**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  December31, 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 ofsmall 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 December 31,2004 there were outstanding 4,135,162 shares of common stock of the registrant.

 

Transitional SmallBusiness Disclosure Format (check one):

Yes o No ý

 

 

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**LEEPHARMACEUTICALS**

**BALANCESHEET**

**DECEMBER31, 2004**

**(Dollarsin thousands)**

**(Unaudited)**

 
| **ASSETS**                                                                                     | ** ** | ** ** |       |       |       |
|------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| Cash                                                                                           |       |       | ** ** | **$**      | **19**     | ** ** |
|                                                                                           |       |       |       |       |       |
| Accounts and  notes receivable (net of allowances: $219)                                       |       |       | ** ** | **1,055**  | ** ** |
|                                                                                           |       |       | ** ** | ** ** | ** ** |
| Inventories (net  of reserves: $850)                                                           |       |       |       |       |       |
| Raw materials                                                                                  |       | **$**      | **1,361**  | ** ** | ** ** | ** ** |
| Work in process                                                                                |       | **102**    | ** ** | ** ** | ** ** |
| Finished goods                                                                                 |       | **380**    | ** ** | ** ** | ** ** |
|                                                                                           |       | ** ** | ** ** | ** ** | ** ** |
| Total  inventories                                                                             |       |       | ** ** | **1,843**  | ** ** |
|                                                                                           |       |       |       |       |       |
| Other current  assets                                                                          |       |       | ** ** | **669**    | ** ** |
|                                                                                           |       |       | ** ** | ** ** | ** ** |
| Total current assets                                                                           |       |       | ** ** | **3,586**  | ** ** |
|                                                                                           |       |       |       |       |       |
| Property, plant  and equipment (less accumulated depreciation and amortization: $5,720)        |       |       | ** ** | **786**    | ** ** |
|                                                                                           |       |       |       |       |       |
| Intangibles and  other assets (net of accumulated amortization: $1,424 and impairment: $2,202) |       |       | ** ** | **1,576**  | ** ** |
|                                                                                           |       |       |       |       |       |
| **TOTAL**                                                                                      | ** ** | ** ** | ** ** | **$**      | **5,948**  | ** ** |
|                                                                                                |            |            |            |            |            |  |  |

 

 

See AccompanyingNotes to Financial Statements.

 

2

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**LEEPHARMACEUTICALS**

**BALANCESHEET**

**DECEMBER31, 2004**

**(Dollarsin thousands)**

**(Unaudited)**

 
| **LIABILITIES**                                                                                       |       |        |       |
|-------------------------------------------------------------------------------------------------------|------------|-------------|------------|
|                                                                                                  |       |        |       |
| Bank overdraft                                                                                        | ** ** | **$**       | **53**     | ** ** |
| Notes payable -  finance company                                                                      | ** ** | **1,196**   | ** ** |
| Current portion  - notes payable, other                                                               | ** ** | **3,292**   | ** ** |
| Current portion  - note payable related party                                                         | ** ** | **2,397**   | ** ** |
| Accounts payable                                                                                      | ** ** | **1,117**   | ** ** |
| Other accrued  liabilities                                                                            | ** ** | **559**     | ** ** |
| Environmental  cleanup liability                                                                      | ** ** | **366**     | ** ** |
| Due to related  parties                                                                               | ** ** | **1,490**   | ** ** |
| Deferred income                                                                                       | ** ** | **162**     | ** ** |
|                                                                                                  |       |        |       |
| Total current  liabilities                                                                            | ** ** | **10,632**  | ** ** |
|                                                                                                  |       |        |       |
| Long-term notes  payable to related parties                                                           | ** ** | **370**     | ** ** |
| Long-term notes  payable, other                                                                       | ** ** | **210**     | ** ** |
| Environmental  cleanup liability - Casmalia Site                                                      | ** ** | **374**     | ** ** |
| Deferred income                                                                                       | ** ** | **98**      | ** ** |
|                                                                                                  |       |        |       |
| Total long-term  liabilities                                                                          | ** ** | **1,052**   | ** ** |
|                                                                                                  |       |        |       |
| Total  liabilities                                                                                    | ** ** | **11,684**  | ** ** |
|                                                                                                  |       |        |       |
|                                                                                                  |       |        |       |
| **COMMITMENTS  AND CONTINGENCIES**                                                                    |       |        |       |
|                                                                                                  |       |        |       |
|                                                                                                  |       |        |       |
| **STOCKHOLDERS’  (DEFICIT)**                                                                     |       |        |       |
|                                                                                                  |       |        |       |
| Common stock,  $.10 par value; authorized, 7,500,00 shares; issued and outstanding,  4,135,162 shares | ** ** | **413**     | ** ** |
|                                                                                                  |       |        |       |
| Additional  paid-in capital                                                                           | ** ** | **4,222**   | ** ** |
|                                                                                                  |       |        |       |
| Accumulated  (deficit)                                                                                | ** ** | **(10,371** | **)**      |
|                                                                                                  |       |        |       |
| Total  stockholders’ (deficit)                                                                   | ** ** | **(5,736**  | **)**      |
|                                                                                                  |       |        |       |
| **TOTAL**                                                                                             | ** ** | **$**       | **5,948**  | ** ** |

 

 

See AccompanyingNotes 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  Ended December 31,** | ** ** |
|-------------------------------------|----------------------------|----------------------------------------------|------------|
| ** **                          | ** **                 | **2004**                                     | ** ** | **2003** |   |
|                                |                       |                                         |       |   |   |
| Gross revenues                      | ** **                 | **$**                                        | **2,339**  |   | $ | 2,826 |   |
| Less:                               | Sales returns              |                                         | **(134**   | **)** | (322 | ) |
|                                | Cash discounts  and others | ** **                                   | **(26**    | **)** | (31 | ) |
|                                |                       |                                         | ** ** |   |   |
| Net revenues                        | ** **                 | **2,179**                                    | ** ** | 2,473 |   |
|                                |                       |                                         | ** ** |   |   |
| Costs and  expenses:                |                       |                                         | ** ** |   |   |
|                                |                       |                                         | ** ** |   |   |
| Cost of sales                       | ** **                 | **1,734**                                    | ** ** | 1,353 |   |
| Selling and  advertising expense    | ** **                 | **723**                                      | ** ** | 741 |   |
| General and  administrative expense | ** **                 | **259**                                      | ** ** | 332 |   |
| Intangible  impairment expense      | ** **                 | **100**                                      | ** ** | — |   |
|                                |                       |                                         | ** ** |   |   |
| Total costs and  expenses           | ** **                 | **2,816**                                    | ** ** | 2,426 |   |
|                                |                       |                                         | ** ** |   |   |
| (Loss) income  from operations      | ** **                 | **(637**                                     | **)**      | 47 |   |
|                                |                       |                                         | ** ** |   |   |
| Other income  (expense):            |                       |                                         | ** ** |   |   |
|                                |                       |                                         | ** ** |   |   |
| Interest expense                    | ** **                 | **(149**                                     | **)**      | (191 | ) |
| Gain on sale of  product line       | ** **                 | **750**                                      | ** ** | **—** |   |
| Service  agreement income           | ** **                 | **116**                                      | ** ** | 156 |   |
| Miscellaneous                       | ** **                 | **5**                                        | ** ** | — |   |
|                                |                       |                                         | ** ** |   |   |
| Total other  income (expense)       | ** **                 | **722**                                      | ** ** | (35 | ) |
|                                |                       |                                         | ** ** |   |   |
| Net income                          | ** **                 | **$**                                        | **85**     | ** ** | $ | 12 |   |
|                                |                       |                                         | ** ** |   |   |
| Per share:                          |                       |                                         | ** ** |   |   |
|                                |                       |                                         | ** ** |   |   |
| Basic and  diluted income per share | ** **                 | **$**                                        | **.02**    | ** ** | $ | .00 |   |

 

 

See AccompanyingNotes to Financial Statements.

 

4

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**LEE PHARMACEUTICALS**

**STATEMENTS OF CASH FLOWS**

**(Dollars in thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **For the Three Months  Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                     | ** ** | **2003** | ** ** |
|                                                                               |       |                                         |       |   |   |
| Cash flows  provided by operating activities:                                      |       |                                         |       |   |   |
| Net income                                                                         | ** ** | **$**                                        | **85**     | ** ** | $ | 12 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                         | ** ** |   |   |
| Depreciation                                                                       | ** ** | **59**                                       | ** ** | 49 |   |
| Amortization of  intangibles                                                       | ** ** | **152**                                      | ** ** | 52 |   |
| (Decrease) in  deferred income                                                     | ** ** | **(49**                                      | **)**      | (70 | ) |
| Gain on sale of  product line                                                      | ** ** | **(750**                                     | **)**      | — |   |
| Gain on sale of  equipment                                                         | ** ** | **(5**                                       | **)**      | — |   |
| Change in  operating assets and liabilities:                                       |       |                                         | ** ** |   |   |
| (Increase) in  accounts receivable, net                                            | ** ** | **(43**                                      | **)**      | (598 | ) |
| Decrease in  inventories                                                           | ** ** | **336**                                      | ** ** | 141 |   |
| (Increase) in  deposits                                                            | ** ** | **(93**                                      | **)**      | (26 | ) |
| (Increase) in  other current assets                                                | ** ** | **(48**                                      | **)**      | (201 | ) |
| Increase in bank  overdraft                                                        | ** ** | **40**                                       | ** ** | 44 |   |
| (Decrease)  increase in accounts payable and accrued liabilities                   | ** ** | **(358**                                     | **)**      | 277 |   |
| Increase  (decrease) in due to related parties                                     | ** ** | **71**                                       | ** ** | (219 | ) |
| Net cash (used  in) operating activities                                           | ** ** | **(603**                                     | **)**      | (539 | ) |
|                                                                               |       |                                         | ** ** |   |   |
| Cash flows from  investing activities:                                             |       |                                         | ** ** |   |   |
| Additions to  property, plant and equipment                                        | ** ** | **(23**                                      | **)**      | (15 | ) |
| Gain on sale of  product line                                                      | ** ** | **750**                                      | ** ** | — |   |
| Gain on sale of  equipment                                                         | ** ** | **5**                                        | ** ** | — |   |
| Net cash  provided by (used in) investing activities                               | ** ** | **732**                                      | ** ** | (15 | ) |
|                                                                               |       |                                         | ** ** |   |   |
| Cash flows from  financing activities:                                             |       |                                         | ** ** |   |   |
| (Payments on)  notes payable to related party                                      | ** ** | **(29**                                      | **)**      | (43 | ) |
| (Decrease)  increase in notes payable, finance company                             | ** ** | **(30**                                      | **)**      | 523 |   |
| Proceeds from  notes payable, other                                                |       | —                                       | ** ** | 150 |   |
| (Payments on)  notes payable, other                                                | ** ** | **(79**                                      | **)**      | (36 | ) |
| Net cash (used  in) provided by financing activities                               | ** ** | **(138**                                     | **)**      | 594 |   |
|                                                                               |       |                                         | ** ** |   |   |
| Net (decrease)  increase in cash                                                   | ** ** | **(9**                                       | **)**      | 40 |   |
| Cash, beginning  of period                                                         | ** ** | **28**                                       | ** ** | 16 |   |
| Cash, end of  period                                                               | ** ** | **$**                                        | **19**     | ** ** | $ | 56 |   |
|                                                                               |       |                                         | ** ** |   |   |
| **Supplemental  disclosures of cash flow information:**                            |       |                                         | ** ** |   |   |
|                                                                               |       |                                         | ** ** |   |   |
| Cash paid during  the year for:                                                    |       |                                         | ** ** |   |   |
| Interest                                                                           | ** ** | **$**                                        | **107**    | ** ** | $ | 170 |   |
| Taxes                                                                              | ** ** | **$**                                        | **1**      | ** ** | $ | — |   |

 

 

See AccompanyingNotes to Financial Statements.

 

5

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LEEPHARMACEUTICALS

 

**Notes toFinancial Statements**

**(Unaudited)**

 

1.     Basis ofpresentation:

 

The condensedinterim financial statements included herein have been prepared by LeePharmaceuticals without audit, pursuant to the rules and regulations of theSecurities 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.

 

These statementsreflect all adjustments, consisting of normal recurring adjustments (except asset forth in Note 5) which, in the opinion of management, are necessary forfair 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 for theyear ended September 30, 2004.  TheCompany follows the same accounting policies in preparation of interim reports.

 

Results ofoperations for the interim periods may not be indicative of annual results.

 

The Company isinvolved in various matters involving environmental cleanup issues.  See “Item 2. Management’s Discussionand Analysis or Plan of Operations” and Note 13 of Notes to FinancialStatements included in the Company’s Form 10-KSB for the fiscal year endedSeptember 30, 2004.  The ultimate outcomeof 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 December 31, 2004, no settlements havebeen reached.

 

2.     Continuedexistence:

 

The financialstatements have been prepared assuming that the Company will continue as agoing concern.  The Company has anaccumulated deficit of $10,371,000.  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.

 

3.     Use ofestimates:

 

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:

 

Certainreclassifications have been made to the prior year financial statements to beconsistent with the 2004 presentation.

 

5.     Impairment ofintangible assets:

 

At December 31,2004, the Company 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 three months ended December 31, 2004, using a twelve monthmoving average, and recorded an impairment charge of $100,000.

 

6.     Earnings (loss)per share:

 

The Company has asimple capital structure, and there were no changes under the SFAS 128methodology to the previously reported earnings (loss) per share amounts forany of the fiscal years.  Basic earnings(loss) per share under SFAS 128 were computed using the weighted average numberof shares outstanding of 4,135,162 for the three months ended December 31, 2004and December 31, 2003.

 

7.     Other income:

 

For the threemonths ended December 31, 2004, other income included realized gains of approximately$49,000 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 $67,000 arising from aservice agreement with Monticello Drug Company, $750,000 realized from the saleof the Nose Better® product line and $5,000 arising from the sale of equipmentretired in prior years.  For the threemonths ended December 31, 2003, other income consisted of realized gains asdescribed above of $70,000 and approximately $86,000 arising from the serviceagreement with Monticello Drug Company.

 

8.     Income taxes:

 

At December 31,2004, the Company has a Federal net operating loss (NOL) carry forward ofapproximately $14,690,000 for which it has recorded a valuation allowance forthe entire NOL.

 

9.     Subsequentevent:

 

Subsequent to thecurrent reporting period of December 31, 2004, the Company will be extendingthe maturity date on certain related parties notes payable which matured duringJanuary 2005.  The extension of thematurity date for an additional five years will move approximately $1,063,000of short-term notes payable, due to related parties, to long-term liabilities.

 

7

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

 

**MaterialChanges in Results of Operations**

**ThreeMonths Ended December 31, 2004, and December 31, 2003**

 

Gross revenues forthe three months ended December 31, 2004, were $2,339,000, a decrease ofapproximately $487,000, or 17%, from the comparable three months ended December31, 2003.  The Company reported decreasedsales volume associated with several product categories.  Specifically, the Company experienced lowersales in the personal care items ($278,000), over-the-counter (OTC) products(approximately $318,000), depilatories ($99,000) and the private label segment($58,000).  The above decreases in grossrevenues was somewhat offset by the increases in Lee® Lip-Ex® ($281,000) andthe Lee Nails® category ($11,000).

 

Net revenuesdecreased approximately $294,000, or 12%, for the three months ended December31, 2004, as compared to the three months ended December 31, 2003.  The change in net revenues was due primarilyto the sales explanations discussed above. The Company’s sales returns decreased approximately $188,000, or 58%,when comparing the three months ended December 31, 2004 and 2003.  The Company experienced fewer reductions oftheir SKUs (stock keeping units) at the retail store level during the threemonths ended December 31, 2004.

 

Cost of sales as apercentage of gross revenues was 74% for the three months ended December 31,2004, as compared to 48% for the three months ended December 31, 2003.  The higher cost of sales percentage was theresult of a $250,000 write off of obsolete inventory and changes in the overallproduct mix along with lower priced commodity-type goods with an accompanyinghigher cost of goods.  Over 40% of theCompany’s gross sales for the three months ended December 31, 2004 weregenerated from the lower gross margin goods. This compares with less than 38% of such sales for the three monthsended December 31, 2003.  In addition,the Company sold a brand in October 2004 which had a higher gross margin, andas a result, the Company did not experience the full quarter sales volume (andgross margin) related to this product. Offsetting in part these increases was a decrease in manufacturing laborand overhead cost of $59,000, or 8%, for the three months ended December 31,2004, in comparison with the three months ended December 31, 2003.  The decrease in expenses was primarily in thefollowing areas: (1) lower outside analytical cost since work is now donein-house ($32,000), (2) lower wages and related fringe benefits ($28,000) and(3) lower machinery and equipment maintenance ($12,000).  Offsetting these decreases were highdepreciation charges on new equipment ($12,000).

 

Selling andadvertising expenses decreased approximately $18,000, or 2%, when comparing thethree months ended December 31, 2004 with the three months ended December 31,2003.  The decreases were primarily in:(1) lower salaries and commissions ($19,000), (2) reduced product liabilityinsurance premiums ($17,000), (3) lower royalty expenses ($15,000), (4) lowerfreight costs ($10,000) and (5) lower convention and related expenses($10,000).  Offsetting these decreaseswere: (1) increased cooperative advertising ($31,000), (2) an increase in theallowance for bad debts ($18,000) and (3) an increase in office supply expense($8,000).

 

General andadministrative expenses decreased approximately $73,000, or 22%, when comparingthe three months ended December 31, 2004, with the three months ended December31, 2003.  This decrease in expenses wasprimarily in the following areas: (1) lower salaries and related fringebenefits ($50,000), (2) lower MIS (Management Information Systems) forconsulting services ($25,000) and (3) lower auditing fees ($17,000).  These decreases were partially offset by: (1)higher legal fees ($10,000) and (2) higher travel and entertainment expenses($9,000).

 

An intangibleimpairment charge of $100,000 was recorded for the three months ended December31, 2004.  There was no comparable chargefor the three months ended December 31, 2003.

 

8

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Other income wasapproximately $722,000 for the three months ended December 31, 2004, ascompared to other expense of $35,000 for the comparable three months endedDecember 31, 2003.  Interest expense forthe three months ended December 31, 2004 was $149,000, a decrease of $42,000,or 22%, when comparing the three months ended December 31, 2004, with the threemonths ended December 31, 2003.  Theprimary reason for this decrease was that in September 2004, the Companyreached an agreement with a non-related party to consolidate eleven (11) of itsnotes payable and related unpaid interest totaling $2,176,000 with interestrates 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 December 31, 2004 was2.40%.  Also included in other income is$750,000 realized from the sale of the Nose Better® product line.  Other income also includes $116,000 relatingto a service agreement with Monticello Drug Company, approximately $67,000, and$49,000 pertaining to realized gains related to the sale of the Klutch® productline ($6,000), the sale of the Astring-o-Sol® product line ($11,000) and thesale of the iodex® product line ($32,000). The realized gains pertain to the recognition of the earned portion ofthe deferred income of the consulting agreements arising from the sale of theseproduct lines.  There was additionalincome of $5,000 arising from the sale of some equipment that had been retiredin prior years.

 

Other expense forthe three months ended December 31, 2003, included interest expense ofapproximately $191,000 and other income of approximately $156,000.  Of this other income, $70,000 pertains torealized gains related to the sale of the Klutch® product line ($27,000), thesale of the Astring-o-Sol® product line ($11,000) and the sale of the iodex®product line ($32,000).  Also included inother income is approximately $86,000 arising from the service agreement withMonticello Drug Company.

 

**Liquidityand Capital Resources**

 

At December 31,2004, working capital was a negative $7,046,000 compared with a negative$3,519,000 as of September 30, 2004.  Theratio of current assets to current liabilities was 0.3 to 1 at December 31,2004 and 0.5 to 1 at September 30, 2004. The increase in current liabilities was principally due to certainlong-term liabilities becoming current.

 

Certain notespayable, due to related parties, which matured during January 2005 will beextended to mature in January 2010.  Theextension of the maturity date will effectively reclassify approximately$1,063,000 of short-term notes payable, due to related parties, to long-termliabilities.  The results will produce acurrent ratio of .4 to 1 as compared to the above .3 to 1.

 

The Company has anaccumulated deficit of $10,371,000.  Pastrecurring losses and inability to generate sufficient cash flow from normaloperations to meet its obligations as they become due, raises substantial doubtabout the Company’s ability to continue as a going concern.  The Company’s ability to continue inexistence is dependent upon future developments, including retaining current financingand achieving a level of profitable operations sufficient to enable it to meetits obligations as they become due.

 

9

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**EnvironmentalMatters**

 

The Company owns amanufacturing facility located in South El Monte, California.  The California Regional Water Quality ControlBoard (The “RWQCB”) ordered the Company in 1988 and 1989 to investigate thecontamination 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 Abatement Order” directing the Company to conduct further testingand clean up the site.  In October 1991,the Company received from an environmental consulting firm an estimate of$465,200 for investigation and cleanup costs. The Company believed that this estimate was inconclusive and overstatedthe contamination levels.  The Companybelieves that subsequent investigations will support the Company’s conclusionsabout that estimate.  The Company did notcomplete 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 &Environment Inc.’s Final Site Assessment Report, which was submitted to the EPAin June 1994, did not rule out the possibility that some of the contaminationoriginated on-site, and resulted from either past or current operations on theproperty.

 

On April 24, 2002,the RWQCB notified the Company that the detection of emergent chemicals ingroundwater, above State and Federal maximum containment levels or actionlevels, 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 informed RWQCBthat it could not comply with the requirement to conduct groundwater samplingdue to ongoing financial difficulties.

 

On July 8, 2002,the RWQCB sent a “Second Notice of Violation” to the Company directing theCompany to comply with the requirement to prepare a groundwater remedial actionplan (RAP).  The Company previouslynotified the RWQCB that it could not comply with the requirement to submit aRAP because of ongoing financial difficulties. The RWQCB requested that the Company submit certain financialinformation by July 29, 2002 to “substantiate any alleged financial losses anddetermine whether any suspension of implementing the...(Cleanup and AbatementOrder) is warranted.”  The Company hasreceived an extension to submit the required financial information to August19, 2002.  The Company submitted therequested financial information on August 16, 2002.  The Company received a response whereby theirrequest for financial hardship was denied. The Company is in the process of appealing this decision based primarilyupon the continued deterioration in the Company finances since the originalfiling.  The Company may be liable forall or part of the costs of remediating the contamination on its property andcould be subject to enforcement action by the RWQCB, including injunctive andcivil monetary remedies.  As of the dateof the financial statements, the Company’s share of the costs have not beendetermined.

 

The Company andnearby property owners, in consort with their comprehensive general liability(CGL) carriers, engaged a consultant to perform a site investigation withrespect 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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The tenants ofnearby properties upgradient have sued the Company, alleging that hazardousmaterials from the Company’s property caused contamination on the propertiesleased by the tenants.  The case name is DelRay Industrial Enterprises, Inc. v. Robert Malone, et al., LosAngeles County Superior Court, Northwest District, and it 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’sSouth El Monte manufacturing facility is also located over a large area ofpossibly contaminated regional groundwater which is part of the San GabrielValley Superfund Site.  The Company hasbeen notified that it is a potentially responsible party (“PRP”)  for the contamination.   In 1995, the Company was informed that theEPA estimated the cleanup costs for the South El Monte’s portion of the SanGabriel Valley Superfund Site to be $30 million.  The Company’s potential share of such amount hasnot been determined.  Superfund PRPs arejointly and severally liable for superfund site costs, and are responsible fornegotiating among themselves the allocation of the costs based on, among otherthings, the outcome of environmental investigation.

 

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 ElMonte 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 notknow what its share of the cost may be, if any. Therefore, no additional accrual has been recognized as a liability onthe Company’s books.  The Companyrequested that the EPA conduct an “ability-to-pay evaluation” to determinewhether the Company is entitled to an early settlement of this matter basedupon a limited ability to pay costs associated with site investigation andremediation.  In August 2000, the EPAinformed the Company that it does not qualify for an early settlement at thistime.

 

The EPA hasinformed the Company 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 EPA statedthat the City of Monterey Park Water Department, San Gabriel Valley WaterCompany and Southern California Water Company are planning to build treatmentfacilities for their wells.  The EPAstated that these three water purveyors contacted some of the SEMOU PRPs, otherthan the Company, to seek funding to develop groundwater treatment facilitiesfor the contaminated wells.  A group ofthese PRPs calling themselves the “South El Monte Cooperative Group” has beenformed and purportedly has reached a general agreement with the water purveyorsto fund the development of treatment facilities and use the water purveyors’wells in an attempt to contain the groundwater contamination to meet EPA’sgoals.  The Company is not able todetermine what contribution, if any, it may be assessed in connection with thiscleanup activity.

 

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By letter datedNovember 13, 2000, the Company was notified that the City of Monterey Park, SanGabriel Valley Water Company and Southern California Water Company intend tobring suit under the Safe Drinking Water and Toxic Enforcement Act of 1986,alleging that the Company has knowingly released volatile organic compounds inthe soil and shallow groundwater beneath the Company’s property between atleast on or before November 8, 1996 and the present and has failed to promptlyclean up all of the contamination.  As ofthe date of this report, the Company has not been served with this lawsuit.

 

The City of SouthEl Monte, the city in which the Company has its manufacturing facility, islocated in the San Gabriel Valley.  TheSan 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 beenvironmentally hazardous and subject to cleanup work.

 

The Companybelieves the City of South El Monte does not appear to be located over any ofthe major plumes.  However, the EPA hasannounced it is studying the possibility that, although the vadose soil andgroundwater, while presenting cleanup problems, there may be a contamination byDNAPs (dense non-aqueous phase liquids), i.e., “sinkers”, usually chlorinatedorganic cleaning solvents.  The EPA hasproposed to drill six “deep wells” throughout the City of South El Monte at anestimated cost 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 this time.

 

The Company andother property owners engaged Geomatrix Consultants, Inc., to do a survey ofvadose soil and shallow groundwater in the “hot spots” detected in the previousstudies.  Geomatrix issued a report datedDecember 1, 1997 (the “Report”), on the impact of volatile organic compounds onthe soil and groundwater at the Lidcombe and Santa Anita Avenue site located inSouth El Monte, California (which includes the Company’s facilities).

 

The Reportindicated generally low concentrations of tetrachloroethene, trichloaethene andtrichloroethane in the groundwater of the upgradient neighbor.  The Report was submitted to the RWQCB for itscomments and response.  A meeting withthe 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 hassubmitted 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$1,406,000 and $1,687,000.  The Companyis actively exploring the less expensive alternative remediation methods, ofwhich the two proposed alternatives range in cost between $985,000 and$1,284,000.  Since there are foureconomic entities involved, the Company’s best estimate at this time, in theirjudgment, would be that their forecasted share would be $287,000 less theliability already recognized on the books of $165,000 thereby requiring anadditional $122,000 liability.

 

Accordingly, theCompany 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, theCompany 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 advised that the Company and the otherproperty owners were unable to submit the required remedial action plan becausethe Company and the other property owners could not agree on the allocation offinancial responsibility to prepare the action plan.  The RWQCB stated that it will no longerencourage the cooperative approach among the Company and the other propertyowners in completing the cleanup requirements and will pursue appropriatemeasures, 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 remedial actionmethod for the site.  After receivingRWQCB approval, LSAAW obtained three cost proposals to implement the RWQCBapproved 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 contingencies areapproximately $300,000.

 

The LSAAW ishopeful the Water Quality Authority (WQA) is willing and able to reauthorizeits grant for one-half (1/2) of the capital costs of its remediation systemconstruction not to exceed $150,000.  Itis estimated at this time that the reserves for the Company’s share of thiscost proposal are adequate since its prior accrual was based on the higher costestimate from Geomatrix.

 

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, the EPAinformed the Company that the EPA believed the Company is able to pay the fullsettlement cost, but offered to reduce the amount of the settlement to $75,271.

 

The Company wasnotified by the EPA that the Company may have potential liability for wastematerial it disposed of at the Casmalia Disposal Site (“Site”) located on a 252acre 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 also pursuingthe 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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The Company hasrequested a reduced financial liability or waiver on the three EPA sites:SEMOU, Operating Industries, Inc. (OII) and Casmalia Disposal Site.  TheCompany has continued to provide the information and documentation requested bythe EPA as it relates to its ability to pay. In connection with this request, the Company understands that the EPA isconsidering the information.

 

The total amountof environmental investigation and cleanup costs that the Company may incurwith 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 December 31,2004, no settlements have been reached. The total amount expensed in prior years relating to this environmentalissue is $860,000.  As of December 31,2004, no additional amounts have been expensed or accrued.  The Company has an accrued liability on thebooks at December 31, 2004 of $740,000 for the environmental cleanup.

 

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

 

The chiefexecutive 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 timeperiods specified by the Commission’s rules and forms, and that the informationis communicated to the certifying officer on a timely basis.

 

The certifyingofficer concluded, based on his evaluation, that the Company’s disclosurecontrols and procedures are effective for the Company.

 

There were nochanges 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 - OTHERINFORMATION**

 

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

 

The informationset forth under Part I, Item 2, “Management’s Discussion and Analysis or Planof Operations - Environmental Matters” is incorporated herein byreference.  See also “LegalProceedings” in the Company’s Form 10-KSB for the fiscal year ended September30, 2004.

 

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

 

The Company hasfailed to make principal and interest payments on certain loans.  The total arrearage is principal of$1,622,000 plus interest of $1,111,000, an aggregate of $2,733,000, of which$1,993,000 is due to related parties and $740,000 to non-related parties.

 

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

 

The followingexhibits are filed herewith:

 
| 10.1                                                               | -      | Cancellation of the  previous secured promissory notes, regarding equipment, and replacing them  with a secured promissory note dated November 23, 2004, consolidating the  cancelled notes with the Registrant |
|--------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                               |   |                                                                                                                                                                                                            |
| 10.2                                                               | -      | Asset Purchase &  Sale Agreement dated October 12, 2004, between Lee Pharmaceuticals and The  Woolfoam Corporation regarding the sale of a product line                                                     |
|                                                               |   |                                                                                                                                                                                                            |
| 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)                                                                                                                                                            |

 
|        |
|--------|
| (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

 

In accordance withthe requirements of the Securities Exchange Acts of 1934, the registrant hascaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |                                                                          | LEE  PHARMACEUTICALS |          |
|--------|-------------------------------------------------------------------------------|----------------------|---------------|
|   | (Registrant)                                                                  |
|   |                                                                          |
|   |                                                                          |
|   |                                                                          |
| Date:  | FEBRUARY 11, 2005                                                             |                 | RONALD G. LEE |
|   | Ronald G. Lee                                                                 |
|   | Chairman of the  Board, President and  Chief Financial and Accounting Officer |
|        |                                                                               |                      |               |  |  |

 

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