantiate anyalleged financial losses and determine whether any suspension of implementingthe...(Cleanup and Abatement Order) is warranted.”  The Company has received an extension tosubmit the required financial information to August 19, 2002.  The Company submitted the requested financialinformation on August 16, 2002.  TheCompany received a response whereby their request for financial hardship wasdenied.  The Company is in the process ofappealing this decision based primarily upon the continued deterioration in theCompany finances since the original filing. The Company may be liable for all or part of the costs of remediatingthe contamination on its property and could be subject to enforcement action bythe RWQCB, including injunctive and civil monetary remedies.  As of the date of the financial statements,the Company’s share of the costs have not been determined.

 

TheCompany and nearby property owners, in consort with their comprehensive generalliability (CGL) carriers, engaged a consultant to perform a site investigationwith respect to soil and shallow groundwater contamination over the entire cityblock.  The CGL carriers provided$290,000 in funding which paid for the $220,000 study, $20,000 in legal feesfor project oversight, and a $50,000 balance in the operating fund.  Earlier the Company had accrued $87,500 asits proportionate share of the earlier quote of $175,000. Since that time, theoverall scope of the project was increased to $205,000 plus $15,000 for wastewater disposal, bringing the total to the above listed $220,000.  The $87,500 accrual was not spent on thisproject (as the entire cost was borne by the CGL carriers), but remains on thebooks as an accrual against the cost of remediation of the same site that wasincluded in the study.

 

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Thetenants of nearby properties upgradient have sued the Company, alleging thathazardous materials from the Company’s property caused contamination on theproperties leased by the tenants.  Thecase name is Del Ray Industrial Enterprises, Inc. v. RobertMalone, et al., Los Angeles County Superior Court, Northwest District, andit commenced August 21, 1991.  Inthis action, the plaintiff alleges environmental contamination by defendants ofits property, and seeks a court order preventing further contamination andmonetary damages.  The Company does notbelieve there is any basis for the allegations and is vigorously defending thelawsuit.

 

TheCompany’s South El Monte manufacturing facility is also located over a largearea of possibly contaminated regional groundwater which is part of the SanGabriel Valley Superfund Site.  TheCompany has been notified that it is a potentially responsible party  (“PRP”) for the contamination.   In 1995,the Company was informed that the EPA estimated the cleanup costs for the SouthEl Monte’s portion of the San Gabriel Valley Superfund Site to be $30million.  The Company’s potential shareof such amount has not been determined. Superfund PRPs are jointly and severally liable for superfund sitecosts, and are responsible for negotiating among themselves the allocation ofthe costs based on, among other things, the outcome of environmentalinvestigation.

 

In August 1995,the Company was informed that the EPA entered into an Administrative Order ofConsent with Cardinal Industrial Finishes (“Cardinal”) for a PRP lead remedialinvestigation and feasibility study (the “Study”) which, the EPA states, willboth characterize the extent of groundwater contamination in South El Monte andanalyze alternatives to control the spread of contamination.  The Company and others entered into the SouthEl Monte Operable Unit Site Participation Agreement with Cardinal pursuant towhich, among other things, Cardinal contracted with an environmental firm toconduct the Study.  The Study has beencompleted.  The Company’s share of thecost of the Study was $15,000 and was accrued for in the financial statementsas of  September 30, 1995.  The South El  Monte Operable Unit (SEMOU)participants developed four remedial alternatives.  The capital cost of the four alternativesrange from $0 (no action) up to $3.49 million. The estimated annual operating cost for the four alternatives range from$0 (no action) to $770,300.  Over a 30-yearperiod, the total cost of the four alternatives range from $0 (no action) up to$13.05 million.  The EPA prefers analternative which estimates the capital cost up to $3.08 million, the annualoperating cost at $.48 million, and the 30-year period total cost up toapproximately $9.09 million.  Theselection of the actual alternative implemented is subject to publiccomment.  At the present time, theCompany does not know what its share of the cost may be, if any.  Therefore, no additional accrual has beenrecognized as a liability on the Company’s books.  The Company requested that the EPA conduct an“ability-to-pay evaluation” to determine whether the Company is entitled to anearly settlement of this matter based upon a limited ability to pay costsassociated with site investigation and remediation.  In August 2000, the EPA informed theCompany that it does not qualify for an early settlement at this time.

 

TheEPA has informed the Company that it has learned that the intermediate zonegroundwater contamination in the western portion of the SEMOU has migratedfurther west and has now impacted the City of Monterey Park and SouthernCalifornia Water Company production wells. The EPA stated that the City of Monterey Park Water Department, SanGabriel Valley Water Company and Southern California Water Company are planningto build treatment facilities for their wells. The EPA stated that these three water purveyors contacted some of theSEMOU PRPs, other than the Company, to seek funding to develop groundwatertreatment facilities for the contaminated wells.  A group of these PRPs calling themselves the “SouthEl Monte Cooperative Group” has been formed and purportedly has reached ageneral agreement with the water purveyors to fund the development of treatmentfacilities and use the water purveyors’ wells in an attempt to contain thegroundwater contamination to meet EPA’s goals.  The Company is not able to determine whatcontribution, if any, it may be assessed in connection with this cleanupactivity.

 

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Byletter dated November 13, 2000, the Company was notified that the City of MontereyPark, San Gabriel Valley Water Company and Southern California Water Companyintend to bring suit under the Safe Drinking Water and Toxic Enforcement Act of1986, alleging that the Company has knowingly released volatile organiccompounds in the soil and shallow groundwater beneath the Company’s propertybetween at least on or before November 8, 1996 and the present and hasfailed to promptly clean up all of the contamination.  As of the date of this report, the Companyhas not been served with this lawsuit.

 

TheCity of South El Monte, the city in which the Company has its manufacturingfacility, is located in the San Gabriel Valley. The San Gabriel Valley has been declared a Superfund site.  The 1995 Water Quality Control Plan issued bythe California Regional Water Quality Control Board states that the primarygroundwater basin pollutants in the San Gabriel Valley are volatile organiccompounds from industry, nitrates from subsurface sewage disposal and pastagricultural activities.  In addition,the Plan noted that hundreds of underground storage tanks leaking gasoline andother toxic chemicals have existed in the San Gabriel Valley.  The California Department of Toxic SubstanceControl has declared large areas of the San Gabriel Valley to be environmentallyhazardous and subject to cleanup work.

 

TheCompany believes the City of South El Monte does not appear to be located overany of the major plumes.  However, theEPA has announced it is studying the possibility that, although the vadose soiland groundwater, while presenting cleanup problems, there may be acontamination by DNAPs (dense non-aqueous phase liquids), i.e., “sinkers”,usually chlorinated organic cleaning solvents. The EPA has proposed to drill six “deep wells” throughout the City ofSouth El Monte at an estimated cost of $1,400,000.  The EPA is conferring with SEMPOA (South ElMonte Property Owners Association) as to cost sharing on this project.  SEMPOA has obtained much lower preliminarycost estimates.  The outcome cost andexact scope of this are unclear at this time.

 

TheCompany and other property owners engaged Geomatrix Consultants, Inc., todo a survey of vadose soil and shallow groundwater in the “hot spots” detectedin the previous studies.  Geomatrixissued a report dated December 1, 1997 (the “Report”), on the impact ofvolatile organic compounds on the soil and groundwater at the Lidcombe andSanta Anita Avenue site located in South El Monte, California (which includesthe Company’s facilities).

 

TheReport indicated generally low concentrations of tetrachloroethene,trichloaethene and trichloroethane in the groundwater of the upgradientneighbor.  The Report was submitted tothe RWQCB for its comments and response. A meeting with the parties and RWQCB was held on February 10,1998.  The RWQCB had advised companiesthat vadose soil contamination is minimal and requires no further action.  However, there is an area of shallowgroundwater which has a higher than desired level of chlorinated solvents, andthe RWQCB requested a proposed work plan be submitted by Geomatrix.

 

Geomatrixhas submitted a “Focused Feasibility Study” which concludes that there are fivepossible methods for cleanup.  The mostexpensive are for a pump and sewer remediation which would cost between $1,406,000and $1,687,000.  The Company is activelyexploring the less expensive alternative remediation methods, of which the twoproposed alternatives range in cost between $985,000 and $1,284,000.  Since there are four economic entitiesinvolved, the Company’s best estimate at this time, in their judgment, would bethat their forecasted share would be $287,000 less the liability alreadyrecognized on the books of $165,000 thereby requiring an additional $122,000liability.

 

Accordingly,the Company recorded an additional accrual of $122,000 in the third quarter offiscal 1998.  The $122,000 accrual is inaddition to the $79,000 accrual for the Monterey Site as will be explained in afollowing paragraph.  The $79,000accrual, in the third quarter of fiscal 1998, related to the Monterey Site isnot included in the $287,000 figure above.

 

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In April 2000,the Company received a Notice of Violation from the RWQCB.  The Notice of Violation states that theCompany and other property owners were required to submit a groundwaterremedial action plan by  November 1,1999,  and that the RWQCB has beenadvised that the Company and the other property owners were unable to submitthe required remedial action plan because the Company and the other propertyowners could not agree on the allocation of financial responsibility to preparethe action plan.  The RWQCB stated thatit will no longer encourage the cooperative approach among the Company and theother property owners in completing the cleanup requirements and will pursueappropriate measures, including when necessary, enforcement actions.  The RWQCB states that it may impose civilliability penalties of up to $1,000 per day from November 1, 1999 forfailure to file the action plan.  Inlight of these events, no assurances can be given that the cleanup costs andpossible penalties will not exceed the amount of the Company’s current accrualsof $287,000 (which includes the $122,000 charge to income in the third quarterof fiscal 1998).

 

In July 2000,the property owners formed the Lidcombe & Santa Anita Avenue WorkGroup (LSAAW) in response to the RWQCB request for the preparation of an actionplan.  The LSAAW submitted a FocusedFeasibility Study to the RWQCB for their review and approval of the selectedremedial action method for the site. After receiving RWQCB approval, LSAAW obtained three cost proposals toimplement the RWQCB approved pump and treat remedial method.  According to these cost proposals, the lowestestimated costs for an assumed five (5) years of pump and treatremediation is $600,000.  This cost islower than the previous cost proposed work plan, discussed above, fromGeomatrix Consultants, Inc.  Thecapital costs including contingencies are approximately $300,000.

 

TheLSAAW is hopeful the Water Quality Authority (WQA) is willing and able toreauthorize its grant for one-half (1/2) of the capital costs of itsremediation system construction not to exceed $150,000.  It is estimated at this time that the reservesfor the Company’s share of this cost proposal are adequate since its prioraccrual was based on the higher cost estimate from Geomatrix.

 

Withoutany prior correspondence or inkling of the Company’s potential liability, theEPA informed the Company that the Company may have potential liability for theongoing remediation of Operating Industries, Inc. (as they have gone outof business) Landfill Superfund Site in Monterey Park, California (the “MontereySite”).  The Monterey Site is a 190 acrelandfill that operated from 1948 to 1984, in which the Company disposed of nontoxic pH balanced waste water on six occasions between 1974 and 1978.  Over 4,000 companies have been identified ashaving contributed waste to the Monterey Site. The EPA has offered to settle the Company’s potential liability withrespect to the Monterey Site for a cost to the Company of $79,233.  The Company accrued a $79,000 charge in thethird quarter of fiscal 1998 with respect to this possible liability.  The Company has elected to file for relieffrom these obligations under the financial hardship option in the EPA’sresponse form.  On June 30, 2000,the EPA informed the Company that the EPA believed the Company is able to paythe full settlement cost, but offered to reduce the amount of the settlement to$75,271.

 

TheCompany was notified by the EPA that the Company may have potential liabilityfor waste material it disposed of at the Casmalia Disposal Site (“Site”)located on a 252 acre parcel in Santa Barbara County, California.  The Site was operational from 1973 to 1989,and over 10,000 separate parties disposed of waste there.  The EPA stated that federal, state and localgovernmental agencies along with the numerous private entities that used theSite for waste disposal will be expected to pay their share as part of thissettlement.  The U.S. EPA is alsopursuing the owner(s)/operator(s) of the Site to pay for Site remediation.  The EPA has a settlement offer to the Companywith respect to the Site for a cost of $373,950.  The Company accrued a $374,000 charge in thefirst quarter of fiscal 1999 with respect to this possible liability.  The Company has elected to file for relieffrom these obligations under the financial hardships option in the EPA’sresponse form.  The Company, the EPA andcertain PRPs have entered into an agreement tolling the applicable statutes oflimitation.  The Company has beennotified by the EPA that their request for a waiver, due to financial hardship,was “partially granted.”  Improvements inthe bidding process has lowered the Company’s estimated share down to $245,000(from $374,000) and of that, the EPA was requesting that the Company pay$113,000, as a result of their findings on the application for waiver due tofinancial hardship.  The Company isconsidering the EPA’s request.

 

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TheCompany has requested a reduced financial liability or waiver on the three EPAsites: SEMOU, Operating Industries, Inc. (OII)  and Casmalia Disposal Site.  The Company has continued to provide theinformation and documentation requested by the EPA as it relates to its abilityto pay.  In connection with this request,the Company understands that the EPA is considering the information.

 

Thetotal amount of environmental investigation and cleanup costs that the Companymay incur with respect to the foregoing is not known at this time.  However, based upon information available tothe Company at this time, the Company has expensed since 1988 a total of$860,000, of which $89,000 were legal fees, exclusive of legal fees expended inconnection with the Securities and Exchange Commission environmentalinvestigation.  The actual costs coulddiffer materially from the amounts expensed for environmental investigation andcleanup costs to date.

 

As of June 30,2005, no settlements have been reached. The total amount expensed in prior years relating to this environmentalissue is $860,000.  As of June 30,2005, no additional amounts have been expensed or accrued.  The Company has an accrued liability on thebooks at June 30, 2005 of $740,000 for the environmental cleanup.

 

**Item 3.****                                    Controlsand Procedures**

 

Thechief executive officer and chief financial officer of the Company (the “certifyingofficer”) evaluated the effectiveness of the Company’s disclosure controls andprocedures as of the end of the period covered by this report.  These disclosure controls and procedures aredesigned to ensure that the information required to be disclosed by the Companyin its periodic reports filed with the Securities and Exchange Commission (the “Commission”)is recorded, processed, summarized and reported, within the time periodsspecified by the Commission’s rules and forms, and that the information iscommunicated to the certifying officer on a timely basis.

 

Thecertifying officer concluded, based on his evaluation, that the Company’sdisclosure controls and procedures are effective for the Company.

 

Therewere no changes in the Company’s internal control over financial reporting thatoccurred during the Company’s most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

**PART II - OTHER INFORMATION**

** **

**Item 1.****                                    LegalProceedings**

 

Theinformation set forth under Part I, Item 2, “Management’s Discussion andAnalysis or Plan of Operations - Environmental Matters” is incorporated hereinby reference.  See also “LegalProceedings” in the Company’s Form 10-KSB for the fiscal year ended September 30,2004.

 

**Item 3.****                                    DefaultsUpon Senior Securities**

 

TheCompany has failed to make principal and interest payments on certainloans.  The total arrearage is principalof $1,622,000 plus interest of $1,185,000, an aggregate of $2,807,000, of which$2,113,000 is due to related parties and $694,000 to non-related parties.

 

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**Item 6.****                                    Exhibitsand Reports on Form 8-K:**

 
|   | The following  exhibits are filed herewith:                        |
|--------|--------------------------------------------------------------------|
|   |                                                               |
|   | 10.1                                                               | - | Promissory note which was amended (modified) in July 2005,  evidencing advance made to the Registrant |
|   |                                                               |   |   |
|   | 10.2                                                               | - | Secured  promissory note dated May 27, 2005, between Lee Pharmaceuticals and  Preferred Business Credit, Inc. |
|   |                                                               |   |   |
|   | 10.3                                                               | - | Secured  promissory note dated May 27, 2005, between Lee Pharmaceuticals and  Preferred Business Credit, Inc. |
|   |                                                               |   |   |
|   | 31.1                                                               | - | Certification by  Chief Executive Officer and Chief Financial Officer |
|   |                                                               |   |   |
|   | 32.1                                                               | - | Section 1350  Certification |
|   |                                                               |
|   | The following  exhibits have previously been filed by the Company: |
|   |                                                               |
|   | 3.1                                                                | - | Articles of  Incorporation, as amended (1) |
|   |                                                               |   |   |
|   | 3.4                                                                | - | By-laws, as  amended December 20, 1977 (2) |
|   |                                                               |   |   |
|   | 3.5                                                                | - | Amendment of  By-laws effective March 14, 1978 (2) |
|   |                                                               |   |   |
|   | 3.6                                                                | - | Amendment to  By-laws effective November 1, 1980 (3) |

 

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|   | (1)    | Filed as an Exhibit of  the same number with the Company’s Form S-1 Registration Statement filed  with the Securities and Exchange Commission on February 5, 1973, (Registrant  No. 2-47005), and incorporated herein by reference. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                         |
|   | (2)    | Filed as  Exhibits 3.4 and 3.5 with the Company’s Form 10-K Annual Report for the  fiscal year ended September 30, 1978, filed with the Securities and  Exchange Commission and incorporated herein by reference.                             |
|   |   |                                                                                                                                                                                                                                                         |
|   | (3)    | Filed as an Exhibit of  the same number with the Company’s Form 10-K Annual Report for the fiscal  year ended September 30, 1979, filed with the Securities and Exchange  Commission and incorporated herein by reference.               |

 

SIGNATURES

 

Inaccordance with the requirements of the Securities Exchange Acts of 1934, theregistrant has caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
|   | LEE PHARMACEUTICALS                    |
|--------|----------------------------------------|
|   | (Registrant)                           |
|   |                                   |
|   |                                   |
| Date:  | AUGUST 5,  2005                   |   | RONALD G. LEE |
|   | Ronald G. Lee                          |
|   | Chairman of the Board, President and   |
|   | Chief Financial and Accounting Officer |
|        |                                        |  |  |

 

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