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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the quarterly period ended June 30, 2004



or



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE EXCHANGE ACT
|- | ----------------------------------------------------------------



For the transition period from  to



Commission File Number 1-15445





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DRUGMAX, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|NEVADA                                                         |  | 34-1755390                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



25400 US Highway 19
North, Suite 137, Clearwater, FL 33763

(Address of principal executive offices)



(727) 533-0431

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has
filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.    x  Yes ̈No



Indicate by check mark whether the
registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act.) ̈Yes    x  No.



As of August 4, 2004 there were 8,193,152 shares of common stock, par value $0.001 per share, outstanding.



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##### Table of Contents

DRUGMAX, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2004



TABLE OF CONTENTS



|                                                                                                               |  |       
|-------------------------------------------------------------------------------------------------------------- |  | ------
|                                                                                                               |  | Page #
|PART I
FINANCIAL INFORMATION                                                                                   |  |       
|Item 1.  
Financial Statements                                                                                 |  |       
|Condensed Consolidated Balance Sheets June 30, 2004 (unaudited) and March 31, 2004                             |  | 3     
|Condensed Consolidated Statements of Operations Three Months Ended June 30, 2004 and June 30, 2003 (unaudited) |  | 4     
|Condensed Consolidated Statements of Cash Flows Three Months Ended June 30, 2004 and June 30, 2003 (unaudited) |  | 5     
|Notes to Condensed Consolidated Financial Statements (unaudited)                                               |  | 7     
|Item 2.  
Managements Discussion and Analysis of Financial Condition and Results of Operations                |  | 14    
|Financial Condition, Liquidity and Capital Resources                                                           |  | 20    
|Item 3.  
Quantitative and Qualitative Disclosures About Market Risk                                           |  | 21    
|Item 4.  
Controls and Procedures                                                                              |  | 22    
|                                                                                                               | 
|PART II
OTHER INFORMATION                                                                                      |  |       
|Item 1.  
Legal Proceedings                                                                                    |  | 23    
|Item 4.  
Submission of Matters to a Vote of Security Holders                                                  |  | 24    
|Item 6.  
Exhibits and Reports on Form 8-K                                                                     |  | 24    
|                                                                                                               | 
|Signature Page                                                                                                 |  | 27    
|Exhibit 31.1 Certification of Principal Executive Officer Pursuant to Section 302                              |  |       
|Exhibit 31.2 Certification of Principal Financial Officer Pursuant to Section 302                              |  |       
|Exhibit 32.1 Certification Pursuant to Section 906                                                             |  |       
|Exhibit 32.2 Certification Pursuant to Section 906                                                             |  |       



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##### Table of Contents

PART I  FINANCIAL INFORMATION



Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



DRUGMAX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                                 |  |               |             |   |                |   |             |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ----------- | - | -------------- | - | ----------- | -
|                                                                                                                                 |  | June 30, 2004 |             |   | March 31, 2004 |  
|                                                                                                                                 |  | (Unaudited)   |             |   |                |  
|ASSETS                                                                                                                           |  |               |             |   |                |   |             |  
|Current assets:                                                                                                                  |  |               |             |   |                |   |             |  
|Cash and cash equivalents                                                                                                        |  | $             | 2,349,690   |   |                | $ | 2,787,793   |  
|Accounts receivable, net of allowance for doubtful accounts of $1.7 million and $2.6 million, respectively.                      |  |               | 10,750,686  |   |                |   | 11,696,387  |  
|Inventory                                                                                                                        |  |               | 17,246,931  |   |                |   | 16,370,969  |  
|Prepaid expenses and other current assets                                                                                        |  |               | 1,998,370   |   |                |   | 1,608,531   |  
|                                                                                                                                 |  |               |             |   |                |   |             |  
|Total current assets                                                                                                             |  |               | 32,345,677  |   |                |   | 32,463,680  |  
|                                                                                                                                 |  |              
|Property and equipment, net                                                                                                      |  |               | 1,453,088   |   |                |   | 1,409,602   |  
|Goodwill                                                                                                                         |  |               | 13,105,000  |   |                |   | 13,105,000  |  
|Notes receivable, net of allowance of $.7 million.                                                                               |  |               | 26,474      |   |                |   | 40,843      |  
|Stockholders notes receivable                                                                                                    |  |               | 21,277      |   |                |   | 21,277      |  
|Intangible assets, net                                                                                                           |  |               | 630,675     |   |                |   | 658,845     |  
|Other assets                                                                                                                     |  |               | 50,538      |   |                |   | 50,625      |  
|Deposits                                                                                                                         |  |               | 25,411      |   |                |   | 108,215     |  
|                                                                                                                                 |  |               |             |   |                |   |             |  
|Total assets                                                                                                                     |  | $             | 47,658,140  |   |                | $ | 47,858,087  |  
|                                                                                                                                 |  |               |             |   |                |   |             |  
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                             |  |               |             |   |                |   |             |  
|Current liabilities:                                                                                                             |  |               |             |   |                |   |             |  
|Accounts payable                                                                                                                 |  | $             | 18,886,157  |   |                | $ | 14,339,752  |  
|Accrued expenses and other current liabilities                                                                                   |  |               | 753,070     |   |                |   | 1,853,823   |  
|Credit line payable                                                                                                              |  |               | 14,571,656  |   |                |   | 17,251,194  |  
|Current portion of long-term liabilities                                                                                         |  |               | 133,673     |   |                |   | 192,222     |  
|                                                                                                                                 |  |               |             |   |                |   |             |  
|Total current liabilities                                                                                                        |  |               | 34,344,556  |   |                |   | 33,636,991  |  
|                                                                                                                                 |  |              
|Long-term debt and capital leases                                                                                                |  |               | 123,348     |   |                |   | 157,950     |  
|                                                                                                                                 |  |               |             |   |                |   |             |  
|Total liabilities                                                                                                                |  |               | 34,467,904  |   |                |   | 33,794,941  |  
|                                                                                                                                 |  |              
|Stockholders' equity:                                                                                                            |  |               |             |   |                |   |             |  
|Preferred stock, $.001 par value, 2,000,000 shares authorized, no preferred shares issued or outstanding                         |  |               |            |   |                |   |            |  
|Common stock, $.001 par value; 24,000,000 shares authorized, 8,193,152 and 8,189,986 shares issued and outstanding,
respectively |  |               | 8,192       |   |                |   | 8,189       |  
|Additional paid-in capital                                                                                                       |  |               | 43,787,879  |   |                |   | 43,784,716  |  
|Accumulated deficit                                                                                                              |  |               | (30,605,835 | ) |                |   | (29,729,759 | )
|                                                                                                                                 |  |               |             |   |                |   |             |  
|Total stockholders' equity                                                                                                       |  |               | 13,190,236  |   |                |   | 14,063,146  |  
|                                                                                                                                 |  |               |             |   |                |   |             |  
|Total liabilities and stockholders' equity                                                                                       |  | $             | 47,658,140  |   |                | $ | 47,858,087  |  
|                                                                                                                                 |  |               |             |   |                |   |             |  



See accompanying notes
to condensed consolidated financial statements.



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DRUGMAX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                       |  |                                          |            |   |                                          |   |            |  
|------------------------------------------------------ |  | ---------------------------------------- | ---------- | - | ---------------------------------------- | - | ---------- | -
|                                                       |  | For the Three Months Ended June 30, 2004 |            |   | For the Three Months Ended June 30, 2003 |  
|Revenues                                               |  | $                                        | 39,993,420 |   |                                          | $ | 60,659,545 |  
|                                                       |  |                                         
|Cost of goods sold                                     |  |                                          | 38,791,676 |   |                                          |   | 58,672,332 |  
|                                                       |  |                                          |            |   |                                          |   |            |  
|Gross profit                                           |  |                                          | 1,201,744  |   |                                          |   | 1,987,213  |  
|                                                       |  |                                         
|Selling, general and administrative expenses           |  |                                          | 1,771,787  |   |                                          |   | 1,741,552  |  
|Amortization expense                                   |  |                                          | 2,800      |   |                                          |   |           |  
|Depreciation expense                                   |  |                                          | 62,467     |   |                                          |   | 52,502     |  
|                                                       |  |                                          |            |   |                                          |   |            |  
|Total operating expenses                               |  |                                          | 1,837,054  |   |                                          |   | 1,794,054  |  
|                                                       |  |                                          |            |   |                                          |   |            |  
|Operating (loss) income                                |  |                                          | (635,310   | ) |                                          |   | 193,159    |  
|                                                       |  |                                          |            |   |                                          |   |            |  
|Other income (expense)                                 |  |                                          |            |   |                                          |   |            |  
|Interest income                                        |  |                                          | 13,271     |   |                                          |   | 9,709      |  
|Other income                                           |  |                                          | 3,342      |   |                                          |   | 434,016    |  
|Interest expense                                       |  |                                          | (257,294   | ) |                                          |   | (672,612   | )
|                                                       |  |                                          |            |   |                                          |   |            |  
|Total other expense                                    |  |                                          | (240,681   | ) |                                          |   | (228,887   | )
|                                                       |  |                                          |            |   |                                          |   |            |  
|Loss before income tax provision and minority interest |  |                                          | (875,991   | ) |                                          |   | (35,728    | )
|Income tax provision                                   |  |                                          |           |   |                                          |   |           |  
|Equity (loss) from unconsolidated subsidiary           |  |                                          | (87        | ) |                                          |   |           |  
|                                                       |  |                                          |            |   |                                          |   |            |  
|Net loss                                               |  | $                                        | (876,078   | ) |                                          | $ | (35,728    | )
|                                                       |  |                                          |            |   |                                          |   |            |  
|Net loss per common share - basic                      |  | $                                        | (0.11      | ) |                                          | $ | (0.01      | )
|                                                       |  |                                          |            |   |                                          |   |            |  
|Net loss per common share - diluted                    |  | $                                        | (0.11      | ) |                                          | $ | (0.01      | )
|                                                       |  |                                          |            |   |                                          |   |            |  
|Weighted average shares outstanding - basic            |  |                                          | 8,191,363  |   |                                          |   | 7,130,475  |  
|                                                       |  |                                          |            |   |                                          |   |            |  
|Weighted average shares outstanding - diluted          |  |                                          | 8,191,363  |   |                                          |   | 7,130,475  |  
|                                                       |  |                                          |            |   |                                          |   |            |  



See accompanying notes
to condensed consolidated financial statements.



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DRUGMAX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



|                                                                            |  |                                         |            |   |                                          |   |            |  
|--------------------------------------------------------------------------- |  | --------------------------------------- | ---------- | - | ---------------------------------------- | - | ---------- | -
|                                                                            |  | For the Three MonthsEnded June 30, 2004 |            |   | For the Three Months Ended June 30, 2003 |  
|Cash flows from operating activities:                                       |  |                                         |            |   |                                          |   |            |  
|Net loss                                                                    |  | $                                       | (876,078   | ) |                                          | $ | (35,728    | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                                         |            |   |                                          |   |            |  
|Amortization of financing costs charged to interest expense                 |  |                                         | 50,369     |   |                                          |   | 96,602     |  
|Depreciation and amortization                                               |  |                                         | 65,267     |   |                                          |   | 52,502     |  
|Forgiveness of liability                                                    |  |                                         |           |   |                                          |   | (501,561   | )
|Equity loss from unconsolidated subsidiary                                  |  |                                         | 87         |   |                                          |   |           |  
|Changes in operating assets and liabilities, net of acquisition:            |  |                                         |            |   |                                          |   |            |  
|Accounts receivable, net                                                    |  |                                         | 938,868    |   |                                          |   | (1,006,790 | )
|Inventory                                                                   |  |                                         | (875,962   | ) |                                          |   | 785,561    |  
|Due from affiliates                                                         |  |                                         |           |   |                                          |   | 10,470     |  
|Prepaid expense and other current assets                                    |  |                                         | (383,006   | ) |                                          |   | (58,457    | )
|Other assets                                                                |  |                                         |           |   |                                          |   | 46,660     |  
|Notes receivable                                                            |  |                                         | 14,369     |   |                                          |   | 58,809     |  
|Deposits                                                                    |  |                                         | 82,804     |   |                                          |   | (5,679     | )
|Accounts payable                                                            |  |                                         | 4,546,405  |   |                                          |   | (2,452,065 | )
|Accrued expenses and other current liabilities                              |  |                                         | (1,100,753 | ) |                                          |   | (117,914   | )
|                                                                            |  |                                         |            |   |                                          |   |            |  
|Net cash provided by (used in) operating activities                         |  |                                         | 2,462,370  |   |                                          |   | (3,127,590 | )
|                                                                            |  |                                         |            |   |                                          |   |            |  
|                                                                            |  |                                        
|Cash flows from investing activities:                                       |  |                                         |            |   |                                          |   |            |  
|Purchases of property and equipment                                         |  |                                         | (105,950   | ) |                                          |   | (33,059    | )
|                                                                            |  |                                         |            |   |                                          |   |            |  
|Net cash used in investing activities                                       |  |                                         | (105,950   | ) |                                          |   | (33,059    | )
|                                                                            |  |                                         |            |   |                                          |   |            |  
|Cash flows from financing activities:                                       |  |                                         |            |   |                                          |   |            |  
|Net change in restricted cash                                               |  |                                         |           |   |                                          |   | 2,000,000  |  
|Net change under revolving line of credit agreement                         |  |                                         | (2,679,538 | ) |                                          |   | 1,391,486  |  
|Increase in deferred financing costs                                        |  |                                         | (25,000    | ) |                                          |   | (270,008   | )
|Payments of long-term debt and capital leases                               |  |                                         | (93,151    | ) |                                          |   | (79,068    | )
|Payments to affiliates                                                      |  |                                         |           |   |                                          |   | (4,377     | )
|Proceeds from issuance of common stock                                      |  |                                         | 3,166      |   |                                          |   |           |  
|                                                                            |  |                                         |            |   |                                          |   |            |  
|Net cash (used in) provided by financing activities                         |  |                                         | (2,794,523 | ) |                                          |   | 3,038,033  |  
|                                                                            |  |                                         |            |   |                                          |   |            |  
|INCREASE IN CASH AND CASH EQUIVALENTS                                       |  |                                         | (438,103   | ) |                                          |   | (122,616   | )
|                                                                            |  |                                        
|Cash and cash equivalents at beginning of period                            |  |                                         | 2,787,793  |   |                                          |   | 161,489    |  
|                                                                            |  |                                         |            |   |                                          |   |            |  
|CASH AND CASH EQUIVALENTS AT END OF PERIOD                                  |  | $                                       | 2,349,690  |   |                                          | $ | 38,873     |  
|                                                                            |  |                                         |            |   |                                          |   |            |  



(continued)



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|                                                                                                                                                                                                               |  |   |         |  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | - | ------- |  | - | ------- | -
|SUPPLEMENTAL DISCLOSURES OF CASH FLOWS ACTIVITIES                                                                                                                                                              |  |   |         |  |   |         |  
|Cash paid for interest                                                                                                                                                                                         |  | $ | 206,925 |  | $ | 195,076 |  
|                                                                                                                                                                                                               |  |   |         |  |   |         |  
|Cash paid for income taxes                                                                                                                                                                                     |  | $ |        |  | $ |        |  
|                                                                                                                                                                                                               |  |   |         |  |   |         |  
|SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:                                                                                                                                          |  |   |         |  |   |         |  
|                                                                                                                                                                                                               |  |  
|In April 2003, pursuant to the agreement with W.A. Butler & Company, the Company recorded the reversal of a long-term debt to W.A. Butler
& Co.                                                                |  |   |         |  | $ | 501,561 |  
|                                                                                                                                                                                                               |  |   |         |  |   |         |  
|In May 2003, the Company purchased substantially all the assets of Avery Pharmaceuticals, Inc. No cash was paid for the acquisition. In
conjunction with the acquisition, liabilities were assumed as follows: |  |   |         |  |   |         |  
|Fair value of assets acquired                                                                                                                                                                                  |  |   |         |  | $ | 789,202 |  
|Acquisition note executed                                                                                                                                                                                      |  |   |         |  |   | (90,000 | )
|Forgiveness of debt owed to the Company                                                                                                                                                                        |  |   |         |  |   | (52,571 | )
|                                                                                                                                                                                                               |  |   |         |  |   |         |  
|Liabilities assumed                                                                                                                                                                                            |  |   |         |  | $ | 646,631 |  
|                                                                                                                                                                                                               |  |   |         |  |   |         |  
|In June 2003, the Company issued 57,143 shares of common stock of the Company to Jugal K. Taneja for his guaranty executed in favor of
Congress.                                                               |  |   |         |  | $ | 91,429  |  
|                                                                                                                                                                                                               |  |   |         |  |   |         |  

(concluded)



See accompanying notes to condensed consolidated financial statements.



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Notes to Condensed Consolidated Financial Statements (Unaudited)



For the Three Months Ended June 30, 2004 and 2003.



NOTE A-BASIS OF PRESENTATION



The accompanying condensed consolidated financial statements include the accounts of DrugMax, Inc. and its wholly-owned subsidiaries, Discount Rx, Inc., a Louisiana
corporation (Discount), Valley Drug Company (Valley) and its wholly-owned subsidiary Valley Drug Company South (Valley South), Desktop Media Group, Inc. (Desktop) and its wholly-owned subsidiary
VetMall, Inc. (VetMall), and Discount Rx, Inc., a Nevada corporation (Discount Nevada), (collectively referred to as the Company). All significant intercompany accounts and transactions have been eliminated.



The accompanying unaudited condensed consolidated financial statements have
been prepared in conformity with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Accordingly, they do not include all of the information and footnotes required by
accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been
included. Interim results are not necessarily indicative of the results that may be expected for a full year. These statements should be read in conjunction with the consolidated financial statements included in the Companys Form 10-K for the
fiscal year ended March 31, 2004.



The Companys fiscal year begins on
April 1 and ends on March 31. Unless otherwise noted, all references to a particular year shall mean the Companys fiscal year.



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NOTE B - STOCK BASED COMPENSATION



In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation(SFAS No. 123), which was
effective for fiscal years beginning after December 15, 1995. Under SFAS No. 123, the Company may elect to recognize stock-based compensation expense based on the fair value of the awards or to account for stock-based compensation under Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion No. 25), and disclose in the consolidated financial statements the effects of SFAS No. 123 as if the recognition provisions
were adopted. The Company has adopted the recognition provisions of APB Opinion No. 25. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation for the three months ended June 30, 2004 and 2003:



|                                                                                                                                    |  |                                         |            |   |                                         |   |          |  
|----------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------- | ---------- | - | --------------------------------------- | - | -------- | -
|                                                                                                                                    |  | For the Three MonthsEnded June 30, 2004 |            |   | For the Three MonthsEnded June 30, 2003 |  
|Net loss reported                                                                                                                   |  | $                                       | (876,078   | ) |                                         | $ | (35,728  | )
|                                                                                                                                    |  |                                        
|Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                         | 795,826    |   |                                         |   | 579,161  |  
|                                                                                                                                    |  |                                         |            |   |                                         |   |          |  
|Pro forma net loss                                                                                                                  |  | $                                       | (1,671,904 | ) |                                         | $ | (614,889 | )
|                                                                                                                                    |  |                                         |            |   |                                         |   |          |  
|Loss per common share as reported:                                                                                                  |  |                                         |            |   |                                         |   |          |  
|Basic                                                                                                                               |  | $                                       | (0.11      | ) |                                         | $ | (0.01    | )
|Diluted                                                                                                                             |  | $                                       | (0.11      | ) |                                         | $ | (0.01    | )
|Loss per common share - pro forma:                                                                                                  |  |                                         |            |   |                                         |   |          |  
|Basic                                                                                                                               |  | $                                       | (0.20      | ) |                                         | $ | (0.09    | )
|Diluted                                                                                                                             |  | $                                       | (0.20      | ) |                                         | $ | (0.09    | )



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For purposes of the above disclosure, the determination of the fair value of stock options granted in the three months
ended June 30, 2004 and 2003, was based on the following: (i) a risk free interest rate of 3.94% (ii) expected option lives of 5 - 10 years; and (iii) expected volatility in the market price of the Companys common stock of 67%.



In addition to the 1999 Incentive Stock Option Plan, the shareholders of the Company approved
the Restricted Stock Plan at the Companys annual meeting in October 2003. There has been no stock issued under the Restricted Stock Plan as of June 30, 2004.



NOTE C - ACQUISITIONS



VetMall, Inc.



In April 2003, W.A. Butler & Company (Butler), a 30% shareholder of VetMall, executed an agreement with the Company and VetMall. The terms of the agreement provide for the transfer of Butlers 30%
ownership of VetMall stock to the Company and the forgiveness of $.5 million of long-term liabilities, which is included in other income in the condensed consolidated financial statements of the Company. Accordingly, the Company now owns 100% of
VetMall. Butler desired to be relieved of any possible future business activities and financial liability of VetMall. Accordingly, in consideration of the transfer of the 30% ownership, the agreement also releases Butler from any present and future
operational expenses of VetMall. The transfer of Butlers 30% interest in VetMall did not have an impact on the revenues or operating expenses of the Company for the three months ended June 30, 2004.



Avery Pharmaceuticals, Inc.



On May 14, 2003, Discount Nevada, a wholly owned subsidiary of the Company, purchased
substantially all of the assets, and assumed certain liabilities, of Avery Pharmaceuticals, Inc., Avery Wholesale Pharmaceuticals, Inc., also known as Texas Vet Supply (jointly Avery Pharmaceuticals), and Infinity Custom Plastics, Inc.
(Infinity), wholesale distributors of pharmaceuticals and respiratory products based in Texas, pursuant to an Asset Purchase Agreement dated May 14, 2003 (the Avery Agreement).



Pursuant to the Avery Agreement, the Company acquired accounts receivable, inventory,
equipment, furniture, the trade name and a patent pending for the process of the manufacture of vials for the respiratory therapy industry, totaling approximately $789,000. The liabilities assumed, which were comprised principally of trade payables,
amounted to approximately $647,000, in addition to the forgiveness of debt owed to the Company of approximately $53,000. In addition, the Company executed a promissory note in the amount of $318,000 to the predecessor companys 50% shareholder
(Sankary) (the Sankary Note), as additional consideration. The Sankary Note includes a right of off set for accounts payable in excess of an agreed upon amount assumed at closing. The original Sankary Note may not be reduced
below $90,000 after set off. Management believes



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the adjusted Sankary note amount will be $90,000 after the set off for accounts payables honored by the Company since the
acquisition; therefore, the Company recorded the Sankary Note in the amount of $90,000. The Company and Avery specifically contemplated that the Company might have to pay certain unknown liabilities in connection with the acquisition in excess of
the amount of assumed liabilities. Accordingly, the Sankary Note and the Avery Agreement permit the Company to set off payments due under the Sankary Note against payments made in excess of the assumed liabilities. The Company believes
that it has paid Averys obligations well in excess of the assumed liabilities. Therefore, all other payments under the Sankary Note are offset such that nothing more is due and payable there under.



On March 26, 2004, Sankary filed a lawsuit against the Company, in the 342ndJudicial District Court of Tarrant County, Texas (Sankary Suit). The complaint in the Sankary Suit alleges that
the Company defaulted under the Sankary Note as a result of the Companys failure to make payments when due to Sankary.



The Company has paid to Sankary the minimum amount due under the Sankary Note (approximately $90,000) and has paid liabilities of Avery in excess of its obligations under
the agreement, such that it is entitled to offset any further liability under the Sankary Note. The Company believes that the Sankary Suit is very likely to be dismissed pursuant to agreement between the partiesthe parties have exchanged
settlement proposals and anticipate the Sankary Suit to be dismissed in the near future. Additionally, the Avery Agreement contains a provision whereby based on Averys earnings, the Sankary Note may be increased to the original amount of
$318,000 which would be treated as an addition to the purchase price; however, the Company has reported a net loss for the Avery operations since its acquisition; therefore, no adjustment was made to the Sankary note based on performance.



Also, the Company executed a Consulting and Non-Competition Agreement
(Consulting Agreement) with John VerVynck (VerVynck) an officer and shareholder of Avery Pharmaceuticals and Infinity. The Consulting Agreement provided for the payment to VerVynck of $39,360, payable bi-monthly, over the
six-month term of the Consulting Agreement. Upon completion of the Consulting Agreement in December 2003 VerVyncks employment with the Company was terminated. The Consulting Agreement prohibits VerVynck from competing for one year following
his termination and the six-month term of the consulting agreement. In October 2003, the Company relocated the Avery operations to St. Rose, Louisiana and currently operates the acquired business through its wholly owned subsidiary Valley South.



The acquisition of Avery was accounted for by the purchase method of
accounting. The result of the operations of the acquired business is included in the condensed consolidated financial statements from the purchase date. The Company acquired the following assets and liabilities in the Avery acquisition:



|                                                 |  |   |          |  
|------------------------------------------------ |  | - | -------- | -
|Accounts receivable - trade                      |  | $ | 47,025   |  
|Accounts receivable - other                      |  |   | 39,920   |  
|Inventory                                        |  |   | 224,643  |  
|Property and equipment                           |  |   | 340,000  |  
|Other assets                                     |  |   | 10,930   |  
|Patent                                           |  |   | 126,684  |  
|Assumption of liabilities                        |  |   | (646,631 | )
|                                                 |  |   |          |  
|Net value of purchased assets                    |  |   | 142,571  |  
|Forgiveness of trade payables due to the Company |  |   | (52,571  | )
|Acquisition note payable                         |  |   | (90,000  | )
|                                                 |  |   |          |  
|Cash paid for acquisition                        |  | $ |         |  
|                                                 |  |   |          |  



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The unaudited pro forma effect of the acquisition of Avery on the Companys revenue, net loss and net loss per share
for the three months ended June 30, 2003 had the acquisition occurred on April 1, 2002, are as follows:



|                                |  |                                         |            |  
|------------------------------- |  | --------------------------------------- | ---------- | -
|                                |  | For the Three MonthsEnded June 30, 2003 |           
|Revenues                        |  | $                                       | 60,821,547 |  
|Net loss before tax benefit     |  |                                         | (107,157   | )
|Tax benefit                     |  |                                         |           |  
|Net loss                        |  |                                         | (107,157   | )
|Loss per common share - basic   |  |                                         | (0.01      | )
|Loss per common share - diluted |  |                                         | (0.01      | )



NOTE D - GOODWILL AND OTHER
INTANGIBLE ASSETS



The carrying value of goodwill did not change for the
three months ended June 30, 2004. The Company has determined that it has one reporting unit in the distribution business. Management further has determined that the distribution reporting unit should be reported in the aggregate based upon similar
economic characteristics within each subsidiary within that segment.



The
carrying value of other intangible assets is as follows:



|                               |  |                      |         |                          |   |                      |  |                          |         |  |   |        
|------------------------------ |  | -------------------- | ------- | ------------------------ | - | -------------------- |  | ------------------------ | ------- |  | - | -------
|                               |  | June 30, 2004        |         | March 31, 2004          
|                               |  | Gross Carying Amount |         | Accumulated Amortization |   | Gross Carying Amount |  | Accumulated Amortization
|Amortizable intangible assets: |  |                      |         |                          |   |                      |  |                          |         |  |   |        
|Patent pending                 |  | $                    | 280,883 |                          | $ | 2,800                |  | $                        | 280,883 |  | $ |       
|Deferred financing costs       |  |                      | 561,601 |                          |   | 209,009              |  |                          | 536,601 |  |   | 158,639
|                               |  |                      |         |                          |   |                      |  |                          |         |  |   |        
|Total                          |  | $                    | 842,484 |                          | $ | 211,809              |  | $                        | 817,484 |  | $ | 158,639
|                               |  |                      |         |                          |   |                      |  |                          |         |  |   |        



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NOTE E - DEBT



On April 15, 2003, the Company obtained from Congress Financial Corporation (Congress) a $40 million revolving line of credit and a $400,000 term loan. The
Congress credit facility along with the Mellon Bank N.A. (Mellon) restricted cash account of $2 million were used to satisfy the outstanding line of credit and term loan with Standard Federal Bank National Association
(Standard), formerly Michigan National Bank as successor in interest to Mellon. The Congress revolving line of credit enables the Company to borrow a maximum of $40 million, with borrowings limited to 85% of eligible accounts receivable
and 65% of eligible inventory. The revolving line of credit and the term note currently bear interest at the rate of 0.50% per annum in excess of the Prime Rate. The Congress credit facility is collateralized by all of the Companys assets. The
line of credit is for a term of 36 months, and the term note is payable over the same 36-month period. The Congress credit facility imposes certain restrictive covenants on Tangible Net Worth and EBITDA. At June 30, 2004, the Company was not in
compliance with the EBITDA and tangible net worth covenants. The Company and Congress executed on August 5, 2004 the Fourth Amendment and Waiver to the Loan and Security Agreement, which waived the non-compliance with the EBITDA and tangible net
worth covenants as of June 30, 2004 and through the period ended September 29, 2004. The Company continues to work with Congress to establish loan covenants that will be achievable in future periods; however, there can be no assurance that this will
occur. The amended agreement also requires the Company to maintain excess availability, as defined, of $1,000,000 and certain other conditions. All costs associated with the Congress credit facility will be amortized as interest expense over the
term of the loan. The outstanding balance on the revolving line of credit and term loan were approximately $14,572,000 and $244,000, respectively, at June 30, 2004. At June 30, 2004, the interest rate on the revolving line of credit and term loan
was 4.5%.



In April 2003, the Company recorded as interest expense the
remaining unamortized financing costs of the Standard credit facility in the amount of $78,913. Additionally, the Company recorded as interest expense the early termination fee of approximately $351,000 and a fee for the waiver of the 90-day notice
of termination of $30,000 paid to Standard.



On April 15, 2003, Jugal K.
Taneja, the Chairman of the Board, CEO and a Director of the Company executed a Guarantee (the Guarantee) in favor of Congress. The Guarantee provides Congress with Mr. Tanejas unconditional guaranty of all obligations,
liabilities, and indebtedness of any kind of the Company to Congress, provided that the Guarantee shall not exceed $2 million in year one; is reduced to $1.5 million in year two; and is further reduced to $1 million in year three, subject to the
Company achieving collateral availability objectives. In June 2003, the Company issued 57,143 shares of common stock of the Company to Mr. Taneja as compensation for his guarantee in favor of Congress, valued at $91,429, based on the fair market
value of the stock on the date of the grant. The cost of the common stock has been recorded as a financing cost related the Congress credit facility and will be amortized as interest expense over the term of the loan.



NOTE F - SEGMENT INFORMATION



The Company has adopted SFAS No. 131, Disclosures About Segments of Enterprise and
Related Information, which established standards for reporting information about a Companys operating segments. Operating segments are defined as components of an enterprise for which separate financial information is available that is
evaluated on a regular basis by the chief operating decision maker, or decision making group, in deciding how to allocate resources to an individual segment and in assessing performance of the segment.



The Company has determined that is has one reportable segment because all distribution
subsidiaries have similar economic characteristics, such as margins, products, customers, distribution networks and regulatory oversight. The distribution line of business represents 100% of consolidated revenues in the three months ended June 30,
2004 and 2003. The critical accounting policies of the operating segment are those discussed in Item 2, Managements Discussion and Analysis of Financial Condition and Results of Operations.



The Company distributes product both within and outside the United States. Revenues from
distribution within the United States represented approximately 99.4% and 99.6% of gross revenues for the three months ended June 30, 2004 and 2003, respectively. Foreign revenues were generated from distribution to customers in Puerto Rico.



NOTE G  CONTINGENCIES



From time to time, the Company may become involved in litigation arising in the ordinary
course of its business. The Company is not presently subject to any material legal proceedings other than as set forth below.



In March 2000, the Company acquired all of the issued and outstanding shares of common stock of Desktop Corporation, a Texas corporation located in Dallas, Texas,
pursuant to an Agreement and Plan of Reorganization by and among the Company, K. Sterling Miller, Jimmy L. Fagala and HCT Capital Corp. (the Reorganization Agreement). On February 7, 2002, Messrs. Miller and Fagala filed a complaint
against the Company in the Circuit Court of the Sixth Judicial Circuit in and for Pinellas County, Florida, alleging, among other things, that the Company had breached the Reorganization Agreement by failing to pay



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38,809 shares of the Companys common stock to plaintiffs. The complaint also includes a count of conversion and
further alleges that the Company breached its employment agreements with Messrs. Miller and Fagala, for which the plaintiffs seek monetary damages. On March 11, 2002, the Company filed its answer, affirmative defenses and counterclaim against
plaintiffs and HCT Capital Corp. (HCT), in which it alleged, among other things, that plaintiffs had breached the Reorganization Agreement by misrepresenting the state of the acquired business, that the Company was entitled to set off
its damages against the shares which the plaintiffs are seeking and further seeking contractual indemnity against the plaintiffs. On April 16, 2002, HCT filed its answer, counterclaim against the Company and cross-claim against the plaintiffs. In
December 2003, a Settlement Agreement and Release (the Release) was executed by HCT and the Company whereby HCT and the Company unconditionally, fully and finally released each other from any future claims relative to the matter. HCT
paid $1,000 to the Company in consideration for the Release. There has been little activity by Messrs. Miller and Fagala with regard to this matter, and the Company is currently considering how to proceed in light of this inactivity. The Company
intends to vigorously defend the actions filed against it and to pursue its counterclaim. The Company cannot reasonably estimate any possible future loss or recovery as a result of this matter; therefore, the Company has made no provision in the
accompanying consolidated financial statements for resolution of this matter.



On May 1, 2002, the Company filed suit against an established customer of the Companys Pittsburgh distribution center for collection of past due accounts receivable. On May 23, 2002, the customer filed a voluntary petition in
bankruptcy in the U.S. Bankruptcy Court, under Chapter Eleven of the United States Bankruptcy Act, subsequent to which the customer failed to file the proper financial data with the court, causing the voluntary bankruptcy filing to be withdrawn. In
June 2004, the Company received approximately $7,000 as settlement of their claim against the customer. The Company had previously recorded an allowance account representing 100% of the account balance. At June 30, 2004, the allowance was applied
against the account receivable to clear the customers unpaid balance from the Companys accounts receivable records.



On October 2, 2003, QK Healthcare, Inc. (QK) filed a complaint against Valley in the United States District Court of the Eastern District of New York, which
included several counts with regard to the sale of twenty bottles of Lipitor by Valley to QK, including breach of contract, violations of the implied warranty of merchantability and fraud. The complaint demands actual damages, punitive damages and
legal fees and expenses. On January 9, 2004, the Company filed an answer and counterclaim against QK, in which the Company seeks to recover from QK losses caused when QK refused to pay for pharmaceuticals ordered from the Company. The Parties
reached a settlement on May 14, 2004, pursuant to which the case will be dismissed. The settlement agreement requires the Company to pay QK $218,000, calls for the parties to resume their business relationship, with the Company giving QK certain
price reductions in the products QK purchases from the Company for one year, and provides for the mutual release of both parties. The Company has recorded $218,000 to operating expenses and $32,000 to legal expense in the fourth quarter of fiscal
2004 relative to this matter.



On November 12, 2003, Phil & Kathys,
Inc. d/b/a Alliance Wholesale Distributors (Alliance) served a complaint against the Company seeking to recover the non-payment of open invoices approximating $2,000,535, based upon an alleged breach of contract for the sale of
pharmaceuticals. On December 18, 2003, the Company filed an answer and counterclaim. The counterclaim seeks to recover lost profits and other damages relating to the purchase of twenty bottles of Lipitor from Alliance, which the Company later sold
to QK. The Company intends to vigorously defend Alliances breach of contract action and prosecute the counterclaim. Valley also filed a separate action against Alliance for breach of an indemnification agreement related to the sale of the
twenty bottles of Lipitor that precipitated the lawsuit against Valley by QK in New York. At March 31, 2004, the amount that the Company recorded as a trade payable balance due Alliance on the above was approximately $1.5 million. While the Company
has recorded the foregoing trade payable, it continues to assess the extent of its full damages and cannot at this time reasonably estimate the total future possible loss that it will sustain as a result of the Alliance complaint or the possible
recovery through the Companys counterclaim or Valleys consolidated action.



On May 14, 2003, Discount Rx, Inc., a Nevada corporation and a wholly owned subsidiary of the Company (Discount), acquired substantially all of Avery Pharmaceutical, Inc.s (Avery) assets (Avery
Assets) in exchange for assuming certain limited liabilities (the Assumed Liabilities) of Avery and issuing a promissory note to Mr. Al Sankary (Sankary) in the original principal amount of $318,000 (the Sankary
Note). The Sankary Note and Avery specifically contemplated that Discount might have to pay certain unknown liabilities in connection with the acquisition in excess of the amount of Assumed Liabilities. Accordingly, the Sankary Note and the
Avery Assets permit Discount to set off payments due under the Sankary Note against payments made in excess of the Assumed Liabilities. Discount believes that it has paid Averys obligations well in excess of the Assumed
Liabilities. Therefore, all other payments under the Sankary Note are offset such that nothing more is due and payable there under.



On March 26, 2004, Sankary filed a lawsuit against Discount, in the 342ndJudicial District Court of Tarrant County, Texas (Sankary Suit). The complaint in the Sankary Suit alleges that Discount defaulted under the Sankary Note as a result of Discounts
failure to make payments when due to Sankary.



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Discount has paid to Sankary the minimum amount due under the Sankary Note (approximately $90,000) and has paid
liabilities of Avery in excess of its obligations under the agreement, such that it is entitled to offset any further liability under the Sankary Note. Discount believes that the Sankary Suit is very likely to be dismissed pursuant to agreement
between the partiesthe parties have exchanged settlement proposals and anticipate the Sankary Suit to be dismissed in the near future.



Additionally, since the closing of the Avery transaction, various creditors and other third parties owed money by Avery have threatened to file lawsuits against Discount.
To date, Discount has not been sued by any of these creditors or other third parties and their claims remain unliquidated. The Company intends to vigorously defend any actions filed against Discount. In the unlikely event that Discount is not
permitted to offset liabilities paid against the obligation under the Sankary Note, the total amount that remains payable under the Sankary Note as of June 30, 2004, is $228,000. However, because the Company believes that it is entitled to offset
any further liability under the Sankary Note, the Company has made no provision in the accompanying consolidated financial statements for resolution of the Sankary Suit. Similarly, because no other lawsuits have been filed nor any threatened to be
filed, the Company has made no provision in the accompanying consolidated financial statements for resolution of any other claims against Discount.



NOTE H - PENDING MERGER



On March 19, 2004, the Company entered into an Agreement and Plan of Merger with Familymeds Group, Inc., a Connecticut Company (FMG), as amended on July 1, 2004, pursuant to which FMG will be merged with
and into the Company, with the Company being the surviving company. FMG is a pharmacy chain with a strategy of locating pharmacies at or near a patients point of medical care. FMG operates more than 76 pharmacies in 14 states. Many of these
pharmacies are located at or near the point of care between physicians and patients, many times inside or near medical office buildings. Across these distribution channels, FMG annually services over 400,000 acute and chronically ill patients, many
with complex specialty and medical product needs. The principal executive offices of FMG are located at 312 Farmington Avenue, Farmington, CT 06032. If the merger is consummated, the Company expects that the current Company stockholders will, as a
group, own approximately 40%, and FMG stockholders, employees and directors will, as a group, own approximately 60%, of the issued and outstanding shares of the Company immediately after the merger, assuming the vesting of all restricted shares
issued in connection with the merger. In addition, at the closing of the merger, the Company will issue warrants to the FMG stockholders and certain FMG warrant holders and note holders entitling them to purchase certain additional shares of the
Company common stock.



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.



The following management discussion and analysis should be read in conjunction with the Condensed Consolidated Financial Statements presented elsewhere in this Form 10-Q.



Certain oral statements made by management from time to time and certain
statements contained in press releases and periodic reports issued by the Company, including those contained herein, that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation
Reform Act of 1995. Because such statements involve risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements, including those in Managements
Discussion and Analysis of Financial Condition and Results of Operations, are statements regarding the intent, belief or current expectations, estimates or projections of the Companys Directors or Officers about the Company and the industry in
which it operates, and assumptions made by management, and include among other items, (a) the Companys strategies regarding growth and business expansion, including its strategy of focusing on higher-margin products while reducing costs and
the Companys proposed merger with Familymeds, Group, Inc. (FMG) and other potential future acquisitions; (b) the Companys financing plans including its intent to enter into a new credit facility in connection with the
proposed merger with FMG; (c) trends affecting the Companys financial condition or results of operations; (d) the Companys ability to continue to control costs and to meet its liquidity and other financing needs; (e) the Companys
ability to improve and maintain effective disclosure and internal controls; and (f) the Companys ability to respond to changes in customer demand and regulations. Although the Company believes that its expectations are based on reasonable
assumptions, it can give no assurance that the anticipated results will occur. When used in this report, the words expects, anticipates, intends, plans, believes, seeks,
estimates, and similar expressions are generally intended to identify forward-looking statements.



Important factors that could cause the actual results to differ materially from those in the forward-looking statements include, among other items, (i) changes in the regulatory and general economic environment
related to the health care and pharmaceutical industries, including possible changes in reimbursement for healthcare products and in manufacturers pricing or distribution policies; (ii) conditions in the capital markets, including the interest
rate environment and the availability of capital; (iii) changes in the competitive marketplace that could affect the Companys revenue and/or cost bases, such as increased competition, lack of qualified marketing, management or other personnel,
and increased labor and inventory costs; (iv) changes in technology or customer requirements; (v) changes regarding the availability and pricing of the products which



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the Company distributes, as well as the loss of one or more key suppliers for which alternative sources may not be
available, (vi) the Companys ability to integrate recently acquired businesses; and (vii) the Companys ability to consummate its proposed. Further information relating to factors that could cause actual results to differ from those
anticipated is included but not limited to information under the headings Business, particularly under the subheading, Risk Factors, and Managements Discussion and Analysis of Financial Condition and Results of
Operations in the Companys Form 10-K for the year ended March 31, 2004, as well as information contained in this Form 10-Q. The Company disclaims any intention or obligation to update or revise forward-looking statements, whether as a
result of new information, future events or otherwise.



Overview



DrugMax, Inc. (Nasdaq: DMAX) is a full-line, wholesale distributor of
pharmaceuticals, over-the-counter products, health and beauty care products, nutritional supplements and related products. The Company is headquartered in Clearwater, Florida and maintains distribution centers in Pennsylvania and Louisiana. The
Company distributes its products primarily to independent pharmacies in the continental United States, and secondarily to small and medium-sized pharmacy chains, alternative care facilities and other wholesalers. The Company maintains an inventory
from leading manufacturers and holds licenses to ship to all 50 states and Puerto Rico. While the Company ships to all 50 states and Puerto Rico, its sales tend to be concentrated around its distribution centers in Pennsylvania and Louisiana and
largely populated states such as New York, California, Texas and Florida.



The
Companys products function within the structure of the healthcare financing and reimbursement system of the United States. As a result of a wide variety of political, economic and regulatory influences, this system is currently under intense
scrutiny and subject to fundamental changes. In recent years, the system has changed significantly in an effort to reduce costs. These changes include increased use of managed care, cuts in Medicare, consolidation of pharmaceutical and
medical-surgical supply distributors, and the development of large, sophisticated purchasing groups. As a result, the Companys profit margins have been negatively impacted, particularly with regard to branded pharmaceuticals. In response, the
Company has implemented a strategy aimed at increasing its margins while reducing costs by focusing on higher-margin products. In general, the Companys branded products enjoy smaller margins than its generic, over-the-counter and other
products. The Company implemented this strategy by focusing on its core business of servicing independent pharmacies, hospitals and small chain stores, and de-emphasizing sales to warehouse customers, which generate high-volume revenue, but nominal
gross profit.



On March 19, 2004, the Company entered into an Agreement and
Plan of Merger with FMG, as amended on July 1, 2004, pursuant to which FMG will be merged with and into the Company, with the Company being the surviving company. FMG is a pharmacy chain with a strategy of locating pharmacies at or near a
patients point of medical care. FMG operates more than 76 pharmacies in 14 states. Many of these pharmacies are located at or near the point of care between physicians and patients, many times inside or near medical office buildings. Across
these distribution channels, FMG annually services over 400,000 acute and chronically ill patients, many with complex specialty and medical product needs. The principal executive offices of FMG are located at 312 Farmington Avenue, Farmington, CT
06032. If the merger is consummated, the Company expects that the current Company stockholders will, as a group, own approximately 40%, and FMG stockholders, employees and directors will, as a group, own approximately 60%, of the issued and
outstanding shares of the Company immediately after the merger, assuming the vesting of all restricted shares issued in connection with the merger. In addition, at the closing of the merger, the Company will issue warrants to the FMG stockholders
and certain FMG warrant holders and note holders entitling them to purchase certain additional shares of the Company common stock. The Company can make no assurances as to when or if the merger will be consummated.



Critical Accounting Policies and Estimates



Managements Discussion and Analysis of Financial Condition and Results of Operations
(MD&A) contains a discussion of the Companys condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these
financial statements requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reporting period. On an on-going basis, the Company evaluates its estimates and judgments, including those related to customer incentives, product returns, bad debts, inventories, intangible assets, income
taxes, and contingencies and litigation. The Company bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.



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Management believes the following critical accounting policies, among others, affect the Companys more significant
judgments and estimates used in the preparation of its condensed consolidated financial statements.



Allowance for Doubtful Accounts



Receivables are stated net of allowances for doubtful accounts of approximately $1.7 million and $1.3 million at June 30, 2004 and 2003, respectively. On a regular basis, the Company evaluates its receivables and establishes the allowance
for doubtful accounts based on a combination of specific customer circumstances and historical write-off experience. Credit is extended to customers based upon an evaluation of their financial position. Generally, advance payment is not required.
The Company feels its allowance for doubtful accounts at June 30, 2004 is adequately stated in relationship to its accounts receivable.



Inventory Valuation



Inventory is stated at the lower of cost or market. Cost is determined using the first-in, first-out basis of accounting. Inventories consist of brand and generic drugs,
over-the-counter products, health and beauty aids, and nutritional supplements for resale. The inventories of the Companys three distribution centers are constantly monitored for out of date or damaged products, which if exist, are reclassed
and physically relocated out of saleable inventory to a holding area, referred to as the morgue inventory, for return to and credit from the manufacturer. It is important that the Company continually monitor the morgue inventory to
assure that merchandise is returnable to the manufacturer in accordance with the vendors return policy. Improper management of the morgue inventory could result in write-downs of the morgue inventory and result in a charge to cost of sales. In
addition, if market acceptance of the Companys existing products or the successful introduction of new products should significantly decrease, inventory write-downs could be required. As of June 30, 2004 and 2003, no inventory valuation
allowances were necessary.



Goodwill and Intangible Assets



The Company has completed several acquisitions which have generated
significant amounts of goodwill and intangible assets and related amortization. The values assigned to goodwill and intangibles, as well as their related useful lives, are subject to judgment and estimation by the Company. In addition, upon adoption
of Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS No. 142), the Company ceased amortization of goodwill effective April 2001, and reviews goodwill annually for
impairment. Goodwill and intangibles related to acquisitions are determined based on purchase price allocations. Valuation of intangible assets is generally based on the estimated cash flows related to those assets, while the initial value assigned
to goodwill is the residual of the purchase price over the fair value of all identifiable assets acquired and liabilities assumed. Thereafter, the value of goodwill cannot be greater than the excess of the fair value of the Companys reportable
unit over the fair value of identifiable assets and liabilities, and the quoted market prices of the Companys common stock, based on the annual impairment test. Downward movement in the Companys common stock could have a material effect
on the fair value of goodwill in future measurement periods. Useful lives are determined based on the expected future period of benefit of the asset, the assessment of which considers various characteristics of the asset, including historical cash
flows. If the carrying amount of goodwill exceeds its fair value, then an indication exists that the Companys goodwill may be impaired. As of June 30, 2004, the Company had unamortized goodwill in the amount of $13,105,000.



Impairment of Long-Lived Assets



Long-lived assets are reviewed for impairment when events or circumstances indicate that a
diminution in value may have occurred, based on a comparison of undiscounted future cash flows to the carrying amount of the long-lived asset. Periodically, the Company evaluates the recoverability of the net carrying value of its property and
equipment, by comparing the carrying values to the estimated future undiscounted cash flows. A deficiency in these cash flows relative to the carrying amounts is an indication of the need for a write-down due to impairment. The impairment write-down
would be the difference between the carrying amounts and the fair value of these assets. Losses on impairments are recognized by a charge to earnings. As of June 30, 2004, managements analysis did not indicate an impairment to the
Companys long-lived assets.



Allowance for Deferred Income Tax
Asset



The Company had a deferred income tax asset and valuation
allowance at March 31, 2001, which primarily represented the potential future tax benefit associated with its operating losses through the fiscal year ended March 31, 2001. In assessing the realizability of deferred income tax assets, management
considered whether it is more likely than not that some portion or all of the deferred income tax assets would not be realized. The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during
the periods in which those temporary differences become deductible. Management evaluated the scheduled reversal of deferred income tax liability, the Companys profitability for the year ended March 31, 2002, reviewed the Companys
business model, and future earnings projections, and believed the evidence indicated that the Company will be able to generate sufficient taxable income to utilize the deferred income tax asset. Based upon the evaluations made, management concluded
that realization of the deferred income tax asset was more likely than not; therefore, the valuation allowance was reversed in fiscal 2002. During the fiscal year ended March 31, 2003, the Company recorded a



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deferred income tax benefit of approximately $.3 million related to losses reported for the fiscal year, and recorded a
valuation allowance of $.6 million for a portion of deferred tax assets which management concluded that their realization was not more likely than not. Based upon managements analysis and discussion in fiscal 2004, the Company reserved the net
deferred tax asset at March 31, 2004, as it appears to be more likely than not that the Company will not be able to utilize the deferred income tax asset of approximately $1.4 million. Therefore, the Company recorded the $1.4 million as a charge to
income tax expense in the fourth quarter of fiscal 2004.



Revenue
Recognition



The Company recognizes revenue when goods are shipped and
title or risk of loss resides with unaffiliated customers, and at which time the appropriate provisions are recorded for estimated contractual chargeback credits from the manufacturers based on the Companys contract with the manufacturer.
Rebates and allowances are recorded as a component of cost of sales in the period they are received from the vendor or manufacturer unless such rebates and allowances are reasonably estimable at the end of a reporting period. The Company records
chargeback credits due from its vendors in the period when the sale is made to the customer which is eligible for contract pricing from the manufacturer. Detailed accounting, internal auditing and reconciliations are necessary for the Company to
maintain accurate records for the rebates, allowances and chargebacks. The Companys failure to properly record, audit and submit timely reports to vendors could result in the loss of revenue related to the rebates, allowances and chargebacks.



The Company accepts return of product from its customers for product which is
saleable, in unopened containers and carries a current date. Generally, product returns are received via the Companys own delivery vehicles, thereby eliminating a direct shipping cost from being incurred by the customer or the Company.
Depending on the length of time the customer has held the product, the Company may charge a handling and restocking fee. Failure to process returns correctly could result in the Company accepting outdated or damaged merchandise from customers. The
Company reviews all requests for return of product to assure that the Company accepts returned merchandise in saleable condition. Overall, the percentage of the return of product to the Company is extremely low. The Company has no sales incentive or
rebate programs with its customers.



Results of Operations



For the Three Months Ended June 30, 2004 and 2003.



|                                                                                    |  |                                     |            |   |                 |     |   |      |   |            |                 |  |     |  
|----------------------------------------------------------------------------------- |  | ----------------------------------- | ---------- | - | --------------- | --- | - | ---- | - | ---------- | --------------- |  | --- | -
|                                                                                    |  | For the Three Months Ended June 30: |           
|                                                                                    |  | 2004                                |            |   | As %of revenues |     |   | 2003 |   |            | As %of revenues | 
|Revenues                                                                            |  | $                                   | 39,993,420 |   |                 |     |   |      | $ | 60,659,545 |                 |  |     |  
|Gross profit                                                                        |  |                                     | 1,201,744  |   |                 | 3.0 | % |      |   | 1,987,213  |                 |  | 3.3 | %
|Loss before tax (expense) benefit and equity (loss) from unconsolidated subsidiary. |  |                                     | (875,991   | ) |                 |     |   |      |   | (35,728    | )               |  |     |  
|Net loss                                                                            |  |                                     | (876,078   | ) |                 |     |   |      |   | (35,728    | )               |  |     |  
|Basic loss per weighted average share                                               |  |                                     | (0.11      | ) |                 |     |   |      |   | (0.01      | )               |  |     |  



Revenues. The Company generated
revenues of approximately $40.0 million and $60.1 million for the three months ended June 30, 2004 and 2003, respectively.



The following schedule summarized the Companys sales in its four product lines for the three months ended June 30, 2004 and 2003:



|                             |  |                                      |            |                          |      |   |                                      |   |                          |  |      |  
|---------------------------- |  | ------------------------------------ | ---------- | ------------------------ | ---- | - | ------------------------------------ | - | ------------------------ |  | ---- | -
|                             |  | For Three Months Ended June 30, 2004 |            | As a % of total revenues |      |   | For Three Months Ended June 30, 2003 |   | As a % of total revenues | 
|Revenues from:               |  |                                      |            |                          |      |   |                                      |   |                          |  |      |  
|Branded pharmaceuticals      |  | $                                    | 36,178,227 |                          | 90.5 | % |                                      | $ | 55,911,236               |  | 92.2 | %
|Generic pharmaceuticals      |  |                                      | 2,365,463  |                          | 5.9  | % |                                      |   | 3,672,093                |  | 6.0  | %
|Over-the-counter and general |  |                                      | 1,165,516  |                          | 2.9  | % |                                      |   | 1,076,217                |  | 1.8  | %
|Respiratory products         |  |                                      | 284,214    |                          | 0.7  | % |                                      |   |                         |  | 0.0  | %
|                             |  |                                      |            |                          |      |   |                                      |   |                          |  |      |  
|Total Revenues               |  | $                                    | 39,993,420 |                          |      |   |                                      | $ | 60,659,546               |  |      |  
|                             |  |                                      |            |                          |      |   |                                      |   |                          |  |      |  



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1. Branded Pharmaceuticals: The decrease in overall revenues was primarily caused by a decrease in the
Companys sales of branded pharmaceuticals, which in turn was caused by several factors as follows: As stated previously, the Companys products function within the structure of the healthcare financing and reimbursement system of the
United States. As a result of a wide variety of political, economic and regulatory influences, this system is currently under intense scrutiny and subject to fundamental changes. In recent years, the system has changed significantly in an effort to
reduce costs. These changes include increased use of managed care, cuts in Medicare, consolidation of pharmaceutical and medical-surgical supply distributors, and the development of large, sophisticated purchasing groups. As a result, the
Companys revenues and margins have been negatively impacted, particularly with regard to branded pharmaceuticals.



As a result of these forces, the Company has implemented a business strategy aimed at increasing its revenues and margins while reducing costs by focusing on
higher-margin products. In general, the Companys branded products experience smaller margins than its generic, over-the-counter and other products. The Company implemented this strategy by focusing on its core business of servicing independent
pharmacies, hospitals and small chain stores, and de-emphasizing sales to warehouse customers, which generate high-volume revenue, but nominal gross profit. The Companys focus on higher margin-products, and corresponding de-emphasis on
lower-margin products, resulted in a decrease of sales of branded pharmaceuticals. Branded drug sales declined by approximately $19.7 million during the three months ended June 30, 2004, as compared to the same period during the prior year.



The decline in the sale of branded pharmaceuticals was also caused, in part,
by:



| |  | Changes in vendor programs affecting alternate source customers. Brand name drug manufacturers recently have started to require drug wholesalers to reduce or eliminate forward
buying, a strategy pursuant to which wholesalers purchase products in anticipation of expected price increases. Further, brand manufacturers are reducing the number of buy-in programs that they are offering. Buy-in programs are special opportunities
provided by manufacturers to purchase greater-than-normal quantities at reduced prices. Both of these trends have resulted in further downward pressure on the Companys gross margins. Therefore, emphasis on generic sales continues to be part of
the Companys focus to improve gross profit;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Loss of business amounting to approximately $9.4 million due to the complaint filed by QK Healthcare, and other warehouse customers amounting to approximately $4.1 million, and the
loss of several of the Companys core business customers as a result of customer credit issues, including bankruptcy filings; and
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Expensive branded drugs going off patent which were replaced by generic equivalent drugs at substantially lower cost.
| | - | ---------------------------------------------------------------------------------------------------------------------



2. Generic Pharmaceuticals. Sales of generic pharmaceuticals decreased by
approximately $1.3 million for the three months ended June 30, 2004 as compared to June 30, 2003 despite the Companys efforts to focus on these higher margin products. Management believes the decrease in sales of generic pharmaceuticals was
primarily caused by the loss of several customers purchasing a significant amount of generic products monthly due to credit and collection concerns and turnover of customer base not replaced during the quarter.



3. Over the Counter and Respiratory Products. During the three months ended
June 30, 2004, total over the counter and respiratory sales amounted to approximately $1.4 million, as compared to approximately $1.1 million for the same three months ended June 30, 2003. The increase was primarily due to the revenues generated by
the respiratory products sold as a result of the Companys acquisition of Avery in May 2003.



Gross Profit. The Company achieved gross profit of approximately $1.2 million and $2.0 million for the three months ended June 30, 2004 and 2003, respectively. The Companys margin, as a percentage of
revenue, was 3.0% and 3.3% for the three months ended June 30, 2004 and 2003, respectively. The decrease in gross margin percentage was primarily as a result of the (a) decline in volume of higher-profit generic sales, (b) the loss of
buy-in opportunities and incentives from manufacturers, which increased the cost of purchased goods for the Company, and (c) loss of several of the Companys core business customers as a result of customer credit issues, including
bankruptcy filings. The loss of buy-in opportunities primarily resulted from the reduced purchasing levels caused by the loss of the QK Healthcare business. The gross profit earned on sales to the Companys core business customers
ranges from 1% to 3%, and represented more than 96% of the total gross profit earned by the Company for fiscal 2004, 2003 and 2002. Gross profit and gross profit margin was also negatively impacted by brand name drug manufacturers continuing
pressures on drug wholesalers to reduce or eliminate forward buying.



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Operating Expenses and Other Income and Expenses. The Company incurred operating expenses of approximately $1.8
million for each of the three months ended June 30, 2004 and 2003, respectively. The following schedule details the major components of operating expenses:



|                                                                     |  |                                          |           |                                          |   |          
|-------------------------------------------------------------------- |  | ---------------------------------------- | --------- | ---------------------------------------- | - | ---------
|                                                                     |  | For the Three Months Ended June 30, 2004 |           | For the Three Months Ended June 30, 2003
|Operating expenses:                                                  |  |                                          |           |                                          |   |          
|Administrative, sales, marketing and other direct operating expenses |  | $                                        | 1,771,787 |                                          | $ | 1,741,552
|Amortization and depreciation expense                                |  |                                          | 65,267    |                                          |   | 52,502   
|                                                                     |  |                                          |           |                                          |   |          
|Total operating expenses                                             |  | $                                        | 1,837,054 |                                          | $ | 1,794,054
|                                                                     |  |                                          |           |                                          |   |          



Administrative, sales, marketing and
other direct operating expenses were approximately 4.4% and 2.9% of gross revenues for the three months ended June 30, 2004 and 2003, respectively. The increase of $.03 million in the administrative, sales, marketing and other direct operating
expenses for the three months ended June 30, 2004 over the three months ended June 30, 2003, was due increased operating costs associated with the acquisition of Avery in mid May 2003.



The Company acquired the business of Avery in May 2003. Based upon the initial projections management received from Avery personnel, it was
anticipated that the Avery operations would impact the Company positively, primarily as a result of the Companys acquisition of a patent on the manufacture of respiratory products. For the three months ended June 30, 2004, the Avery operations
combined with the Valley South operations incurred a net loss of $307,000. The Company has completed the testing of the patented product, and has begun production in July 2004.



Other income and expense. The Company realized approximately $17,000 and $444,000 in other income for the three months ended June 30,
2004 and 2003, respectively. For the three months ended June 30, 2004, other income and expense primarily represented interest and finance charge income. In April 2003, the Company recorded approximately $73,000 in costs associated with the
termination of the Standard credit facility, which were charged as other expense, and recorded as other income the reversal of a long-term liability due to Butler of approximately $502,000 in connection with the agreement between the Company and
Butler whereby Butler assigned its 30% ownership in VetMall to the Company. (See Acquisitions.)



For the three months ended June 30, 2004, the Company recorded a loss of approximately $100 as loss from unconsolidated subsidiary. The joint venture with MorepenMax has begun initial operations during this period and
currently has nominal sales. The income or loss recorded represents 49% of the joint ventures operations.



Interest expense. Interest expense was approximately $257,000 and $673,000, for the three months ended June 30, 2004 and 2003, respectively. Included in interest
expense is the amortization of loan financing costs, which were approximately $62,000 and $96,000 for the three months ended June 30, 2004 and 2003, respectively, and the early termination fee of $350,934 and the 90-day notice waiver fee of $30,000
charged by Standard for the early termination of that credit facility in April 2003.



Net income (loss) per share. EPS is calculated by dividing the net income (loss) by the weighted average number of shares of common stock outstanding for the period. Diluted EPS is calculated by dividing net income (loss) by the
weighted average number of shares of common stock outstanding for the period, adjusted for the dilutive effect of options and warrants, using the treasury stock method. The net loss per share for the three months ended June 30, 2004 and 2003 was
$.11 and $.01 per basic and diluted shares, respectively. The Company had issued and outstanding 1,530,143 and 1,977,148 options, respectively, to purchase shares of the Companys common stock, in addition to warrants to purchase 150,000 shares
of the Companys common stock, which were anti-dilutive and not included in the computation of diluted EPS for the three months ended June 30, 2004 and 2003. These anti-dilutive shares could potentially dilute the basic EPS in the future.
Shares of common stock used in the calculation of basic and dilutive net income per share for the three months ended June 30, 2004 and 2003 were 8,191,363 and 7,130,475, respectively.



Income Taxes.SFAS No. 109 requires a valuation allowance to reduce the deferred income tax assets reported, if based on the weight
of the evidence, it is more likely than not that a portion or all of the deferred income tax assets will not be realized. The Company had an estimated gross deferred income tax asset and valuation allowance of approximately $1.5 million as of the



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fiscal year ended March 31, 2001, which primarily represented the potential future tax benefit associated with its
operating losses through the fiscal year ended March 31, 2001. Management evaluated the scheduled reversal of deferred income tax liability, the Companys profitability for the year ended March 31, 2002, reviewed the Companys business
model, and future earnings projections, and based on such evaluation believed the evidence indicated that the Company would be able to generate sufficient taxable income to utilize the deferred income tax asset; therefore, the Company recognized the
full $1.5 million deferred income tax asset, offset by deferred income tax expense of $.4 million, for a net deferred income tax benefit of $1.1 million for the year ended March 31, 2002. During the fiscal year ended March 31, 2003, the Company
recorded income tax benefit of $313,882. At March 31, 2003, management believed that it was more likely than not that the Company would be able to generate sufficient taxable income to utilize the deferred income tax asset. At March 31, 2003,
management recorded a valuation allowance of $580,100 for a portion of the deferred tax assets that it concluded that their realization is not more likely than not. Based upon current results and managements analysis and discussion at March
31, 2004, the Company reserved the entire deferred income tax asset at March 31, 2004, as it appears to be more likely than not that the Company will not be able to utilize the deferred income tax asset of approximately $1.4 million. Therefore, the
Company recorded the $1.4 million as a charge to income tax expense in the fourth quarter of fiscal 2004. The Companys total valuation allowance at March 31, 2004 is approximately $4.5 million.



Inflation and Seasonality. Management believes that there was no material effect on
operations or the financial condition of the Company as a result of inflation for the three months ended June 30, 2004 and 2003. Management also believes that its business is not seasonal; however, significant promotional activities can have a
direct impact on sales volume in any given quarter.



Financial Condition, Liquidity and Capital Resources



The Company has a working capital deficit and cash and cash equivalents of approximately ($2.0) million and $2.3 million, respectively, at June 30, 2004.



In April 2003, the Company obtained a $40 million revolving line of credit and a $400,000 term note from Congress to satisfy the outstanding
line of credit and term loan with Standard, and to provide working capital for possible future acquisitions. The Congress credit facility is collateralized by all assets of the Company. The revolving line of credit enables the Company to borrow a
maximum of $40 million, with borrowings limited to 85% of eligible accounts receivable and 65% of eligible inventory and is available until April 2006. At June 30, 2004, availability on the Congress credit facility was approximately $2.4 million.
The revolving line of credit and the term note currently bear interest at the rate of 0.50% per annum in excess of the Prime Rate. The term note and revolving line of credit are payable over a 36-month period. The Congress credit facility imposes
certain restrictive covenants on tangible net worth and EBIDTA. On March 31, 2004, the Company and Congress executed a Second Amendment to the Loan and Security Agreement revising the EBITDA and tangible net worth covenants beginning March 31, 2004
and forward. On June 30, 2004, the Company and Congress executed a Third Amendment to the loan and Security Agreement, which amended the EBITDA and tangible net worth covenants going forward. At June 30, 2004, the Company was not in compliance with
the EBITDA and tangible net worth covenants. The Company and Congress executed on August 5, 2004 the Fourth Amendment and Waiver to the Loan and Security Agreement, which waived the non-compliance with the EBITDA and tangible net worth covenants as
of June 30, 2004 and through the period ended September 29, 2004. The Company continues to work with Congress to establish loan covenants that will be achievable in future periods; however, there can be no assurance that this will occur. The amended
agreement also requires the Company to maintain excess availability, as defined, of $1,000,000 and certain other conditions.



The Companys principal commitments at June 30, 2004 consist of the outstanding loan agreement with Congress and leases on its office and warehouse space. There were
no material commitments for capital expenditures at that date.



On March
19, 2004, the Company entered into an Agreement and Plan of Merger with FMG, pursuant to which FMG would be merged with and into the Company, with the Company being the surviving company. If the merger is consummated, the Company expects that the
current Company stockholders will, as a group, own approximately 40%, and FMG stockholders, employees and directors will, as a group, own approximately 60%, of the issued and outstanding shares of the Company immediately after the merger. In
addition, at the closing of the merger the Company will issue warrants to the FMG stockholders, the FMG warrant holders and the FMG note holders entitling them to purchase certain additional shares of the Company common stock. While the merger
agreement does not require the payment of any cash consideration at closing, the Company will incur certain expenses in connection with the closing of the merger, including legal, accounting, investment banking, filing, printing and mailing fees.
Further, if any shareholders of either DrugMax or FMG dissent from the merger, the Company will be required to pay such shareholders the fair value of their shares in cash. The merger agreement limits the number of shares of the Company that may
dissent to 200,000 and the number of shares of FMG that may dissent to $1,000,000 worth of FMG stock. Neither FMG nor the Company are required to consummate the merger if shareholders holding shares in excess of these limits notify the Company and
FMG of their intent to dissent.



Further, if the merger is consummated, the
combined company will inherit the debt and obligations of FMG. FMG has incurred significant losses and negative cash flow in the past. Further, unless restructured in connection with the merger, FMGs senior collateralized revolving credit
facility with General Electric Capital Corporation (General Electric), and its debt under that



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facility will mature on August 31, 2004. As of May 22, 2004, the amount outstanding under the General Electric facility
was approximately $27.7 million. These facts raise doubt about FMGs ability to continue as a going concern. FMGs auditor has issued a going concern opinion, in part as a result of its credit facility having a maturity date of less than
one year. While management believes that the merger offers the combined company a greater opportunity than either company individually would have to improve its financial position, for the reasons discussed under the heading Risk Factors
in the Companys Form 10-K for the year ended March 31, 2004, there can be no assurance that management will be able to integrate the two companies or that the anticipated benefits of the merger will be realized. If the Company and FMG fail to
integrate the companies, achieve its business plan, realize some or all of the anticipated revenue opportunities or cost savings and other benefits of the merger, or if the costs of the merger or the integration of the companies exceeds what is
anticipated, its working capital and financial condition will be materially negatively impacted.



To complete the merger, the merger agreement requires that the Company obtain a new credit facility for at least $60 million. The Company has received proposals for a $65 million facility. While the Company has
obtained these proposals, there can be no assurance that the loan, or any other acceptable credit facility, will be available to the Company prior to the closing of the merger.



Further, while management presently believes that the new credit facility that it will obtain in connection with the merger will be
sufficient to allow the surviving company to integrate the businesses of FMG and the Company and to fund its business plan for the next 12 months, it may be insufficient to fund the Companys credit needs. If the Company fails to realize some
or all of the anticipated revenue opportunities or cost savings and other benefits of the merger, or if the costs of the merger or the integration of the companies exceeds what is anticipated, the Company may need to seek alternate or additional
financing.



In the event the merger with FMG is not consummated, management
believes the Company has sufficient capital resources from its current credit facility with Congress, which expires in April 2006, and capital injected into the Company during the fourth quarter 2004, to fund the Companys operations for the
next twelve months in spite of the negative $2.0 million working capital position reported at June 30, 2004. Managements long-range viewpoint believes that the growth and capital needs of the Company will be met through primarily achieving
positive results from its business model, utilization of available debt financing from its Congress bank facility and continually looking to the equity markets for new capital.



Net cash provided by operating activities was approximately $2.5 million for the three months ended June 30, 2004. Cash was provided
primarily by decreases in accounts receivables, notes receivable, deposits, and an increase in accounts payable; offset by increases in inventory, prepaid expense and other current assets, and accrued expense and other current liabilities. The
decreases in accounts receivable and the increase in inventory was caused by a decrease in sales during the quarter and inventory build up to service the customer base, respectively. The increase in accounts payable to trade vendors and the related
decrease in the Companys line of credit was caused principally by the due dates of the payments to vendors and the availability of the line of credit to fund disbursements. Net cash used in operating activities was $3.1 million for the three
months ended June 30, 2003. Cash was used primarily by increases in accounts receivables, prepaid and other current assets, decreases in accounts payables, and accrued expenses and other current liabilities; offset by decreases in inventory, due
from affiliates, other assets and notes receivable.



Net cash used in
investing activities was approximately $.1 million for the three months ended June 30, 2004, which represented cash invested in property and equipment.



Net cash used in financing activities was approximately $2.8 million for the three months ended June 30, 2004, primarily representing a decrease in the Companys
line of credit of approximately $2.7 million, an increase in deferred financing costs associated with the Congress credit facility, and payments of long-term debt, capital leases. The decrease in the line of credit balance was principally caused by
the payment cycles due to vendors. Fluctuations between accounts payable and the line of credit balances are normal depending upon the payment cycles.



Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.



The Company is subject to market risk from exposure to changes in interest rates based on its financing and cash management activities, which could effect its results of operations and financial condition. At June 30,
2004, the Companys outstanding debt with Congress was approximately $14.6 million on the line of credit and $.2 million on the term loan. The interest rates charged on the line of credit and term loan currently bear interest at the rate of
0.5% per annum in excess of the Prime Rate. The Company is at risk of increased interest rates, due to fluctuations in the Prime Rate, contingent upon economic conditions. At June 30, 2004, the interest rate charged on the line of credit and term
loan was 4.5%. The company manages its risk by choosing the most advantageous interest option offered by its lender. See Managements Discussion and Analysis of Financial



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Condition and Results of Operations - Financial Condition, Liquidity and Capital Resources. The Company holds
several notes receivable from its customers which do not carry variable interest rates. The Company does not currently utilize derivative financial instruments to address market risk.



Item 4. CONTROLS AND PROCEDURES.



The Company
maintains disclosure controls and procedures designed to ensure that information required to be disclosed in its Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SECs rules and
forms, and that such information is accumulated and communicated to the Companys management, including its Chief Executive Officer and its Chief Financial Officer/Principal Accounting Officer, as appropriate, to allow timely decisions
regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving
the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



As recently reported in the Companys annual report on Form 10-K for the year ended March 31, 2004, in connection with the completion
of its audit of, and the issuance of an unqualified report on, the Companys consolidated financial statements for the fiscal year ended March 31, 2004, the Companys independent auditors, BDO Seidman, LLP (BDO), communicated
to the Companys Audit Committee that the following matters involving the Companys internal controls and operation were considered to be reportable conditions, as defined under standards established by the American Institute
of Certified Public Accountants, or AICPA:



| |  | Processes relating to account analysis and reconciliations including lack of timely management review, which contributed to fourth quarter adjustments relating to inventories,
accounts receivable and accounts payable; and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The Companys recognition of accruals in connection with litigation.
| | - | --------------------------------------------------------------------



Reportable conditions are matters coming to the attention of the independent auditors that, in their judgment, relate to significant deficiencies in the design or
operation of internal controls and could adversely affect the Companys ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. In addition, BDO has advised the
Company that they consider these matters, which are listed above, to be material weaknesses that, by themselves or in combination, result in a more than remote likelihood that a material misstatement in our financial statements will not
be prevented or detected by our employees in the normal course of performing their assigned functions.



As required by SEC Rule 13a-15(b), for the first quarter ended June 30, 2004, the Company once again carried out an evaluation, under the supervision and with the participation of its management, including its Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures as of June 30, 2004. Although the Company continues to make improvements, as of June 30, 2004,
the Companys Chief Executive Officer and Chief Financial Officer determined that deficiencies identified by BDO continue to cause the Companys disclosure controls and procedures not to be effective at a reasonable assurance level.
However, the CEO and CFO noted that the Company continues to remedy the deficiencies identified by BDO and did not note any other material weaknesses or significant deficiencies in the Companys disclosure controls and procedures during their
evaluation. The Company continues to improve and refine its internal controls. This process is ongoing, and includes the following:



1. The Company decided to convert its operating divisions to new accounting software and an integrated networked computerized system linking all divisions, which will
roll up financial information on a real-time basis. The implementation of that process began during the fourth quarter of 2004 and is expected to be completed during the second quarter of 2005. The Company believes this conversion will provide more
timely operating information, a more efficient system of checks and balances to assure accurate reporting of detailed transactions, and more efficient month-end closing procedures to provide a comprehensive internal review before financial
information is considered final. The Companys accounts payable detailed ledger at Valley is not fully integrated to the general ledger system, which has caused large amounts of reconciling items. Management believes this issue will be
significantly improved with the conversion to the new integrated accounting system. As a result of the efficiencies of the new system, the Companys controllers will have appropriate time to better analyze cutoff and other detailed transactions
in order to assure the proper processing of its accounts payable and other accounting functions.



2. The Company has reorganized its credit and collection functions and previously hired a Vice President of Asset Management to assist in the granting of credit to customers or potential customers. In addition, in the
first week of July 2004, the Company hired a credit manager, who will report directly to the Vice President of Asset Management, and who will be



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responsible for daily management of the credit function. Recently, more independent pharmacies, which are a significant
part of the Companys core business, have incurred financial difficulties, as indicated by the number of recent bankruptcies by such pharmacies. As a result, the Companys credit policy is being reviewed and restructured.



3. The Company improved its control over morgue inventory during the fourth quarter of 2004
in connection with the relocation of Valley to its new warehouse facility. In the future the Company will be taking frequent physical inventory counts to properly record quantities in the morgue inventory at Valley. In addition, the Company has
hired a full-time warehouse clerk assigned to manage the movement of the morgue inventory.



4. Management continues to evaluate the number of personnel involved in the accounting and finance function of the Company. Due to the acquisitions made by the Company over the past three years and pressures on
operations resulting from competition, shrinking margins and regulatory matters, management is reassessing its existing personnel and resources to address its internal control and operational requirements. This is an ongoing process.



Other than for the matters discussed above, the Companys Chief Executive Officer and
Chief Financial Officer/Principal Accounting Officer have determined that the Companys internal controls and procedures were effective as of the end of the period covered by this report. Other than the improvements discussed above, in the
fourth quarter of fiscal 2004, there were no significant changes in the Companys internal control over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, the Companys internal
controls over financial reporting.



PART II - OTHER INFORMATION



Item 1. LEGAL PROCEEDINGS.



In March 2000, the
Company acquired all of the issued and outstanding shares of common stock of Desktop Corporation, a Texas corporation located in Dallas, Texas, pursuant to an Agreement and Plan of Reorganization by and among the Company, K. Sterling Miller, Jimmy
L. Fagala and HCT Capital Corp. (the Reorganization Agreement). On February 7, 2002, Messrs. Miller and Fagala filed a complaint against the Company in the Circuit Court of the Sixth Judicial Circuit in and for Pinellas County, Florida,
alleging, among other things, that the Company had breached the Reorganization Agreement by failing to pay 38,809 shares of the Companys common stock to plaintiffs. The complaint also includes a count of conversion and further alleges that the
Company breached its employment agreements with Messrs. Miller and Fagala, for which the plaintiffs seek monetary damages. On March 11, 2002, the Company filed its answer, affirmative defenses and counterclaim against plaintiffs and HCT Capital
Corp. (HCT), in which it alleged, among other things, that plaintiffs had breached the Reorganization Agreement by misrepresenting the state of the acquired business, that the Company was entitled to set off its damages against the
shares which the plaintiffs are seeking and further seeking contractual indemnity against the plaintiffs. On April 16, 2002, HCT filed its answer, counterclaim against the Company and cross-claim against the plaintiffs. In December 2003, a
Settlement Agreement and Release (the Release) was executed by HCT and the Company whereby HCT and the Company unconditionally, fully and finally released each other from any future claims relative to the matter. HCT paid $1,000 to the
Company in consideration for the Release. There has been little activity by Messrs. Miller and Fagala with regard to this matter, and the Company is currently considering how to proceed in light of this inactivity. The Company intends to vigorously
defend the actions filed against it and to pursue its counterclaim. The Company cannot reasonably estimate any possible future loss or recovery as a result of this matter; therefore, the Company has made no provision in the accompanying consolidated
financial statements for resolution of this matter.



On May 1, 2002, the
Company filed suit against an established customer of the Companys Pittsburgh distribution center for collection of past due accounts receivable. On May 23, 2002, the customer filed a voluntary petition in bankruptcy in the U.S. Bankruptcy
Court, under Chapter Eleven of the United States Bankruptcy Act, subsequent to which the customer failed to file the proper financial data with the court, causing the voluntary bankruptcy filing to be withdrawn. In June 2004, the Company received
approximately $7,000 as settlement of their claim against the customer. The Company had previously recorded an allowance account representing 100% of the account balance. At June 30, 2004, the allowance was applied against the account receivable to
clear the customers unpaid balance from the Companys accounts receivable records.



On October 2, 2003, QK Healthcare, Inc. (QK) filed a complaint against Valley in the United States District Court of the Eastern District of New York, which included several counts with regard to the sale
of twenty bottles of Lipitor by Valley to QK, including breach of contract, violations of the implied warranty of merchantability and fraud. The complaint demands actual damages, punitive damages and legal fees and expenses. On January 9, 2004, the
Company filed an answer and counterclaim against QK, in which the Company seeks to recover from QK losses caused when QK refused to pay for pharmaceuticals ordered from the Company. The Parties reached a settlement on May 14, 2004, pursuant to which
the case will



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be dismissed. The settlement agreement requires the Company to pay QK $218,000, calls for the parties to resume their
business relationship, with the Company giving QK certain price reductions in the products QK purchases from the Company for one year, and provides for the mutual release of both parties. The Company has recorded $218,000 to operating expenses and
$32,000 to legal expense in the fourth quarter of fiscal 2004 relative to this matter.



On November 12, 2003, Phil & Kathys, Inc. d/b/a Alliance Wholesale Distributors (Alliance) served a complaint against the Company seeking to recover the non-payment of open invoices approximating $2,000,535, based upon
an alleged breach of contract for the sale of pharmaceuticals. On December 18, 2003, the Company filed an answer and counterclaim. The counterclaim seeks to recover lost profits and other damages relating to the purchase of twenty bottles of Lipitor
from Alliance, which the Company later sold to QK. The Company intends to vigorously defend Alliances breach of contract action and prosecute the counterclaim. Valley also filed a separate action against Alliance for breach of an
indemnification agreement related to the sale of the twenty bottles of Lipitor that precipitated the lawsuit against Valley by QK in New York. At March 31, 2004, the amount that the Company recorded as a trade payable balance due Alliance on the
above was approximately $1.5 million. While the Company has recorded the foregoing trade payable, it continues to assess the extent of its full damages and cannot at this time reasonably estimate the total future possible loss that it will sustain
as a result of the Alliance complaint or the possible recovery through the Companys counterclaim or Valleys consolidated action.



On May 14, 2003, Discount Rx, Inc., a Nevada corporation and a wholly owned subsidiary of the Company (Discount), acquired substantially all of Avery
Pharmaceutical, Inc.s (Avery) assets (Avery Assets) in exchange for assuming certain limited liabilities (the Assumed Liabilities) of Avery and issuing a promissory note to Mr. Al Sankary
(Sankary) in the original principal amount of $318,000 (the Sankary Note). The Sankary Note and Avery specifically contemplated that Discount might have to pay certain unknown liabilities in connection with the acquisition in
excess of the amount of Assumed Liabilities. Accordingly, the Sankary Note and the Avery Assets permit Discount to set off payments due under the Sankary Note against payments made in excess of the Assumed Liabilities. Discount believes
that it has paid Averys obligations well in excess of the Assumed Liabilities. Therefore, all other payments under the Sankary Note are offset such that nothing more is due and payable there under.



On March 26, 2004, Sankary filed a lawsuit against Discount, in the 342ndJudicial District Court of Tarrant County, Texas (Sankary Suit). The complaint in the Sankary Suit alleges that
Discount defaulted under the Sankary Note as a result of Discounts failure to make payments when due to Sankary.



Discount has paid to Sankary the minimum amount due under the Sankary Note (approximately $90,000) and has paid liabilities of Avery in excess of its obligations under
the agreement, such that it is entitled to offset any further liability under the Sankary Note. Discount believes that the Sankary Suit is very likely to be dismissed pursuant to agreement between the partiesthe parties have exchanged
settlement proposals and anticipate the Sankary Suit to be dismissed in the near future.



Additionally, since the closing of the Avery transaction, various creditors and other third parties owed money by Avery have threatened to file lawsuits against Discount. To date, Discount has not been sued by any of
these creditors or other third parties and their claims remain unliquidated. The Company intends to vigorously defend any actions filed against Discount. In the unlikely event that Discount is not permitted to offset liabilities paid against the
obligation under the Sankary Note, the total amount that remains payable under the Sankary Note as of June 30, 2004, is $228,000. However, because the Company believes that it is entitled to offset any further liability under the Sankary Note, the
Company has made no provision in the accompanying consolidated financial statements for resolution of the Sankary Suit. Similarly, because no other lawsuits have been filed nor any threatened to be filed, the Company has made no provision in the
accompanying consolidated financial statements for resolution of any other claims against Discount.



The Company is, from time to time, involved in litigation relating to claims arising out of its operations in the ordinary course of business. The Company believes that none of the claims that were outstanding as of
June 30, 2004 should have a material adverse impact on its financial position, results of operations, or cash flows.



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



None.



Item 6. EXHIBITS AND REPORTS ON FORM 8-K.



(a)
Exhibits.



|2.1 | Agreement and Plan of Merger by and between NuMed Surgical, Inc. and Nutriceuticals.com Corporation, dated as of January 15, 1999. (1)
|--- | --------------------------------------------------------------------------------------------------------------------------------------



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|2.2 | Agreement and Plan of Reorganization dated September 8, 1999 by and between Nutriceuticals.com Corporation and Dynamic Health Products, Inc. (2)
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------



|2.3 | Agreement and Plan of Reorganization between DrugMax, Inc., Jimmy L. Fagala, K. Sterling Miller, and HCT Capital Corp. dated as of March 20, 2000. (3)
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------



|2.4 | Stock Purchase Agreement between DrugMax, Inc. and W.A. Butler Company dated as of March 20, 2000. (3)
|--- | ------------------------------------------------------------------------------------------------------



|2.5 | Merger Agreement between DrugMax, Inc., DrugMax Acquisition Corporation, and Valley Drug Company, Ronald J. Patrick and Ralph A. Blundo dated as of April 19, 2000. (4)
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|
|



|2.6 | Agreement for Purchase and Sale of Assets by and between Discount Rx, Inc., and Penner & Welsch, Inc., dated October 12, 2001. (11)
|--- | -----------------------------------------------------------------------------------------------------------------------------------



|2.7 | Agreement and Plan of Merger between DrugMax, Inc. and Familymeds Group, Inc. dated March 19, 2004, as amended. (19)
|--- | --------------------------------------------------------------------------------------------------------------------



|2.8 | First Amendment to Agreement and Plan of Merger between DrugMax, Inc. and Familymeds Group, Inc., dated July 1, 2004. (19)
|--- | --------------------------------------------------------------------------------------------------------------------------



|3.1 | Restated Articles of Incorporation of DrugMax, Inc. filed September 5, 2001. (18)
|--- | ---------------------------------------------------------------------------------



|3.7 | Amended and Restated Bylaws, dated November 11, 1999. (5)
|--- | ---------------------------------------------------------



|4.2 | Specimen of Stock Certificate. (8)
|--- | ----------------------------------



|10.1 | Employment Agreement by and between DrugMax, Inc. and William L. LaGamba dated April 1, 2003. (16)
|---- | --------------------------------------------------------------------------------------------------



|10.2 | Employment Agreement by and between DrugMax, Inc. and Ronald J. Patrick dated April 1, 2003 (16)
|---- | ------------------------------------------------------------------------------------------------



|10.3 | Employment Agreement by and between DrugMax, Inc. and Jugal K. Taneja, dated April 1, 2003. (16)
|---- | ------------------------------------------------------------------------------------------------



|10.4 | DrugMax.com, Inc. 1999 Incentive and Non-Statutory Stock Option Plan. (8)
|---- | -------------------------------------------------------------------------



|10.5 | Amendment No. 1 to DrugMax, Inc. 1999 Incentive and Non-Statutory Stock Option Plan, dated June 5, 2002. (14)
|---- | -------------------------------------------------------------------------------------------------------------



|10.6 | Loan and Security Agreement by an between Congress Financial Corporation and DrugMax, Inc., Valley Drug Company, Valley Drug Company South and Discount Rx, Inc., dated April 15,
2003. (15)
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|10.7 | DrugMax, Inc. 2003 Restricted Stock Plan dated August 27, 2003. (17)
|---- | --------------------------------------------------------------------



|10.8 | First Amendment to the Loan and Security Agreement by and between Congress Financial Corporation and DrugMax, Inc., Valley Drug Company, Valley Drug Company South and Discount Rx,
Inc., dated August 19, 2003. (19)
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|10.9 | Second Amendment to the Loan and Security Agreement by and between Congress Financial Corporation and DrugMax, Inc., Valley Drug Company, Valley Drug Company South and Discount Rx,
Inc., dated March 31. 2004. (19)
|---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|10.10 | Third Amendment to the Loan and Security Agreement by and between Congress Financial Corporation and DrugMax, Inc., Valley Drug Company, Valley Drug Company South and Discount Rx,
Inc., dated June 30, 2004. *
|----- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|21.0 | Subsidiaries of DrugMax, Inc. (18)
|---- | ----------------------------------



|31.1 | Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
|---- | ---------------------------------------------------------------------------------------------------------



|31.2 | Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
|---- | ---------------------------------------------------------------------------------------------------------



|32.1 | Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
|---- | -------------------------------------------------------------------------------------------------------------------------



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|32.2 | Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
|---- | -------------------------------------------------------------------------------------------------------------------------

---

|* | Filed herewith.
|- | ---------------

|(1) | Incorporated by reference to the Companys Registration Statement on Form SB-2, filed June 29, 1999, File Number 0-24362, as amended.
|--- | -------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to Amendment No. 1 to the Companys Registration Statement on Form SB-2, filed on September 13, 1999, File No. 0-24362.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Incorporated by reference to the Companys Report on Form 8-K, filed April 6, 2000, File Number 0-24362.
|--- | --------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to the Companys Report on Form 8-K, filed May 3, 2000, File Number 0-24362.
|--- | ------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to Amendment No. 2 to the Companys Registration Statement on Form SB-2, filed on November 12, 1999, File No. 0-24362.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(6) | Incorporated by reference to the Companys Report on Form 8-K, filed February 8, 2000, File No. 0-24362.
|--- | --------------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to the Companys Form 10-KSB, filed June 29, 2000, File No. 0-24362.
|--- | ----------------------------------------------------------------------------------------------

|(8) | Incorporated by reference to the Companys Form 10-KSB/A, filed July 14, 2000, File No. 0-24362.
|--- | ------------------------------------------------------------------------------------------------

|(9) | Incorporated by reference to the Companys Registration Statement on Form SB-2, filed on November 1, 2000.
|--- | ----------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference to the Companys Form 10-QSB, filed November 14, 2000, File No. 1-15445.
|---- | --------------------------------------------------------------------------------------------------

|(11) | Incorporated by reference to the Companys Report on Form 8-K, filed November 9, 2001.
|---- | --------------------------------------------------------------------------------------

|(12) | Incorporated by reference to the Companys Form 10-QSB, filed November 14, 2001.
|---- | --------------------------------------------------------------------------------

|(13) | Incorporated by reference to the Companys Form 10-QSB, filed February 14, 2002.
|---- | --------------------------------------------------------------------------------

|(14) | Incorporated by reference to the Companys Form 10-KSB, filed July 1, 2002.
|---- | ---------------------------------------------------------------------------

|(15) | Incorporated by reference to the Companys Form 10-K, filed July 15, 2003.
|---- | --------------------------------------------------------------------------

|(16) | Incorporated by reference to the Companys Form 10-K/A, filed July 29, 2003.
|---- | ----------------------------------------------------------------------------

|(17) | Incorporated by reference to the Companys Definitive Proxy Statement filed September 8, 2003.
|---- | ----------------------------------------------------------------------------------------------

|(18) | Incorporated by reference to the Companys Form 10-Q, filed November 14, 2003.
|---- | ------------------------------------------------------------------------------

|(19) | Incorporated by reference to the Companys Form 10-K, filed July 14, 2004.
|---- | --------------------------------------------------------------------------



(b) Reports on Form 8-K.



During the three months ended June 30, 2004, the Company filed no reports on Form 8-K.



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SIGNATURES



In accordance with the requirements of
the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                     |  |               |  |                             
|-------------------- |  | ------------- |  | ----------------------------
|                     |  | DrugMax, Inc.
|                     |  |              
|Date: August 6, 2004 |  | By:           |  | /s/ Jugal K. Taneja         
|                     |  |               |  | Jugal K. Taneja             
|                     |  |               |  | Chief Executive Officer     
|                     |  |              
|Date: August 6, 2004 |  | By:           |  | /s/ Ronald J. Patrick       
|                     |  |               |  | Ronald J. Patrick           
|                     |  |               |  | Chief Financial Officer and 
|                     |  |               |  | Principal Accounting Officer
|                     |  |              
|Date: August 6, 2004 |  | By:           |  | /s/ William L. LaGamba      
|                     |  |               |  | William L. LaGamba          
|                     |  |               |  | President and Chief         
|                     |  |               |  | Operations Officer          



27