**UNITEDSTATES SECURITIES AND EXCHANGE 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,  2004** |
|----------------------------------------------------------|
|                                                     |
| **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**                                                                                                                                                                                                                                                                                                                             |

 
| **LEE  PHARMACEUTICALS**                                                            |
|-------------------------------------------------------------------------------------|
| (Exact name of  small business issuer as specified in its charter)                  |
|                                                                                |   |   |
| **California**                                                                      |   | **95-2680312** |
| (State or other  jurisdiction of incorporation  or organization)                    |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |   |
| **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 June 30, 2004 therewere outstanding 4,135,162 shares of common stock of the registrant.

 

Transitional SmallBusiness Disclosure Format (check one):

YesoNoý

 

 

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**LEEPHARMACEUTICALS**

**BALANCESHEET**

**JUNE 30,2004**

**(Dollarsin thousands)**

**(Unaudited)**

** **
| **Assets**                                                                                   |   |    |      |      |      |
|----------------------------------------------------------------------------------------------|--------|---------|-----------|-----------|-----------|
| Cash                                                                                         |   |    |      | **$**     | **18**    |   |
|                                                                                         |   |    |      |      |      |
| Accounts and  notes receivable (net of allowances: $509)                                     |   |    |      | **250**   |      |
|                                                                                         |   |    |      |      |      |
| Inventories (net  of reserves: $555)                                                         |   |    |      |      |      |
| Raw materials                                                                                |   | **$**   | **1,948** |      |      |   |
| Work in process                                                                              |   | **167** |      |      |      |
| Finished goods                                                                               |   | **560** |      |      |      |
|                                                                                         |   |    |      |      |      |
| Total  inventories                                                                           |   |    |      | **2,675** |      |
|                                                                                         |   |    |      |      |      |
| Other current  assets                                                                        |   |    |      | **372**   |      |
|                                                                                         |   |    |      |      |      |
| Total current  assets                                                                        |   |    |      | **3,315** |      |
|                                                                                         |   |    |      |      |      |
| Property, plant  and equipment (less accumulated depreciation and amortization: $5,602)      |   |    |      | **689**   |      |
|                                                                                         |   |    |      |      |      |
| Intangibles and  other assets (net of accumulated amortization: $2,470 and impairment: $952) |   |    |      | **1,780** |      |
|                                                                                         |   |    |      |      |      |
| **TOTAL**                                                                                    |   |    |      | **$**     | **5,784** |   |
|                                                                                              |        |         |           |           |           |  |  |

 

See Accompanying Notes to Financial Statements.

 

2

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**LEEPHARMACEUTICALS**

**BALANCESHEET**

**JUNE 30,2004**

**(Dollarsin thousands)**

**(Unaudited)**

 
| **LIABILITIES**                                                                                       |   |        |      |
|-------------------------------------------------------------------------------------------------------|--------|-------------|-----------|
|                                                                                                  |   |        |      |
| Bank overdraft                                                                                        |   | **$**       | **97**    |   |
| Notes payable -  finance company                                                                      |   | **830**     |      |
| Current portion  - notes payable, other                                                               |   | **2,202**   |      |
| Current portion  - note payable related party                                                         |   | **1,000**   |      |
| Accounts payable                                                                                      |   | **906**     |      |
| Other accrued  liabilities                                                                            |   | **813**     |      |
| Environmental  cleanup liability                                                                      |   | **366**     |      |
| Due to related  parties                                                                               |   | **1,607**   |      |
| Deferred income                                                                                       |   | **191**     |      |
|                                                                                                  |   |        |      |
| Total current  liabilities                                                                            |   | **8,012**   |      |
|                                                                                                  |   |        |      |
| Long-term notes  payable to related parties                                                           |   | **1,523**   |      |
| Long-term notes  payable - finance company                                                            |   | **107**     |      |
| Long-term notes  payable, other                                                                       |   | **1,091**   |      |
| Environmental  cleanup liability - Casmalia Site                                                      |   | **374**     |      |
| Deferred income                                                                                       |   | **167**     |      |
|                                                                                                  |   |        |      |
| Total long-term  liabilities                                                                          |   | **3,262**   |      |
|                                                                                                  |   |        |      |
| Total  liabilities                                                                                    |   | **11,274**  |      |
|                                                                                                  |   |        |      |
| **COMMITMENTS  AND CONTINGENCIES**                                                                    |   |        |      |
|                                                                                                  |   |        |      |
| **STOCKHOLDERS’  (DEFICIT)**                                                                     |   |        |      |
|                                                                                                  |   |        |      |
| Common stock,  $.10 par value; authorized, 7,500,00 shares; issued and outstanding, 4,135,162  shares |   | **413**     |      |
|                                                                                                  |   |        |      |
| Additional  paid-in capital                                                                           |   | **4,222**   |      |
|                                                                                                  |   |        |      |
| Accumulated  (deficit)                                                                                |   | **(10,125** | )         |
|                                                                                                  |   |        |      |
| Total  stockholders’ (deficit)                                                                   |   | **(5,490**  | )         |
|                                                                                                  |   |        |      |
| **TOTAL**                                                                                             |   | **$**       | **5,784** |   |

 

See Accompanying Notes to Financial Statements.

 

3

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**LEEPHARMACEUTICALS**

**STATEMENTSOF OPERATIONS**

**(Dollarsin thousands, except per share amounts)**

**(Unaudited)**

 
|                                |                      | **For the  Three Months  Ended June 30,** |       | **For the  Nine Months  Ended June 30,** |       |
|-------------------------------------|---------------------------|-------------------------------------------|------------|------------------------------------------|------------|
|                                |                      | **2004**                                  |       | **2003**                                 | ** ** | **2004** | ** ** | **2003** |   |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Gross revenues                      |                      | **$**                                     | **1,810**  | ** **                               | $          | 2,430 |   | **$** | **7,183** | ** ** | $ | 7,946 |   |
| Less:                               | Sales  returns            |                                      | **(111**   | **)**                                    | (159       | ) | **(840** | **)** | (708 | ) |
|                                | Cash discounts and others |                                      | **(19**    | **)**                                    | (22        | ) | **(78** | **)** | (85 | ) |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Net revenues                        |                      | **1,680**                                 | ** ** | 2,249                                    |       | **6,265** | ** ** | 7,153 |   |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Costs and  expenses:                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Cost of sales                       |                      | **979**                                   | ** ** | 1,348                                    |       | **3,762** | ** ** | 3,931 |   |
| Selling and  advertising expense    |                      | **686**                                   | ** ** | 666                                      |       | **2,175** | ** ** | 2,133 |   |
| General and  administrative expense |                      | **322**                                   | ** ** | 309                                      |       | **960** | ** ** | 970 |   |
| Interest expense                    |                      | **219**                                   | ** ** | 221                                      |       | **647** | ** ** | 664 |   |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Total costs and  expenses           |                      | **2,206**                                 | ** ** | 2,544                                    |       | **7,544** | ** ** | 7,698 |   |
| Loss from  operations               |                      | **(526**                                  | **)**      | (295                                     | )          | **(1,279** | **)** | (545 | ) |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Other income                        |                      | **94**                                    | ** ** | 74                                       |       | **381** | ** ** | 270 |   |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Net (loss)                          |                      | **$**                                     | **(432**   | **)**                                    | $          | (221 | ) | **$** | **(898** | **)** | $ | (275 | ) |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Per share:                          |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
|                                |                      |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Basic and  diluted (loss) per share |                      | **$**                                     | **(.11**   | **)**                                    | $          | (.05 | ) | **$** | **(.22** | **)** | $ | (.07 | ) |

 

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,** |       |
|------------------------------------------------------------------------------------|--------|------------------------------------------|------------|
|                                                                               |   | **2004**                                 |       | **2003** |   |
|                                                                               |   |                                     | ** ** |   |   |
| Cash flows (used  in) provided by operating activities:                            |   |                                     | ** ** |   |   |
| Net (loss)                                                                         |   | **$**                                    | **(898**   | **)** | $ | (275 | ) |
| Adjustments to  reconcile net income to net cash provided by operating activities: |   |                                     | ** ** |   |   |
| Depreciation                                                                       |   | **147**                                  | ** ** | 123 |   |
| Amortization of  intangibles                                                       |   | **195**                                  | ** ** | 149 |   |
| (Decrease) in  deferred income                                                     |   | **(195**                                 | **)**      | (113 | ) |
| Change in  operating assets and liabilities:                                       |   |                                     | ** ** |   |   |
| Decrease in  accounts receivable, net                                              |   | **330**                                  | ** ** | 104 |   |
| (Increase) in  inventories                                                         |   | **(169**                                 | **)**      | (153 | ) |
| (Increase)  decrease in deposits                                                   |   | **(16**                                  | **)**      | 35 |   |
| (Increase)  decrease in other current assets                                       |   | **(27**                                  | **)**      | 22 |   |
| (Decrease)  increase in bank overdraft                                             |   | **(3**                                   | **)**      | 152 |   |
| Increase in  accounts payable and accrued liabilities                              |   | **286**                                  | ** ** | 494 |   |
| (Decrease)  increase in due to related parties                                     |   | **(112**                                 | **)**      | 21 |   |
| Net cash (used  in) provided by operating activities                               |   | **(462**                                 | **)**      | 559 |   |
|                                                                               |   |                                     | ** ** |   |   |
| Cash flows from  investing activities:                                             |   |                                     | ** ** |   |   |
| Additions to  property , plant and equipment                                       |   | **(181**                                 | **)**      | (273 | ) |
| (Decrease) in  due on investment acquisitions                                      |   | **—**                               | ** ** | (215 | ) |
| Net cash (used  in) investing activities                                           |   | **(181**                                 | **)**      | (488 | ) |
|                                                                               |   |                                     | ** ** |   |   |
| Cash flows from  financing activities:                                             |   |                                     | ** ** |   |   |
| Proceeds from  notes payable to related party                                      |   | **330**                                  | ** ** | 93 |   |
| (Payments on)  notes payable to related party                                      |   | **(112**                                 | **)**      | (89 | ) |
| (Decrease) in  notes payable, finance company                                      |   | **(39**                                  | **)**      | (256 | ) |
| Proceeds from  notes payable, other                                                |   | **550**                                  | ** ** | 800 |   |
| (Payments on)  notes payable, other                                                |   | **(84**                                  | **)**      | (617 | ) |
| Net cash  provided by (used in) financing activities                               |   | **645**                                  | ** ** | (69 | ) |
|                                                                               |   |                                     | ** ** |   |   |
| Net increase in  cash                                                              |   | **2**                                    | ** ** | 2 |   |
| Cash, beginning  of period                                                         |   | **16**                                   | ** ** | 26 |   |
| Cash, end of  period                                                               |   | **$**                                    | **18**     | ** ** | $ | 28 |   |
|                                                                               |   |                                     | ** ** |   |   |
| **Supplemental  disclosures of cash flow information:**                            |   |                                     | ** ** |   |   |
|                                                                               |   |                                     | ** ** |   |   |
| Cash paid during  the year for:                                                    |   |                                     | ** ** |   |   |
| Interest                                                                           |   | **$**                                    | **184**    | ** ** | $ | 593 |   |
| Taxes                                                                              |   | **$**                                    | **1**      | ** ** | $ | 1 |   |

 

See Accompanying Notes to Financial Statements.

 

5

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LEEPHARMACEUTICALS

 

**Notes to Financial Statements**

**(Unaudited)**

 

1.               Basis ofpresentation:

 

The condensed interimfinancial statements included herein have been prepared by Lee Pharmaceuticalswithout audit, pursuant to the rules and regulations of the Securities andExchange Commission.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations, although theCompany believes that the disclosures are adequate to make the informationpresented not misleading.

 

These statements reflectall adjustments, consisting of normal recurring adjustments (except as setforth in Note 5) which, in the opinion of management, are necessary for fairpresentation of the information contained herein.  It is suggested that these condensed financial statements be readin conjunction with the financial statements and notes thereto included in theCompany’s Annual Report on Form 10-KSB for the year ended September 30,2003.  The Company follows the sameaccounting policies in preparation of interim reports.

 

Results of operations forthe interim periods may not be indicative of annual results.

 

The Company is involvedin various matters involving environmental cleanup issues.  See “Item 2. Management’s Discussionand Analysis or Plan of Operations” and Note 13 of Notes to Financial Statementsincluded in the Company’s Form 10-KSB for the fiscal year ended September 30,2003.  The ultimate outcome of thesematters cannot presently be determined. Environmental expenditures that relate to an existing condition causedby past operations, and which do not contribute to current or future revenuegeneration, are expensed.  The Company’sproportionate share of the liabilities are recorded when environmentalremediation and/or cleanups are probable, and the costs can be reasonablyestimated.  As of June 30, 2004, nosettlements have been reached.

 

2.               Continuedexistence:

 

The financial statementshave been prepared assuming that the Company will continue as a goingconcern.  The Company has an accumulateddeficit of $10,125,000.  The Company’srecurring losses from operations and inability to generate sufficient cash flowfrom normal operations to meet its obligations as they come due raisesubstantial doubt about the Company’s ability to continue as a going concern.  The Company’s ability to continue inexistence is dependent upon future developments, including retaining currentfinancing and achieving a level of profitable operations sufficient to enableit to meet its obligations as they become due. Management’s plans in regard to these matters are to increaseprofitability by increasing sales, control expenses and seek additionalfinancing from outside lenders.  Thefinancial statements do not include any adjustments to reflect the possiblefuture effects of the recoverability and classification of assets or theamounts and classification of liabilities that may result from the possibleinability of the Company to continue as a going concern.

 

3.               Use of estimates:

 

The preparation offinancial statements in conformity with generally accepted accountingprincipals requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosures of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

6

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4.               Reclassification:

 

Certain reclassificationshave been made to the prior year financial statements to be consistent with the2004 presentation.

 

5.               Impairment ofintangible assets:

 

At June 30, 2004, theCompany had $5.1 million of product line and certain identifiableintangibles.  In assessing therecoverability of these intangibles, the Company must make assumptionsregarding estimated future cash flows and other factors to determine the fairvalue of the respective assets.  If theestimates or their related assumptions change in the future, the Company may berequired to record impairment charges for these assets not previouslyrecorded.  In connection with theadoption of SFAS 142 issued in July 2001, the Company performed an impairmentassessment for the nine months ended June 30, 2004, using a twelve month movingaverage, and determined that an incorrect formula was used during the quarterended March 31, 2004 resulting in a $90,000 overcharge.  This was adjusted in the quarter ended June30, 2004.

 

6.               Loss per share:

 

The Company has a simplecapital structure, and there were no changes under the SFAS 128 methodology tothe previously reported earnings (loss) per share amounts for any of the fiscalyears.  Basic earnings (loss) per shareunder SFAS 128 were computed using the weighted average number of sharesoutstanding of 4,135,162 for the nine months ended June 30, 2004 and June 30,2003.

 

7.               Other income:

 

For the nine months endedJune 30, 2004, other income included realized gains of approximately $195,000related to the sale of three product lines. These realized gains pertain to the recognition of the earned portion ofthe deferred income of the consulting agreements arising from the sale of theseproduct lines.  Also included is$187,000 arising from a service agreement with Monticello Drug Company.  For the nine months ended June 30, 2003,other income consisted of realized gains as described above of $112,000, jointventure income of $143,000 and $15,000 in property tax refunds.

 

For the quarter endedJune 30, 2004, other income included realized gains of approximately $56,000related to the sale of three product lines. These realized gains pertain to the recognition of the earned portion ofthe deferred income of the consulting agreements arising from the sale of theseproduct lines.  Also included is $39,000arising from a service agreement with Monticello Drug Company.  For the quarter ended June 30, 2003, otherincome consisted of realized gains as described above of $37,000 and jointventure income of $39,000.

 

8.               Income taxes:

 

At June 30, 2004, theCompany has a Federal net operating loss (NOL) carry forward of approximately$14,750,000 for which it has recorded a valuation allowance for the entire NOL.

 

7

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

 

**Material Changes in Results ofOperations**

**Three Months Ended June 30, 2004, andJune 30, 2003**

 

Gross revenues for thethree months ended June 30, 2004, were $1,810,000, a decrease of $620,000, or26%, from the comparable three months ended June 30, 2003.  The decrease was due to lower sales ofvarious over-the-counter items ($292,000), the Lee® Lip-Ex®line ($213,000), private label segment ($104,000), depilatories ($26,000) andLee Nails® category ($54,000). These decreases were somewhat offset by increases in otherover-the-counter items ($66,000) along with a newly acquired brand ($46,000).

 

Net revenues declinedapproximately $569,000, or 25%, for the three months ended June 30, 2004, ascompared to the three months ended June 30, 2003.  The change in net revenues was primarily due to the explanationsgiven above.  The Company’s salesreturns decreased $48,000, or 30%, when comparing the three months ended June30, 2004 and 2003.  The Companyexperienced lower product returns during the June 30, 2004 quarter when comparedto the June 30, 2003 quarter because many of the overstocked items related tothe over-the-counter items were returned during the quarter ended June 30,2003.

 

Cost of sales as apercentage of gross revenues was 54% for the three months ended June 30, 2004,compared to 55% for the three months ended June 30, 2003.  This decrease was primarily due to loweranalytical testing costs, the result of more testing being done in house($24,000) and lower equipment maintenance costs ($20,000).  These reductions were somewhat offset byhigher laboratory supplies due to additional in-house testing ($5,000), higherdepreciation ($4,000) due to additional equipment, higher freight costs($8,000) and higher workers’ compensation insurance premiums ($3,000).  The continued change in the overall productmix, particularly pertaining to lower gross margin items, has causedfluctuations in the Company’s cost of sales percentage.

 

Selling and advertisingexpenses increased $20,000, or 3%, when comparing the three months ended June30, 2004 and June 30, 2003.  Thisincrease was due primarily to higher advertising costs ($78,000), highersalaries and related fringe benefits due to the hiring of an additionalsalesman ($33,000), higher insurance expense due to increased premiums forproduct liability insurance ($25,000) and higher building rent due to abuilding previously subleased now being used for warehouse and shipping$21,000).  Somewhat offsetting theseincreases were lower freight costs due to lower sales volume ($23,000) andlower bad debt expense due to an increase in the reserve of $25,000 in thequarter ended June 30, 2003, with no similar increases in the quarter endedJune 30, 2004.  Also, the Companyoverstated the recognition of its asset impairment adjustment during the March31, 2004 quarter due to the incorrect application of an impairmentformula.  The Company reversed a portionof the overstated charge to expense ($90,000) during the quarter ended June 30,2004.

 

General andadministrative expenses increased $13,000, or 4%, when comparing the threemonths ended June 30, 2004 and June 30, 2003. The increase was due to higher labor costs and related fringe benefitsfor annual salary reviews and additional personnel ($9,000) and increasedtravel and entertainment expenses ($6,000).

 

Interest expense wasrelatively constant when comparing the three months ended June 30, 2004 withthe three months ended June 30, 2003.

 

The Company realizedother income of approximately $94,000 for the three months ended June 30, 2004,as compared to $74,000 for the comparable three months ended June 30,2003.  Of this  income for the three months ended June 30, 2004, $56,000 pertainsto realized gains related to the sale of the Klutch® product line($13,000), the sale of the Astring-o-Sol® product line ($11,000) andthe sale of the iodex® product line ($32,000).  The realized gains pertain to therecognition of the earned portion of the deferred income of the consulting  agreements arising from the sale of the Klutch®,Astring-o-Sol® and iodex® brands.   Also included in other income in 2004 isapproximately $39,000 arising from the service agreement with Monticello DrugCompany.  For the three months endedJune 30, 2003, the Company realized other income related to the sale of Klutch®($26,000) and Astring-o-Sol® ($11,000) product lines along with$39,000 which was the Company’s portion of the net profits from its investmentwith Monticello Drug Company.

 

8

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**Material Changes in Results ofOperations**

**Nine Months Ended June 30, 2004, andJune 30, 2003**

 

Gross revenues for thenine months ended June 30, 2004, were $7,183,000, a decrease of $763,000, or10%, from the comparable nine months ended June 30, 2003.  The decrease was due to lower sales invarious over-the-counter brand products ($890,000), the Lee® Lip-Ex®line ($359,000) and Lee Nails® category (105,000).  Somewhat offsetting these decreases wereincreases of other over-the-counter items ($314,000), private label segment($148,000) and a newly acquired brand ($146,000).

 

Net revenues declinedapproximately $888,000, or 12%, for the nine months ended June 30, 2004, ascompared to the nine months ended June 30, 2003.  The change in net revenues was primarily due to the sales volume explanationsgiven above.  The Company’s salesreturns increased $132,000, or approximately 19%, when comparing the ninemonths ended June 30, 2004 and 2003. The higher sales returns were due to the deletion of a couple of theCompany’s SKUs (stock keeping units) at the retail store level.

 

Cost of sales as apercentage of gross revenues was 52% for the nine months ended June 30, 2004,compared to 50% for the nine months ended June 30, 2003.  The Company has continued to experiencechanges in the overall product mix along with lower priced commodity-type goodswith an accompanying higher cost of goods attached to them.  This increase is primarily due to thecontinued change in the product mix to higher cost of goods products resultingin lower gross margins for these products. In addition, the Company increased its inventory obsolescence reserve($132,000) during the three months ended March 31, 2004.  The Company also incurred highermanufacturing overhead expenses of $24,000 for depreciation of newly acquiredequipment, $16,000 in equipment repairs and maintenance along with suppliesexpense and $13,000 in workers’ compensation insurance costs due to higherpremium rates.  These increased costswere partially offset by lower analytical testing costs ($48,000) due to moretesting being performed in-house and lower freight costs ($15,000).

 

Selling and advertisingexpenses increased $42,000, or 2%, when comparing the nine months ended June30, 2004 with the nine months ended June 30, 2003.  The increase in expenses was due to the following factors: (1)higher insurance expense due to increased premiums for product liabilitycoverage ($89,000), (2) higher building rent due to a building, previouslysubleased, now being used for warehousing and shipping ($64,000), (3) higherlabor and related fringe benefit costs ($54,000), (4) higher amortization costs($46,000) due to the recognition of impairment of one of the Company’s productlines in compliance with the Financial Accounting Standards Board issuance ofStatement of Financial Accounting Standards No. 142 (FAS-142), Goodwill andOther Intangible Assets and (5) higher advertising costs ($43,000).  These increases were somewhat offset by: (1)lower commissions to outside sales reps ($37,000), (2) lower royalty expense($81,000), (3) lower convention expenses ($7,000), (4) lower freight costs($86,000) and (5) lower travel and entertainment expenses ($28,000).

 

General andadministrative expenses decreased $10,000, or 1%, when comparing the ninemonths ended June 30, 2004, with the nine months ended June 30, 2003.  The decrease was principally due to: (1)lower legal fees ($42,000) and (2) lower MIS expenses for consulting services($46,000).  These decreases werepartially offset by (1) higher audit fees ($13,000), (2) increased costs forvarious supplies ($40,000), (3) increased travel and entertainment expenses($7,000), (4) increased workers’ compensation insurance premiums ($5,000) and(6) increased shareholder expenses ($4,000).

 

Interest expensedecreased $17,000, or 3%, when comparing the nine months ended June 30, 2004,with the nine months ended June 30, 2003. This was due principally to lower borrowings.

 

9

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The Company realizedother income of approximately $381,000 for the nine months ended June 30, 2004,as compared to $270,000 for the comparable nine months ended June 30,2003.  Of this  income, $194,000 pertains to realized gains related to the saleof 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($95,000).  The realized gains pertainto the recognition of the earned portion of the deferred income of theconsulting  agreements arising from thesale of the Klutch®, Astring-o-Sol® and iodex®brands.   Also included in other incomeis approximately $187,000 arising from the service agreement with MonticelloDrug Company.  For the nine months endedJune 30, 2003, the Company realized other income related to the sale of Klutch®($81,000) and Astring-o-Sol® ($32,000) product lines along with$144,000 which was the Company’s portion of the net profits from its investmentwith Monticello Drug Company plus $15,000 of property tax refunds.

 

**Liquidity and Capital Resources**

 

At June 30, 2004, workingcapital was a negative $4,697,000 compared with a negative $3,525,000 as ofSeptember 30, 2003.  The ratio ofcurrent assets to current liabilities was 0.4 to 1 at June 30, 2004 and 0.5 to1 at September 30, 2003.  The Companyhas failed to make principal and interest payments on certain loans.  The total arrearage is principal of$2,178,000 plus interest of $1,152,000, an aggregate of $3,330,000 of which$1,889,000 is due to related parties and $1,441,000 to non relatedparties.  The Company is negotiating thesale of one or more of its product lines. If these sales occur, an amount of $1,084,000 of principal and interest,due as of June 30, 2004, will be paid to two non related party investors.  There can be no guarantee that this transactionwill materialize.

 

The Company has anaccumulated deficit of $10,125,000. Past recurring losses and inability to generate sufficient cash flowfrom normal operations to meet its obligations as they become due, raisessubstantial 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.

 

**Environmental Matters**

 

The Company owns amanufacturing facility located in South El Monte, California.  The California Regional Water QualityControl Board (The “RWQCB”) ordered the Company in 1988 and 1989 to investigatethe contamination on its property (relating to soil and groundwatercontamination).  The Company engaged aconsultant who performed tests and reported to the then Chairman of theCompany.  The Company resisted furtherwork on its property until the property upgradient was tested in greater detailsince two “apparent source” lots had not been tested.  On August 12, 1991, the RWQCB issued a “Cleanup and AbatementOrder” directing the Company to conduct further testing and cleanup thesite.  In October 1991, the Companyreceived from an environmental consulting firm an estimate of $465,200 forinvestigation and cleanup costs.  TheCompany believed that this estimate was inconclusive and overstated the contamination levels.  The Company believes that subsequent investigationswill support the Company’s conclusions about that estimate.  The Companydid not complete the testing for the reasons listed above as well as “financialconstraints”.  In June 1992, the RWQCBrequested that the EPA evaluate the contamination and take appropriateaction.  At the EPA’s request, Ecology& Environment, Inc. conducted an investigation of soil and groundwater onthe Company’s property.  Ecology & EnvironmentInc.’s Final Site Assessment Report, which was submitted to the EPA in June 1994,did not rule out the possibility that some of the contamination originatedon-site, and resulted from either past or current operations on the property.

 

On April 24, 2002, theRWQCB notified the Company that the detection of emergent chemicals in groundwater,above State and Federal maximum containment levels or action levels, has causedthe RWQCB and the EPA to reassess the threat posed to groundwater resourcesused for domestic supply.  The RWQCBdirected the Company to test for the presence of emergent chemicals in itsgroundwater monitoring wells.  Thegroundwater monitoring analytical results were due by July 15, 2002.  On May 24, 2002, the Company informed RWQCBthat it could not comply with the requirement to conduct groundwater samplingdue to ongoing financial difficulties.

 

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On July 8, 2002, theRWQCB sent a “Second Notice of Violation” to the Company directing the Companyto comply with the requirement to prepare a groundwater remedial action plan(RAP).  The Company previously notifiedthe RWQCB that it could not comply with the requirement to submit a RAP becauseof ongoing financial difficulties.  TheRWQCB requested that the Company submit certain financial information by July29, 2002 to “substantiate any alleged financial losses and determine whetherany suspension of implementing the...(Cleanup and Abatement Order) iswarranted.”  The Company received anextension to submit the required financial information to August 19, 2002.  The Company submitted the requestedfinancial information on August 16, 2002. The Company received a response whereby their request for financialhardship was denied.  The Company is inthe process of appealing this decision based primarily upon the continued deteriorationin the Company finances since the original filing.  The Company may be liable for all or part of the costs ofremediating the contamination on its property and could be subject toenforcement action by the RWQCB, including injunctive and civil monetaryremedies.  As of the date of thefinancial statements, the Company’s share of the costs have not beendetermined.

 

The Company and nearbyproperty owners, in consort with their comprehensive general liability (CGL)carriers, engaged a consultant to perform a site investigation with respect tosoil and shallow groundwater contamination over the entire city block.  The CGL carriers provided $290,000 infunding which paid for the $220,000 study, $20,000 in legal fees for projectoversight, 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.

 

The tenants of nearbyproperties upgradient have sued the Company alleging that hazardous materialsfrom the Company’s property caused contamination on the properties leased bythe tenants.  The case name is DelRay Industrial Enterprises, Inc. v. Robert Malone, et al., LosAngeles County Superior Court, Northwest District, commenced August 21,1991.  In this action, the plaintiffalleges environmental contamination by defendants of its property, and seeks acourt order preventing further contamination and monetary damages.  The Company does not believe there is anybasis for the allegations and is vigorously defending the lawsuit.

 

The Company’s South ElMonte manufacturing facility is also located over a large area of possiblycontaminated regional groundwater which is part of the San Gabriel ValleySuperfund Site.  The Company has beennotified that it is a potentially responsible party  (“PRP”)  for thecontamination.   In 1995, the Companywas informed that the EPA estimated the cleanup costs for the South El Monte’sportion of the San Gabriel Valley Superfund Site to be $30 million.  The Company’s potential share of such amounthas not been determined.  Superfund PRPsare jointly and severally liable for superfund site costs, and are responsiblefor negotiating among themselves the allocation of the costs based on, amongother things, the outcome of environmental investigation.

 

In August 1995, theCompany 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 theSouth El Monte Operable Unit Site Participation Agreement with Cardinalpursuant to which, among other things, Cardinal contracted with anenvironmental firm to conduct the Study. The Study has been completed. The Company’s share of the cost of the Study was $15,000 and was accruedfor in the financial statements as of September 30, 1995.  TheSouth  El  Monte Operable Unit (SEMOU) participants developed four remedialalternatives.  The capital cost of thefour alternatives range from $0 (no action) up to $3.49 million.  The estimated annual operating cost for thefour alternatives range from $0 (no action) to $770,300.  Over a 30-year period, the total cost of thefour alternatives range from $0 (no action) up to $13.05 million.  The EPA prefers an alternative whichestimates the capital cost up to $3.08 million, the annual operating cost at$.48 million, and the 30-year period total cost up to approximately $9.09million.  The selection of the actualalternative implemented is subject to public comment.  At the present time, the Company does not know what its share ofthe cost may be, if any.  Therefore, noadditional accrual has been recognized as a liability on the Company’sbooks.  The Company requested that theEPA conduct an “ability-to-pay evaluation” to determine whether the Company isentitled to an early settlement of this matter

 

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based upon a limitedability to pay costs associated with site investigation and remediation.  In August 2000, the EPA informed the Companythat it does not qualify for an early settlement at this time.

 

The EPA has informed theCompany that it has learned that the intermediate zone groundwatercontamination in the western portion of the SEMOU has migrated further west andhas now impacted the City of Monterey Park and Southern California WaterCompany production wells.  The EPAstated that the City of Monterey Park Water Department, San Gabriel ValleyWater Company and Southern California Water Company are planning to buildtreatment 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 “South El MonteCooperative Group” has been formed and purportedly has reached a generalagreement with the water purveyors to fund the development of treatment facilitiesand use the water purveyors’ wells in an attempt to contain the groundwatercontamination to

meet EPA’s goals.  The Company is not able to determine whatcontribution, if any, it may be assessed in connection with this cleanupactivity.

 

By letter dated November13, 2000, the Company was notified that the City of Monterey Park, San GabrielValley Water Company and Southern California Water Company intend to bring suitunder the Safe Drinking Water and Toxic Enforcement Act of 1986 alleging thatthe Company has knowingly released volatile organic compounds in the soil andshallow groundwater beneath the Company’s property between at least on orbefore November 8, 1996 and the present and has failed to promptly clean up allof the contamination.  As of the date ofthis report, the Company has not been served with this lawsuit.

 

The City of South ElMonte, the city in which the Company has its manufacturing facility, is locatedin the San Gabriel Valley.  The SanGabriel Valley has been declared a Superfund site.  The 1995 Water Quality Control Plan issued by the CaliforniaRegional Water Quality Control Board states that the primary groundwater basinpollutants in the San Gabriel Valley are volatile organic compounds fromindustry, nitrates from subsurface sewage disposal and past agriculturalactivities.  In addition, the Plan notedthat hundreds of underground storage tanks leaking gasoline and other toxicchemicals have existed in the San Gabriel Valley.  The California Department of Toxic Substance Control has declaredlarge areas of the San Gabriel Valley to be environmentally hazardous andsubject to cleanup work.

 

The Company believes theCity of South El Monte does not appear to be located over any of the majorplumes.  However, the EPA has announcedit is studying the possibility that, although the vadose soil and groundwater,while presenting cleanup problems, there may be a contamination by DNAPs (densenon-aqueous phase liquids), i.e., “sinkers”, usually chlorinated organiccleaning solvents.  The EPA has proposedto drill six “deep wells” throughout the City of South El Monte at an estimatedcost of $1,400,000.  The EPA isconferring with SEMPOA (South El Monte Property Owners Association) as to costsharing on this project.  SEMPOA hasobtained much lower preliminary cost estimates.  The outcome cost and exact scope of this are unclear at thistime.

 

The Company and otherproperty owners engaged Geomatrix Consultants, Inc., to do a survey of vadosesoil and shallow groundwater in the “hot spots” detected in the previousstudies.  Geomatrix issued a reportdated December 1, 1997 (the “Report”), on the impact of volatile organiccompounds on the soil and groundwater at the Lidcombe and Santa Anita Avenuesite located in South El Monte, California (which includes the Company’sfacilities).  The Report indicatedgenerally low concentrations of tetrachloroethene, trichloaethene andtrichloroethane in the groundwater of the upgradient neighbor.  The Report was submitted to the RWQCB forits comments and response.  A meetingwith the parties and RWQCB was held on February 10, 1998.  The RWQCB had advised companies that vadosesoil 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.  Geomatrix has submitted a “FocusedFeasibility Study” which concludes that there are five possible methods forcleanup.  The most expensive are for apump and sewer remediation which would cost between $1,406,000 and$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,

 

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would be that theirforecasted share would be $287,000 less the liability already recognized on thebooks of $165,000 thereby requiring an additional $122,000 liability.  Accordingly, the Company recorded anadditional accrual of $122,000 in the third quarter of fiscal 1998.  The $122,000 accrual is in addition to the$79,000 accrual for the Monterey Site as will be explained in the followingparagraph.  The $79,000 accrual, in thethird quarter of fiscal 1998, related to the Monterey Site is not included inthe $287,000 figure above.  In April2000, 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 been advisedthat the Company and the other property owners were unable to submit therequired remedial action plan because the Company and the other property ownerscould not agree on the allocation of financial responsibility to prepare theaction plan.  The RWQCB stated that itwill 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 for failureto file the action plan.  In light ofthese events, no assurances can be given that the cleanup costs and possiblepenalties will not exceed the amount of the Company’s current accruals of$287,000 (which includes the $122,000 charge to income in the third quarter offiscal 1998).

 

In July 2000, theproperty owners formed the Lidcombe & Santa Anita Avenue Work Group (LSAAW)in response to the RWQCB request for the preparation of an action plan.  The LSAAW submitted a Focused FeasibilityStudy to the RWQCB for their review and approval of the selected remedialaction method for the site.  Afterreceiving RWQCB approval, LSAAW obtained three cost proposals to implement theRWQCB approved pump and treat remedial method. According to these cost proposals, the lowest estimated costs for anassumed five (5) years of pump and treat remediation is $600,000.  This cost is lower than the previous costproposed work plan, discussed above, from Geomatrix Consultants, Inc.  The capital costs including contingenciesare approximately $300,000.

 

The LSAAW is hopeful theWater Quality Authority (WQA) is willing and able to reauthorize its grant forone-half (1/2) of the capital costs of its remediation system construction notto exceed $150,000.  It is estimated atthis time that the reserves for the Company’s share of this cost proposal areadequate since its prior accrual was based on the higher cost estimate fromGeomatrix.

 

Without any priorcorrespondence or inkling of the Company’s potential liability, the EPAinformed the Company that the Company may have potential liability for theongoing remediation of Operating Industries, Inc. (as they have gone out ofbusiness) 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, theEPA informed the Company that the EPA believed the Company is able to pay thefull settlement cost, but offered to reduce the amount of the settlement to$75,271.

 

The Company was notifiedby the EPA that the Company may have potential liability for waste material itdisposed of at the Casmalia Disposal Site (“Site”) located on a 252 acre parcelin Santa Barbara County, California. The Site was operational from 1973 to 1989, and over 10,000 separateparties disposed of waste there.  The EPAstated that federal, state and local governmental agencies along with the numerousprivate entities that used the Site for waste disposal will be expected to paytheir share as part of this settlement. The U.S. EPA is also pursuing the owner(s)/operator(s) of the Site topay for Site remediation.  The EPA has asettlement offer to the Company with respect to the Site for a cost of$373,950.  The Company accrued a$374,000 charge in the first quarter of fiscal 1999 with respect to thispossible liability.  The Company haselected to file for relief from these obligations under the financial hardshipsoption in the EPA’s response form.  TheCompany, the EPA and certain PRPs have entered into an agreement tolling theapplicable statutes of limitation.  The Companyhas been notified by the EPA that their request for a waiver, due to financialhardship, was “partially granted.” Improvements in the bidding process has lowered the Company’s estimatedshare down to

 

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$245,000 (from $374,000)and of that, the EPA was requesting that the Company pay $113,000, as a resultof their findings on the application for waiver due to financial hardship.  The Company is considering the EPA’srequest.

 

The Company has requesteda reduced financial liability or waiver on the three EPA sites: SEMOU, OperatingIndustries, Inc. (OII)  and CasmaliaDisposal Site.  The Company hascontinued to provide the information and documentation requested by the EPA asit relates to its ability to pay.  Inconnection with this request, the Company understands that the EPA isconsidering the information.

 

The total amount ofenvironmental investigation and cleanup costs that the Company may incur withrespect to the foregoing is not known at this time.  However, based upon information available to the Company at thistime, the Company has expensed since 1988 a total of $860,000, of which $89,000were legal fees, exclusive of legal fees expended in connection with theSecurities and Exchange Commission environmental investigation.  The actual costs could differ materially fromthe amounts expensed for environmental investigation and cleanup costs to date.

 

As of June 30, 2004, nosettlements have been reached.  Thetotal amount expensed in prior years relating to this environmental issue is$860,000.  As of June 30, 2004, no additionalamounts have been expensed or accrued. The Company has an accrued liability on the books at June 30, 2004 of$740,000 for the environmental cleanup.

 

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

 

The chief executiveofficer and chief financial officer of the Company (the “certifying officer”)evaluated the effectiveness of the Company’s disclosure controls and proceduresas of the end of the period covered by this report.  These disclosure controls and procedures are designed to ensurethat the information required to be disclosed by the Company in its periodicreports filed with the Securities and Exchange Commission (the “Commission”) isrecorded, processed, summarized and reported, within the time periods specifiedby the Commission’s rules and forms, and that the information is communicatedto the certifying officer on a timely basis.

 

The certifying officerconcluded, based on his evaluation, that the Company’s disclosure controls andprocedures are effective for the Company.

 

There were no changes inthe Company’s internal control over financial reporting that occurred duringthe Company’s most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**PARTII - Other Information**

 

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

 

The information set forthunder Part I, Item 2, “Management’s Discussion and Analysis or Plan ofOperations - Environmental Matters” is incorporated herein by reference.  See also “Legal Proceedings” in the Company’sForm 10-KSB for the fiscal year ended September 30, 2003.

 

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

 

The Company has failed tomake principal and interest payments on certain loans.  The total arrearage is principal of$2,178,000 plus interest of $1,152,000, an aggregate of $3,330,000 of which$1,889,000 is due to related parties and $1,441,000 to non relatedparties.  The Company is negotiating thesale of one or more of its product lines. If these sales occur, an amount of $1,084,000 of principal and interest,due as of June 30, 2004, will be paid to two non related party investors.  There can be no guarantee that thistransaction will materialize.

 

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

 

The following exhibitsare filed herewith:

 
| 10.1                                                               | -      | Promissory note  evidencing advance made to the Registrant                                                                                                                         |
|--------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                               |   |                                                                                                                                                                               |
| 10.2                                                               | -      | Modification of loan  and security agreement dated May 20, 2004, between Lee Pharmaceuticals and  Preferred Business Credit, Inc. regarding a revolving credit facility  financing |
|                                                               |   |                                                                                                                                                                               |
| 10.3                                                               | -      | Demand promissory note  evidencing advance made to the Registrant                                                                                                                  |
|                                                               |   |                                                                                                                                                                               |
| 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, 1997 (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)               Filedas an Exhibit of the same number with the Company’s Form S-1 RegistrationStatement filed with the Securities and Exchange Commission on February 5,1973,  (Registrant No. 2-47005), andincorporated herein by reference.

 

(2)               Filedas Exhibits 3.4 and 3.5 with the Company’s Form 10-K Annual Report for thefiscal year ended September 30, 1978, filed with the Securities and ExchangeCommission and incorporated herein by reference.

 

(3)               Filedas an Exhibit of the same number with the Company’s Form 10-K Annual Report forthe fiscal year ended September 30, 1979, filed with the Securities andExchange Commission and incorporated herein by reference.

 

 

SIGNATURES

 

In accordance with therequirements of the Securities Exchange Acts of 1934, the registrant has causedthis report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |           | LEE  PHARMACEUTICALS                                                         |          |   |
|--------|----------------|------------------------------------------------------------------------------|---------------|--------|
|   |           | (Registrant)                                                                 |          |
|   |           |                                                                         |          |
|   |           |                                                                         |          |
| Date:  | AUGUST 9, 2004 |                                                                         | RONALD G. LEE |   |   |
|   |           | Ronald G. Lee                                                                |          |
|   |           | Chairman of the Board, President and Chief Financial  and Accounting Officer |          |
|        |                |                                                                              |               |        |  |

 

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