**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**





x
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


**FOR
      THE FISCAL YEAR ENDED DECEMBER 31, 2005**


**or**


o
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


**Commission
      File No. 1-15445**





**DRUGMAX,
      INC.**


**(Name
      of registrant as specified in its charter)**





**STATE
                OF NEVADA**
            
            **34-1755390****(State
                or other jurisdiction of**
              **incorporation
                or organization)**
            
            **(IRS
                Employer**
              **Identification
                No.)****312
                Farmington Avenue**
              **Farmington,
                CT**
            
            **06032-1968****(Address
                of Principal Executive Officers)**
            
            **(Zip
                Code)**


**Issuer’s
      telephone number: (860) 676-1222**





**Securities
      registered pursuant to Section 12(b) of the Exchange Act: None.**


**Securities
      registered pursuant to Section 12(g) of the Exchange Act:**


**Common
      stock, Par value $.001 per share**


**(Title
      of Class)**





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.  Yes o  No
x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act.


Yes
o
      No x





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





Indicate
      by check mark if disclosure of delinquent filers in response to Item 405 of
      Regulation S-B is not contained herein, and no disclosure will be contained,
      to
      the best of registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-K or any
      amendment to this Form 10-K. x





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):


Large
      accelerated filer o  Accelerated
      filer o   Non-accelerated
      filer x





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).  Yes o  No
x





The
      aggregate market value of the Common Stock, $.001 par value, held by
      non-affiliates of the Registrant based upon the last price at which the common
      stock was sold as of the last business day of the Registrant’s most recently
      completed second fiscal quarter, July 2, 2005, as reported on the NASDAQ Stock
      Market was approximately $31,266,865. Shares of Common Stock held by each
      officer and director and by each person who owns 5% or more of the outstanding
      Common Stock have been excluded in that such persons may be deemed to be
      affiliates. This determination of affiliate status is not necessarily a
      conclusive determination for other purposes.





The
      number of shares outstanding of common stock as of March 21, 2006 was
      66,001,855.





**DOCUMENTS
      INCORPORATED BY REFERENCE**


Portions
      of the Registrant’s definitive Proxy Statement to be used in connection with the
      Registrant’s 2006 Annual Meeting of Stockholders, which DrugMax, Inc. expects to
      file on or before April 30, 2006, are incorporated by reference in Part III,
      Items 10-14 of this Form 10-K. Except with respect to information specifically
      incorporated by reference in this Form 10-K, the Proxy Statement is not deemed
      to be filed as a part hereof.




1


**CAUTIONARY
      STATEMENTS**


Certain
      oral statements made by management from time to time and certain statements
      contained in press releases and periodic reports issued by DrugMax, Inc.,
      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, are
      statements regarding the intent, belief or current expectations, estimates
      or
      projections of DrugMax, its directors or its officers about DrugMax and the
      industry in which it operates, and include among other items, statements
      regarding (a) DrugMax’s strategies regarding growth and business expansion,
      including its strategy of building an integrated specialty drug distribution
      platform with multiple sales channels through both organic growth and
      acquisitions, (b) its financing needs and plans, including its need for
      additional capital related to its growth plans(c) trends affecting its financial
      condition or results of operations. Although DrugMax 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) management’s
      ability to execute its strategy of growth and business expansion, (ii)
      management’s ability to identify and integrate new acquisitions, (iii) 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; (iv)
      conditions in the capital markets, including the interest rate environment
      and
      the availability of capital; (v) changes in the competitive marketplace that
      could affect DrugMax’s revenue and/or cost bases, such as increased competition,
      lack of qualified marketing, management or other personnel, and increased labor
      and inventory costs; and (v) changes regarding the availability and pricing
      of
      the products which DrugMax distributes, as well as the loss of one or more
      key
      suppliers for which alternative sources may not be available. Further
      information relating to factors that could cause actual results to differ from
      those anticipated is included under the heading “Risk Factors” contained in this
      Annual Report on Form 10-K. 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,” and “Management’s
      Discussion and Analysis of Financial Condition and Results of Operations” in
      this Form 10-K. 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.




2




**TABLE
      OF CONTENTS**




**ITEM**
              
              **PAGE****PART
                  I**1.
              Business
              41A.
              Risk
                  Factors
              91B.
              Unresolved
                  Staff Comments
              112.
              Properties
              113.
              Legal
                  Proceedings
              114.
              Submission
                  of Matters to a Vote of Security Holders
              12**PART
                  II**5.
              Market
                  for Registrant’s Common Equity, Related Stockholder Matters and Issuer
                  Purchases of Equity Securities
              146.
              Selected
                  Financial Data
              147.
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              167A.
              Quantitative
                  and Qualitative Disclosures About Market Risks
              298.
              Financial
                  Statements and Supplemental Data
              309.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              549A.
              Controls
                  and Procedures
              549B
              Other
                  Information
              54**PART
                  III**10.
              Directors
                  and Executive Officers of theRegistrant
              5511.
              Executive
                  Compensation
              5512.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              5513.
              Certain
                  Relationships and Related Transactions
              5514.
              Principal
                  Accountant Fees and Services
              55**PART
                  IV**15.
              Exhibits,
                  Financial Statement Schedule, and Reports on Form 8-K
              56SignaturesCertifications




3


**PART
      I**





**Item
      1. BUSINESS.**





***Overview***





DrugMax,
      Inc. (“DrugMax,” the “Company,” or “we” and other similar pronouns) is a
      pharmacy and drug distribution provider formed by the merger on November 12,
      2004 of DrugMax, Inc. and Familymeds Group, Inc. (“FMG”) (the “Merger”).
      Subsequent to the Merger, our operations consisted of pharmacy operations,
      representing the prior FMG business, and drug distribution operations,
      representing the prior DrugMax business.





Since
      the
      Merger, our strategy has been to reduce our cost of goods sold by integrating
      our pharmacy operations and our drug distribution operations, reducing our
      cost
      of goods sold on generic pharmaceuticals, and increasing our generic and higher
      margin pharmaceutical sales to existing customers including physician groups,
      small hospitals and clinics. However, the low gross margin drug distribution
      operations continued to experience downward pressures on profit margins,
      particularly with regard to branded pharmaceuticals. Therefore, during the
      third
      quarter 2005, we determined that we would discontinue substantially all of
      our
      drug distribution operations by selling certain assets of that business and
      eliminating operations conducted out of the New Castle, Pennsylvania facility
      and St. Rose, Louisiana facilities related directly to the distribution of
      pharmaceuticals to independent pharmacies. Accordingly, we considered
      substantially all of the wholesale distribution business as discontinued
      operations for financial statement presentation purposes. In December 2005,
      we
      sold certain assets held by Valley Drug Company at the New Castle, Pennsylvania
      facility. We continue to purchase pharmaceuticals utilizing the authorized
      distributor agreements and to distribute pharmaceuticals directly to physicians,
      medical clinics and other health care providers from the St. Rose, Louisiana
      facility, Valley Drug Company South. This facility was temporarily closed in
      September 2005 as a result of Hurricane Katrina and reopened in January 2006.





As
      of
      December 31, 2005, we operated 77 pharmacies, including one home health center
      and one non-pharmacy mail order center, in 14 states under the Arrow Pharmacy
      & Nutrition Center, Familymeds Pharmacy, and Worksite Pharmacy SM brand
      names. We work closely with doctors, patients, managed care providers, medical
      centers and employers to improve patient outcomes while delivering low cost
      and
      effective healthcare solutions.





We
      are
      incorporated in the state of Nevada and our corporate offices are located at
      312
      Farmington Avenue, Farmington, CT 06032, telephone (860) 676-1222. Our common
      stock is listed on Nasdaq Capital Market under the stock symbol “DMAX.” General
      information, financial news releases and filings with the Securities and
      Exchange Commission, including annual reports on Form 10-Q, current reports
      on
      Form 8-K, and all amendments to these reports are available free of charge
      on
      our website at www.drugmax.com .
      The
      Company is currently considering changing its name from DrugMax, Inc. to
      Familymeds Group, Inc. to better reflect the Company’s core business. The
      Company’s Board of Directors has approved this change and the Company intends to
      seek shareholder approval at its next annual meeting. The Company has reserved
      the stock symbol “FMRX” in anticipation of this change.





***Drug
      Distribution Discontinued Operations***





Net
      revenues related to the discontinued operations were $103.6 million and $15.3
      million for the fiscal year ended December 31, 2005 and for the period November
      12, 2004 (the Merger date) to January 1, 2005, respectively. The loss from
      discontinued operations of $33.0 million and $31.3 million for the fiscal year
      ended December 31, 2005 and for the period November 12, 2004 (the Merger date)
      to January 1, 2005, respectively, represents the loss from operations of the
      discontinued operations of $5.7 million and $0.3 million, respectively and
      loss
      on disposal of the discontinued operations of $27.3 million and $31.0 million,
      respectively. The loss on disposal of discontinued operations includes goodwill
      and other intangible asset impairments (trademarks and customer lists) of $22.6
      million and $31.0 million and other exit losses primarily representing estimated
      losses on accounts receivable, inventory and vendor chargebacks of $4.7 million
      and $0 million, for fiscal years ended December 31, 2005 and January 1, 2005,
      respectively.





As
      noted
      above, during the third quarter 2005, we determined that we would discontinue
      substantially all of our drug distribution operations by selling certain assets
      of that business and eliminating operations conducted out of the New Castle,
      Pennsylvania facility and St. Rose, Louisiana facilities related directly to
      the
      distribution of pharmaceuticals to independent pharmacies. Accordingly, in
      December 2005, Rochester Drug Cooperative (“RDC”) acquired select assets from
      Valley Drug Company, including a customer list, fixtures and equipment located
      in the Company’s New Castle, Pennsylvania facility. In connection with the sale,
      RDC assumed certain property leases, customer contracts and other miscellaneous
      contracts. The total purchase price for these select assets is $655,000, of
      which $405,000 was received by the closing and $250,000 is required to be paid
      if and when the Pennsylvania Industrial Development Authority (“PIDA”) consents
      to the assignment of the lease for the New Castle facility to RDC, as discussed
      below. The Company expects payment of the $250,000 during the second quarter
      of
      2006.




In
      addition, RDC agreed to assist the Company with the collection of customer
      accounts receivable associated with the purchased customer list which was
      transferred to RDC at closing. Further, the Company allocated Valley Drug
      Company’s pharmaceutical inventory to the Company’s Familymeds pharmacies and
      into its continuing distribution business. The Company intends to continue
      with
      that portion of the wholesale distribution business related to the distribution
      of pharmaceuticals directly to physicians, medical clinics, and other health
      care providers. The total estimated inventory allocated was approximately $7.8
      million. Proceeds from the transaction and amounts realized from the collection
      of accounts receivable and sale of inventory were used to decrease the Company’s
      borrowings under its credit facility with Wells Fargo Retail Finance,
      LLC.




In
      connection with the sale of these assets, the Company and its landlord, Becan
      Development LLC, agreed to amend the lease for the New Castle, Pennsylvania
      facility pursuant to the Amendment No. 1 to Lease. The amendment provides that
      the term of the lease be 5 years, commencing December 21, 2005, with 2
      additional 5-year options for renewal, and provides an option to purchase
      the premises from the landlord. RDC has agreed to enter into a lease assignment
      and assumption agreement for the amended New Castle lease contingent upon the
      Company and the landlord securing consents from the PIDA to such assignment.
      Until such time as the consents are obtained, the parties have agreed to operate
      under a sublease agreement. The Company’s obligation under the lease was
      approximately $200,000 annually.





4


Further
      as part of the discontinuance of the drug distribution business, the Company
      wrote off substantially all of the remaining goodwill related to that business
      resulting from the Merger. Of the $51.8 million of goodwill related to the
      Merger, $31.0 million was considered impaired and written off as of fiscal
      year
      end 2004, and $19.4 million written off during fiscal year 2005 as part of
      the
      discontinuance.





***Strategy***




***General***




Our
      primary strategy is to build an integrated specialty drug pharmacy platform
      with
      multiple sales channels including: clinic and apothecary pharmacies, Worksite
      Pharmacies SM ,
      institutional “closed door” type pharmacies, a central fill mail order based
      pharmacy and a pharmaceutical distribution center focused on medical specialty
      sales. We believe this can be accomplished through the present base of
      operations, through additional organic opening of new pharmacies and by
      acquiring pharmacies. We believe the integration of these types of locations
      will uniquely enable us to supply specialty drugs and other pharmaceuticals
      to
      patients, physicians and other healthcare providers.




Our
      strategy is to locate specialty clinic and apothecary pharmacy operations near
      or in medical facilities. The strategy is driven by the location concept whereby
      situating a clinical or specialty type pharmacy near the point of acute or
      chronic care provides us with a “first capture” opportunity to service patients
      when they visit their physicians. This also enables us to collaborate with
      the
      physician in the therapeutic regimen and may provide opportunities for generic
      drug sales or alternative pharmaceutical therapy, which generally provide us
      with higher profit margins. Many of these patients or special patient groups
      require central fill and or mail order follow-up care that can be provided
      through our “closed door” pharmacy or mail order center located in Connecticut.
      We also supply online web based access to all or most of our services and
      products through our nationally known website www.familymeds.com.





We
      offer
      a comprehensive selection of branded and generic prescription and
      non-prescription pharmaceuticals, specialty injectables, generic biologics,
      compounded medicines, healthcare-related products and diagnostic products.
      These
      products are used for the treatment of acute or chronic medical conditions
      and
      may be purchased through our platforms. Also, we have recently placed
      significant emphasis on the injectable and orally administered specialty
      pharmaceuticals. We intend to increase pharmacy revenues through these
“Specialty Pharmaceuticals,” which generally are more expensive and provide a
      higher gross profit.





The
      company strategy also includes selling specialty pharmaceuticals and healthcare
      products to physicians, home care providers and related healthcare providers
      including respiratory therapists and nurse practitioners that often
      re-administer these products to their patient immediately. We are growing this
      strategy by combining selling access through our existing physician
      relationships and medically based pharmacies with a sales force who actively
      pursues these practitioners as well as new potential practitioner customers.
      Our
      unique selling proposition to these practitioners is ease of obtaining product
      through same day delivery through our onsite pharmacies as well as our ability
      to supply the pharmaceutical to the physician already prepared and “ready to
      use.” As part of our service, we bill the physicians/patients payor/insurance
      carrier or Medicare under part B depending on the type of coverage each patient
      has. This strategy for distribution of pharmaceuticals will be ongoing and
      utilizes our wholesale authorized distribution agreements to obtain the drugs
      through the proper channel pricing and together with central and decentralized
      distribution to the practitioner customer depending on the customer
      needs.




***Pharmacy
      Operations*** ****




As
      of December 31, 2005, we operated 77 corporate pharmacies, including one central
      fill home healthcare product center and franchised seven pharmacies in 14
      states. 43 of our pharmacies are located at the point of care between physicians
      and patients, oftentimes inside medical office buildings or on a medical campus.
      The balance of our locations are usually nearby medical facilities though more
      retail accessible. The majority of our revenues from pharmacy operations come
      from the sale of prescription pharmaceuticals, which represented approximately
      94% of our net revenues for the fiscal year ended December 31, 2005 and fiscal
      year ended January 1, 2005. Our corporate pharmacies provide services to
      approximately 400,000 acute or chronically ill patients each year, many with
      complex specialty and medical product needs.




We
      operate our pharmacies under the trade names Familymeds Pharmacy (“Familymeds”),
      Arrow Pharmacy and Nutrition Centers (“Arrow”) and Worksite Pharmacy SM .
      Familymeds is primarily used for pharmacies outside of New England. The
      Familymeds locations were primarily originated by acquiring the base pharmacy
      business from HMO’s, hospitals and regional independent operators. The locations
      are primarily clinic size with a small footprint, usually less than 1,500 sq.
      ft. The Arrow trade name is used in New England where most of the pharmacies
      were opened as a start-up or re-acquired from former Arrow franchise operators
      who opened these legacy pharmacy operations as start-ups. These locations are
      primarily apothecary size, approximately 2,000 sq. ft. and may be more visible
      as retail type locations, though primarily nearby hospitals or medical campus
      locations. Our locations in Michigan and certain locations elsewhere throughout
      our trading area may have a larger footprint to accommodate a comprehensive
      inventory of nutritional and home medical supplies.





By
      our
      estimates there are more than 5,000 locations nationwide at or near the point
      of
      care which may be available to open additional pharmacies. Because of our
      experience with operating pharmacies in similar locations, we believe we are
      uniquely positioned to target these sites and increase our core pharmacy market
      presence. We also believe that we can grow our pharmacy operations through
      selective acquisitions. The company is actively pursuing appropriate
      acquisitions. By increasing our store count, through acquisitions or the opening
      of new pharmacies at or near the point of medical care, we believe we can
      increase our customer base, expand our geographic reach and improve
      profitability by leveraging our existing infrastructure.





Our
      strategy also includes offering our customers or patients multiple sales
      channels by which they can purchase our products. We offer them the opportunity
      to purchase a broad array of health-related products online including a
      comprehensive selection of prescription medications, vitamins and nutritional
      supplements, home medical equipment, and health and beauty aids directly from
      our pharmacies, by mail order, and via the Internet. Familymeds.com is the
      foundation of our Internet offering. This website is one of the few sites
      certified as a Verified Internet Pharmacy Provider Site (VIPPS) by the National
      Association of Boards of Pharmacy (NABP). The VIPPS program is a voluntary
      certification program designed to approve and identify online pharmacies that
      are appropriately licensed and prepared to practice Internet pharmacy.
      Familymeds.com is the non-prescription Internet commerce partner for select
      prescription benefit managers (PBMs) including Medco Health. We will continue
      to
      pursue opportunities to partner with managed care and others providers to
      increase our sales through our Internet sales channel.





5


We
      operate and locate Worksite Pharmacies SM (pharmacies
      that service a single, defined population) for large employers who are seeking
      to control overall employee prescription drug benefit expenditures while
      maintaining high employee satisfaction through improved accessibility. Our
      Worksite Pharmacies SM offer
      prescription services exclusively to the employer’s covered population. We can
      deliver these services at or near the employer’s work site by opening, staffing
      and managing a pharmacy. Our initial results have proven that this strategy
      reduces healthcare costs for the employer. Our research has shown that many
      employers, especially large Fortune 500 companies are seeking more aggressive
      methods to control healthcare expenditures, especially the pharmacy component
      of
      benefits. We have identified key large employers, those with over 2,000
      employees in a single location, to be target opportunities for this type of
      Employer Sponsored Worksite Pharmacy SM .
      Currently, we have a Worksite Pharmacy SM in
      the
      employee center of the Mohegan Sun Casino in Connecticut and Scotts Company
      L.L.C headquarters in Merryville, Ohio. Combined, these employers have more
      than
      14,000 employees and dependents as potential patients.





We
      have
      developed programs designed to improve patient compliance and to reduce costs.
      We have three major programs, a prescription compliance program called Reliable
      Refill, a discount plan called Senior Save15 and an automated telephony system
      designed to notify patients of recalls, provide refill reminders and notify
      our
      customers of other important information. Reliable Refill is a compliance
      program that identifies prescriptions that are due to be filled and schedules
      them for filling before the patient has run out of the previous prescriptions.
      Our Senior Save15 program, introduced prior to the Medicare Modernization Act,
      is our own discount program that gives senior customers access to all of our
      prescription and over-the-counter products at discounted prices. Our programs
      are designed to improve medication therapy management among patients with
      chronic therapeutic needs especially the elderly population. Our data warehouse
      identifies these patients and allows us to target these patients with special
      needs. We believe our data warehouse and our medication therapy management
      programs uniquely position our company as a pharmacy provider.




***Electronic
      Prescription Solutions***





We
      are
      implementing electronic prescription solutions to include the ability to accept
      delivery of prescriptions through electronic prescribing software and kiosk
      technologies. Our pharmacies are able to accept delivery of electronic
      prescription orders and refill authorizations with secure, reliable transmission
      directly from physician practices. In certain locations such as medical clinics
      and medical office buildings where we do not have a full-service pharmacy,
      we
      are also installing kiosks that allow customers to transmit their prescriptions
      directly to us for pick up at one of our nearby pharmacies or direct delivery. **





***Medicare
      Part D***




Pharmacy
      sales trends are expected to continue to grow due, in part, to the Medicare
      Part
      D prescription drug benefit. As of January 1, 2006, Medicare beneficiaries
      have
      the opportunity to receive subsidized prescription drug coverage through the
      Medicare Part D program. The new drug benefit is delivered by competing plans,
      and our pharmacies have contracted with each of the major providers to ensure
      our customers can continue purchasing their prescriptions from our stores.
      While, the new Medicare drug benefit is entirely voluntary, we believe a
      significant portion of the Medicare population will enjoy this new benefit.
      While it is difficult to fully predict the impact on our business, we believe
      we
      are well positioned to capture additional prescription sales. However, we expect
      the gross margin from this business to be less than what the traditional
      prescription drug plans provide.





**Industry
      Overview**





The
      pharmaceutical distribution industry faces numerous challenges and
      opportunities. While we expect significant growth in this segment of healthcare
      due to an aging population, the introduction of new pharmaceuticals, rising
      pharmaceutical prices, increased use of injectable drug therapies, and the
      expiration of patents for branded pharmaceuticals, we also face challenges
      due
      to changes in contracting practices, new Medicare and Medicaid regulations,
      and
      third party reimbursement issues.





In
      recent
      months, our industry has undergone significant changes driven by various efforts
      to reduce costs. These changes include changes to Medicare, Medicaid or similar
      government health benefit programs or the amounts paid by those programs for
      our
      services. The Medicare Modernization Act, or the MMA, includes a major expansion
      of the Medicare prescription drug benefit under new Medicare Part D. Beginning
      in 2006, Medicare beneficiaries may enroll in prescription drug plans offered
      by
      private entities that will provide coverage of outpatient prescription drugs.
      The MMA changes Medicare’s payment methodology over the next three years from a
      system based on average wholesale price, or AWP, to one based on average selling
      price, or ASP. As the ASP methodology of reimbursement is implemented, it may
      affect our current AWP based reimbursement structure with our private payors.





While
      we
      cannot predict the eventual results of these law changes, the effect of the
      MMA
      has been and will be to reduce prices and gross margins on some of the drugs
      that we distribute. Further, if other third-party payors revise their pricing
      based on new methods of calculating the AWP, or based on ASP, this could have
      a
      material adverse affect on our business, financial condition and results of
      operation, by reducing the pricing and margins on certain of our products.





While
      current federal laws prohibit the importation of pharmaceuticals, there is
      increasing pressure on the FDA to change current law to allow individuals to
      purchase pharmaceuticals from outside of the United States of America.
      Legislation has been introduced at the state and federal level advocating such
      a
      change. Some of the congressional sponsors of importation legislation say that
      the bill could lower drug prices for seniors by 30 to 50 percent. If these
      laws
      are changed to permit the re-importation of pharmaceuticals into the United
      States, this could have a negative impact on our results of operations by
      reducing the pricing and margins of certain of our products.





6


Despite
      the potential negative effects of legislation that would permit re-importation,
      the National Association of Chain Drug Stores (“NACDS”) expects an increase in
      the number of prescriptions dispensed, going from 3.2 billion in 2003 to nearly
      4.5 billion in 2010, yet the supply of all community pharmacists is expected
      to
      increase only 9.2% versus an estimated 47% increase in prescriptions. The
      expected increased demand is expected to favorably benefit us, but if we are
      unable to successfully attract and retain pharmacists, we may not be able to
      take full advantage of the increase in sales.





Recently,
      many states have passed or have proposed laws and regulations that are intended
      to protect the integrity of the supply channel. These laws and regulations
      may
      also restrict our ability to purchase drugs from alternate source supplier
      and
      are likely to increase the overall regulatory burden and costs associated with
      our operations.





**New Credit
      Facility**





On
      October 12, 2005, we entered into a secured senior credit agreement with Wells
      Fargo Retail Finance, LLC (“WFRF”), which matures in October 2010. Available
      credit under this facility is based on eligible receivables, inventory and
      prescription files, as defined in the agreement. The $65 million of maximum
      availability is reduced by a $7.0 million minimum reserve. While the credit
      facility currently does not require compliance with financial covenants, the
      company has the ability to reduce this minimum reserve by agreeing to implement
      certain financial covenants. As of December 31, 2005, $36.3 million was
      outstanding on the line and $9.3 million was available for additional
      borrowings. The New Credit Facility is secured by substantially all of our
      assets.





**Primary
      Supplier Relationship**





In
      December 2004, we entered into a prime warehouse supplier agreement with D&K
      Healthcare Resources, Inc. (“D&K”). Under the terms of this agreement,
      D&K agreed to be our primary supplier of prescription drugs,
      over-the-counter pharmaceuticals, and other merchandise generally available
      from
      D&K. The D&K agreement contains certain volume requirements and has an
      initial term of two years, through December 2006 and renews automatically for
      successive one-year periods unless either party provides the other party a
      written non-renewal notice. Either party may terminate this agreement for
      material breach, and subsequent failure to cure, including failure to make
      payments when due. On August 30, 2005 D&K was acquired by McKesson
      Corporation and our agreement was assumed by McKesson. In December 2005, the
      agreement was amended to provide five day a week delivery of pharmaceuticals
      and
      other merchandise directly to our pharmacy locations.





**Competition**





The
      healthcare industry in which we operate is highly competitive. Our failure
      to
      compete effectively in this segment may adversely affect our business, financial
      condition and results of operations. Many of our competitors are offering
      similar products and services. However, we believe no competitor focuses on
      establishing services at the point of care similar to our core focus. Some
      of
      our competitors have greater resources than we have. These competitive pressures
      could have a material adverse effect on our business, financial condition or
      results of operations.





We
      compete on the basis of breadth of our product lines, marketing programs,
      support services and pricing. Increased competition may result in price
      reductions, reduced gross margins and loss of market share. Competitors, many
      of
      which have significantly greater financial, technical, marketing and other
      resources, include:





•
            
            Chain
                drugstores including CVS, Rite Aid and Walgreen’s;•
            
            Mass
                marketers including Target and Wal-Mart;•
            
            Warehouse
                clubs including BJ’s, Costco and Sam’s Club;•
            
            Mail
                order prescription providers including Express Scripts and
                Medco;•
            
            Online
                drugstores including drugstore.com;•
            
            Specialty
                medication providers including Accredo Health and Priority Healthcare;
                and•
            
            Specialty
                pharmaceutical distributors including FloridaInfusion Pharmacy, Allion
                Healthcare, Inc., and Bioscrip.





In
      addition, certain of our competitors have developed or may be able to develop
      e-commerce operations that compete with our pharmacy and e-commerce operations,
      and may be able to devote substantially more resources to web site development
      and systems development. The online commerce market is rapidly evolving and
      intensely competitive. We expect competition to intensify in the future because
      barriers to entry are minimal, and current and new competitors can launch new
      web sites at relatively low cost.





**Government
      Regulations and Legal Uncertainties**





We
      are
      subject to extensive federal, state and local licensing and registration laws
      and regulations with respect to our business, including our pharmacy and
      franchise operations and the pharmacists we employ. Regulations in these areas
      often involve subjective interpretation and we do not know if our attempts
      to
      comply with these regulations will be deemed sufficient by the appropriate
      regulatory agencies. We believe we have satisfied our licensing and registration
      requirements and continue to actively monitor our compliance with these
      requirements. However, violations of any of these regulations could result
      in
      various penalties, including suspension or revocation of our licenses or
      registrations, and seizure of our inventory or monetary fines, any of which
      could adversely affect our operations and damage our brand.





In
      recent
      months, our industry has undergone significant changes driven by various efforts
      to reduce costs. These changes include changes to Medicare, Medicaid or similar
      government health benefit programs or the amounts paid by those programs for
      our
      services. The Medicare Modernization Act, the MMA, includes a major expansion
      of
      the Medicare prescription drug benefit under new Medicare Part D. Beginning
      in
      2006, Medicare beneficiaries may enroll in prescription drug plans offered
      by
      private entities that will provide coverage of outpatient prescription drugs.
      The MMA changes Medicare’s payment methodology over the next three years from a
      system based on average wholesale price, or AWP, to one based on average selling
      price, or ASP. As the ASP methodology of reimbursement is implemented, it may
      affect our current AWP based reimbursement structure with our private
      payors.





7


We
      also
      are subject to requirements under the Controlled Substances Act and Federal
      Drug
      Enforcement Agency regulations, as well as state and local laws and regulations
      related to our pharmacy operations such as registration, security, record
      keeping and reporting requirements related to the purchase, storage and
      dispensing of controlled substances, prescription drugs and certain
      over-the-counter drugs. Under the Food, Drug & Cosmetic Act of 1938, the
      distribution of adulterated or misbranded homeopathic remedies or other drugs
      is
      prohibited. Violations could result in substantial fines and other monetary
      penalties, seizure of the misbranded or adulterated items, and/or criminal
      sanctions. We also are required to comply with the Dietary Supplement Health
      and
      Education Act when selling dietary supplements and vitamins.





In
      addition, our pharmacy compounding services are subject to FDA regulation.
      The
      FDA also regulates drug advertising and promotion, including direct-to-patient
      advertising, done by or on behalf of manufacturers and marketers. If we expand
      our product and service offerings, more of our products and services will likely
      be subject to Food and Drug Administration regulation. Failure to comply with
      these regulations could result in significant penalties which may be material.
      We also are subject to federal statutes and state legislation that prohibit
      the
      offer, payment, solicitation, or receipt of any remuneration directly or
      indirectly in exchange for, or intended to induce, the referral of patients
      or
      the sale or purchase of services and supplies covered by certain governmental
      programs (Anti-Kickback Laws). We also are subject to the Ethics in Patient
      Referrals Act of 1989, commonly referred to as “Stark Law,” which prohibits the
      billing of federally-funded health care programs for certain health care
      services provided by entities with which the referring physician has certain
      financial arrangements. Violations of these laws are punishable by civil
      sanctions, including significant monetary penalties and exclusion from
      participation in the Medicare and Medicaid programs, and criminal sanctions
      in
      the case of the Anti-Kickback Law. Due to the breadth and complexity of these
      laws, there can be no assurance that we, any of our personnel, or any of our
      significant customers or business partners, will not become subject to sanctions
      that could have a material adverse effect on our business, financial condition
      and results of operations. Additionally, the sanctioning or exclusion of a
      manufacturer or recipient of our products or services, even for activities
      unrelated to us, could also have a material adverse effect on our business,
      financial condition and results of operations.





Pursuant
      to the Omnibus Budget and Reconciliation Act of 1990 and similar state and
      local
      laws and regulations, our pharmacists are required to offer counseling to our
      customers about medication, dosage, delivery systems, common side effects,
      adverse effects or interactions and therapeutic contraindications, proper
      storage, prescription refill and other information deemed significant by our
      pharmacists. In the event that our pharmacists or our mail order and online
      pharmacies provide erroneous or misleading information to our customers, we
      may
      be subject to liability or negative publicity that could have an adverse impact
      on our business. Although we carry general, professional and product liability
      insurance, our insurance may not cover potential claims of this type or may
      not
      be adequate to protect us from all liability that may be imposed.





The
      Health Insurance Portability and Accountability Act of 1996, and regulations
      promulgated thereunder (collectively “HIPAA”), require health care providers,
      like us, to comply with specified standards for electronic billing and other
      transactions and to adopt and comply with policies and procedures to protect
      the
      security and privacy of an individual’s protected health information consistent
      with HIPAA requirements, and prohibit the use or dissemination of an
      individual’s protected health information without the individual’s consent.
      There are significant civil monetary and criminal penalties for failure to
      comply.





Although
      we do not offer franchises for sale at this time, in the case of renewing
      franchisees, we are subject to the disclosure requirements of the Federal Trade
      Commission and may be subject to pre-sale disclosure requirements and
      registration requirements of various state laws regulating the offer and sale
      of
      franchises. In addition, with respect to our existing franchisees, we also
      may
      be subject to certain state laws regulating the franchisor-franchisee
      relationship. Failure to comply with these regulations could result in
      substantial financial penalties. As of December 31, 2005, we held franchise
      agreements for seven stores and are not materially dependent on these
      agreements.





We
      also
      are subject to laws governing our relationship with employees, including minimum
      wage requirements, overtime and working conditions. Increases in the federal
      minimum wage rate, employee benefit costs or other costs associated with
      employees could adversely affect our results of operations. Other legislation
      being considered at the federal and state level could affect our business
      including state legislation related to the regulation of nonresident pharmacies.
      We believe we are currently in material compliance with the state and federal
      laws and regulations governing our business.





As
      a
      publicly traded company, we are subject to numerous federal securities laws
      and
      regulations. These laws include the Securities Act of 1933 and the Securities
      Exchange Act of 1934 and related rules and regulations promulgated by the SEC.
      These laws and regulations impose significant requirements in the areas of
      financial reporting, accounting practices, and corporate governance among
      others.





While
      current federal laws prohibit the importation of pharmaceuticals, there is
      increasing pressure on the FDA to change current law to allow individuals to
      purchase pharmaceuticals from outside of the United States of America.
      Legislation has been introduced at the state and federal level advocating such
      a
      change. Some of the congressional sponsors of importation legislation say that
      the bill could lower drug prices for seniors by 30 to 50 percent. If these
      laws
      are changed to permit the re-importation of pharmaceuticals into the United
      States, this could have a negative impact on our results of operations.




Recently,
      many states have passed or have proposed laws and regulations that are intended
      to protect the integrity of the supply channel. These laws and regulations
      may
      also restrict our ability to purchase drugs from alternate source supplier
      and
      are likely to increase the overall regulatory burden and costs associated with
      our drug distribution operations.





The
      costs
      associated with complying with various federal and state regulations could
      be
      significant and the failure to comply with any such legal requirements could
      have a significant impact on our business, results of operations and financial
      condition.





8





**Intellectual
      Property**





We
      hold
      various trademarks, trade names, service marks, patents and business licenses
      that are essential to the operation of our business. These trademarks, service
      marks and licenses have varying statutory lives and are generally renewable
      indefinitely. Although we believe that our trademarks and other proprietary
      products do not infringe upon the intellectual property rights of any third
      parties, third parties may assert infringement claims against us from time
      to
      time.





**Employees**





At
      December 31, 2005, we employed 835 persons, which represent 535 full-time
      equivalents. Approximately 22% of our employees are pharmacists. Labor unions do
      not
      represent any of these employees.





**Management**





On
      March
      31, 2006, the Company entered into a new employment agreement with Edgardo
      A.
      Mercadante, Chairman of the Board, President and Chief Executive Officer. The
      initial term of Mr. Mercadante’s agreement terminates on November 30, 2008,
      and is subject to successive, automatic one-year renewals, unless one party
      notifies the other of its desire not to renew the agreement. The agreement
      provides an initial salary of approximately $346,000, which represents no change
      from fiscal year ended December 31, 2005, and for bonuses as determined by
      the
      board of directors. For
      2006,
      the employment agreement requires, if the Company achieves the performance
      levels set by the board, that Mr. Mercadante receive a cash bonus equal to
      100% of his salary. Additionally, at the end of the first year of the
      initial term of the employment, the Company is required to issue to Mr.
      Mercadante stock options and restricted stock at fair market value and
      comparable in amounts to those issued to a chief executive officer and chairman
      of the board of directors of a comparable publicly traded corporation.The agreement also contains standard termination provisions for
      disability, for cause, and for good reason, and it also contains confidentiality
      and non-competition provisions that prohibit Mr. Mercadante from disclosing
      certain information belonging to the Company and from competing against the
      Company. If the employment agreement is terminated other than for cause prior
      to
      November 30, 2009, or if the Company fails to renew the agreement at least
      through November 30, 2009, the Company is required to continue to pay to
      Mr. Mercadante (or to his estate in the event of termination due to his
      death) two year’s severance equal to the amount of the compensation and other
      benefits, to
      which
      he was entitled at the time of termination,subject to the terms of the
      agreement.





**Item
      IA. RISK FACTORS**





An
      investment in our common stock involves a high degree of risk. You should
      consider carefully the following information about these risks, together with
      the other information contained or incorporated by reference in this Form 10-K,
      before you decide to invest. If any of the following risks actually occur,
      our
      business, financial condition or results of operations would likely suffer.
      In
      this case, the market price of our common stock could decline, and you could
      lose all or part of your investment.





**There
      are a large number of shares that are available for future sale; the sale of
      these shares may depress the market price of our common stock.**





Under
      a
      registration statement dated November 15, 2005, we have registered the resale
      of
      an aggregate of 66,628,217 shares which consists of 44,093,432 shares
      of common stock and 22,046,715 shares of common stock issuable upon the exercise
      of warrants, issued to certain qualified institutional buyers and accredited
      investors pursuant to the securities purchase agreements on September 23, 2005
      and September 26, 2005 and an additional 488,070 shares issued to certain
      former Series A Preferred Shareholders. Under a registration statement
      dated July 7, 2005, we registered 25,718,731 shares. Accordingly, the two
      registration statements cover the resale of 92,346,948 shares. Generally, we
      are
      required to use our best efforts to keep the registration statements
      continuously effective until the date which is the earlier of (i) five years
      after the effectiveness of the registration statements, (ii) such time as all
      the securities included in the registration statements have been publicly sold;
      and (iii) such time as all of the shares of the selling shareholders included
      in
      the registration statements may be sold pursuant to Rule 144(k) as determined
      by
      our counsel pursuant to a written opinion. During the effectiveness of the
      registration statements, all the shares covered hereby generally will be freely
      trading. Because we have a relatively small daily trading volume and the sale
      of
      any of the foregoing shares in the public markets may materially adversely
      affect the market price of our common stock. Further, the exercise of the
      warrants will result in dilution to our shareholders.




**We
      have received a non-compliance letter from Nasdaq.**




On
      March
      20, 2006, we received notice from the Nasdaq Stock Market (“NASDAQ”) that for
      the past 30-consecutive business days, the bid price of our common stock has
      closed below the $1.00 per share minimum requirement for continued inclusion
      on
      the Nasdaq Capital Market under Marketplace Rule 4310(c)(4). In accordance
      with
      Marketplace Rule 4310(c)(8)(D), we will be provided with 180-calendar days,
      until September 18, 2006, to regain compliance with the minimum
      bid requirement. If, at any time before September 18, 2006, the bid price the
      our common stock closes at $1.00 per share or more for a minimum of 10
      consecutive business days, NASDAQ will provide us with written notification
      that
      we again comply with Marketplace Rule 4310(c)(4). We intend to monitor the
      bid
      price between now and September 18, 2006, and will consider available options
      if
      our common stock does not trade at a level likely to result in regained
      compliance with the minimum
      bid requirement. There can be no assurance that we will regain
      compliance.




**We
      have a history of losses. Our independent registered public accounting firm
      has
      issued an opinion with an explanatory paragraph discussing the substantial
      doubt
      about our ability to continue as a going concern.**




We
      incurred net losses of $54.9 million, $39.8 million and $12.2 million for the
      years ended December 31, 2005, January 1, 2005, and December 27, 2003,
      respectively. The opinion from the independent registered public accounting
      firm
      on our accompanying consolidated financial statements as of December 31, 2005
      and January 1, 2005 and for each of the three years in the period ended December
      31, 2005 was modified with respect to the substantial doubt surrounding our
      ability to continue as a going concern.




9




**The
      Company’s growth strategy is uncertain and w** **e
      will require additional capital to implement our growth strategy.**





To
      achieve profitability, among other things, the Company is seeking to open new
      pharmacies and to acquire existing pharmacies. However, the Company may not
      succeed in locating and completing accretive acquisitions. Many of the Company’s
      competitors have greater resources than the Company does to complete such
      acquisitions. Even if acquired, management may not be able to successfully
      integrate the new businesses with the Company. Management has limited resources.
      Further, in order to implement our growth strategy, we will need additional
      capital resources and may incur, from time to time, additional indebtedness,
      the
      terms of which will depend on market and other conditions. We cannot be certain
      that additional financing will be available to us on acceptable terms, if at
      all. As a result, we may not be able to fully pursue our growth strategy.
      Further, additional financing may involve the issuance of equity or debt
      securities that would reduce the percentage ownership of our then current
      shareholders. If we do not open additional pharmacies, either through organic
      growth or through accretive acquisitions, we may not be able to improve our
      results of operations and financial condition.





**Changes
      to current Medicare laws and the implementation of the Medicare Modernization
      Act may reduce the amounts paid by these programs. These changes could have
      a
      material adverse effect on our gross margins, results of operations and
      financial condition.**





In
      recent
      months, our industry has undergone significant changes driven by various efforts
      to reduce costs. These changes include changes to Medicare, Medicaid or similar
      government health benefit programs or the amounts paid by those programs for
      our
      services. The Medicare Modernization Act, the MMA, includes a major expansion
      of
      the Medicare prescription drug benefit under new Medicare Part D. Beginning
      in
      2006, Medicare beneficiaries may enroll in prescription drug plans offered
      by
      private entities that will provide coverage of outpatient prescription drugs.
      The MMA changes Medicare’s payment methodology over the next three years from a
      system based on average wholesale price, or AWP, to one based on average selling
      price, or ASP. As the ASP methodology of reimbursement is implemented, it may
      affect our current AWP based reimbursement structure with our private payors.
      While we cannot predict the eventual results of these law changes, we believe
      the effect of the MMA has been and will be to reduce prices and gross margins
      on
      some of the drugs that we distribute. Further, if other third-party payors
      revise their pricing based on new methods of calculating the AWP, or based
      on
      ASP, this could have a material adverse affect on our business, financial
      condition and results of operation, including reducing the pricing and margins
      on certain of our products.





**Our
      success is dependent upon entering into and maintaining profitable contracts
      with third-party payors including: health insurers, managed care organizations
      and pharmacy benefit managers. Changes in reimbursement policies or efforts
      by
      payors to recoup payments already made could have an adverse effect on our
      business, financial condition and results of operations.**





We
      derive
      a majority of our revenue from health insurers, managed care organizations
      and
      pharmacy benefit managers called third-party payors. Our contracts with these
      organizations enable us to obtain reimbursement on behalf of our customers
      for
      the prescription products that they purchase at our pharmacies. If we are unable
      to maintain existing contracts or obtain additional contracts, we may not be
      able to obtain reimbursement for prescription products purchased at our retail,
      mail order and online pharmacies, which could decrease the demand for our
      services and products and impair our ability to retain and expand our customer
      base. Furthermore, recent efforts by Medicaid, Medicare and other third-party
      payors to control costs have resulted in reduced rates of reimbursement for
      our
      services. If these trends continue, they could adversely affect our results
      of
      operations. Third-party payors also have certain contractual rights permitting
      them to audit our records to determine if they have overpaid us. Subject to
      the
      outcome of the audit, we may be required to reimburse the third-party payor
      for
      any overpayments. If we are required to reimburse the payor, it could have
      a
      material adverse effect on us.





**The
      healthcare industry in which we operate is highly competitive. Our failure
      to
      compete effectively in this segment may adversely affect our business, financial
      condition and results of operations.**





We
      face a
      highly competitive environment in the distribution of pharmaceuticals. Many
      of
      our competitors are offering similar products and services. Some of our
      competitors have greater resources than we have. These competitive pressures
      could have a material adverse effect on our business, financial condition or
      results of operations.





**Because
      many of our pharmacies are located at or near the point of care, our operations
      are dependent upon the activities of the healthcare providers in our trade
      area.
      Changes to the blend of the healthcare providers or to their prescribing
      practices may adversely affect our business, financial condition or operating
      results.**





Our
      strategy has been to locate our pharmacies at or near the point of care. As
      such, we are dependent upon the healthcare providers practicing in our trade
      areas. We rely on the number of patient visits, the number of prescriptions
      written, and the types of prescriptions written by the provider. These providers
      may choose to relocate or close their practices, may limit their patient visits,
      or may prescribe a mix of products with low gross margins such as branded
      prescription products. These changes could have a material adverse effect on
      our
      business, results of operations and financial condition.





**The
      implementation of our business plan is dependent upon the continued employment
      of our management team and attracting and retaining qualified pharmacists.**





Our
      success depends on our ability to attract, retain and motivate our executive
      management team, key employees and pharmacists. We have not experienced such
      difficulties in the recent past. However as is generally true in the industry,
      if any of our senior management or key personnel with an established reputation
      within the industry were to leave our employment, there can be no assurance
      that
      our customers or suppliers who have relationships with such person would not
      purchase products from such person’s new employer, rather than from us. Further,
      there is currently a national shortage of pharmacists. As a result, pharmacists’
wage requirements continue to increase, thus we may not be able to attract
      and
      retain an adequate number of pharmacists required in order to maintain our
      existing level of customer service. The shortage of pharmacists and the
      increased wage requirements of pharmacists could have a material adverse effect
      on our business, result of operations and financial condition.




10


**Our
      business could be adversely affected if relations with our primary supplier
      are
      terminated; substantially all of our supplier agreements are terminable at
      will.**





In
      December 2004, we entered into a new primary supplier agreement with D&K
      Healthcare Resources, Inc. (“D&K”) pursuant to which we are required to
      purchase primarily all of our products for sale in our pharmacies from D&K.
      The D&K agreement contains certain volume requirements and has an initial
      term of two years, through December 2006 and renews automatically for successive
      one-year periods unless either party provides the other party a written
      non-renewal notice. Although we purchase products from many different brand
      name
      and generic pharmaceutical manufacturers and while we believe that if we were
      to
      cease to be able to purchase products directly from D&K, we could secure the
      same products through other sources, including other distributors; there is
      a
      risk that our costs would increase if our primary supplier agreement is
      terminated. On August 30, 2005 D&K was acquired by McKesson Corporation and
      our agreement was assumed by McKesson. In December 2005, the agreement was
      amended to provide five day a week delivery of pharmaceuticals and other
      merchandise directly to our pharmacy locations.





**Our
      operations are subject to extensive regulations. Changes to these regulations
      or
      failure to comply with these regulations may adversely affect our business,
      financial condition or operating results.**





We
      are
      subject to extensive federal, state and local licensing and registration laws
      and regulations with respect to our business, including our pharmacy and
      franchise operations and the pharmacists we employ. Regulations in these areas
      often involve subjective interpretation and we do not know if our attempts
      to
      comply with these regulations will be deemed sufficient by the appropriate
      regulatory agencies. While we believe we have satisfied our licensing and
      registration requirements and continue to actively monitor our compliance with
      these requirements, we cannot assure you that such monitoring will be adequate
      to achieve full compliance. Violations of any of these regulations could result
      in various penalties, including suspension or revocation of our licenses or
      registrations, and seizure of our inventory or monetary fines, any of which
      could adversely affect our operating results. See “Business” And “Governmental
      Regulation and Legal Uncertainties.”





**Item 1B.
      Unresolved Staff Comments**




None.





**Item
      2. PROPERTIES.**





As
      of
      December 31, 2005, we did not own or hold any legal or equitable interest in
      any
      real estate, but instead leased all of our locations, including our corporate
      headquarters, which is located at 312 Farmington Avenue, in Farmington,
      Connecticut. Our headquarters contains approximately 30,000 square feet. The
      lease for our headquarters expires April 30, 2007, with a monthly lease payment
      of $52,151.





We
      also
      lease our various pharmacy locations many of which are within medical complexes.
      The leases vary as to rental amounts, expiration dates, renewal options and
      other rental provisions.





We
      also
      lease an administrative facility containing approximately 5,216 square feet
      of
      office space, located at 25400 US Highway 19 North, Suite 137, Clearwater,
      Florida 33763. The term of the lease for the Clearwater office is for five
      years
      expiring January 14, 2008, with an initial monthly lease payment of $6,303.
      We
      are currently subletting this facility and attempting to either permanently
      sublet this facility or negotiate a termination of this lease.





Our
      drug
      distribution operations operated out of two locations, one in New Castle,
      Pennsylvania and one in St. Rose, Louisiana. The Pennsylvania facility is
      located at 209 Green Ridge Road, New Castle, Pennsylvania 16105. We lease this
      premises from Becan Development LLC, a related party. This facility consists
      of
      approximately 45,000 square feet of office, warehouse, shipping and distribution
      space. The property was initially leased pursuant to a lease with a base term
      of
      15 years expiring December 30, 2018, with a monthly lease payment of $17,000.
      In
      connection with the sale of select assets from Valley Drug Company located
      in
      New Castle, Pennsylvania to Rochester Drug Cooperative (“RDC”) on December 27,
      2005, the lease was amended. The amendment provides that the term of the lease
      be 5 years, commencing December 21, 2005, with 2 additional 5-year options
      for
      renewal, and provides an option to purchase the premises from the landlord.
      RDC has agreed to enter into a lease assignment and assumption agreement for
      the
      amended New Castle lease contingent upon the Company and the landlord securing
      consents from the Pennsylvania Industrial Development Authority (“PIDA”) to such
      assignment. Until such time as the consents are obtained, the parties have
      agreed to operate under a sublease agreement.





We
      also
      lease our Louisiana facility, which is located at 10016 River Road, St. Rose,
      Louisiana, 70087, from River Road Real Estate LLC, a related party. The building
      consists of approximately 39,000 square feet of air-conditioned office and
      warehouse space. The lease for the St. Rose location is for a term of five
      years
      expiring October 2006, and carries a monthly lease payment of $15,000. As a
      result of Hurricane Katrina, on August 30, 2005, we were forced to temporarily
      discontinue operations at this facility. The Company reopened this facility
      in
      January 2006. The Company is currently evaluating this location and exploring
      alternative sites.





We
      believe all of our properties have been adequately maintained, are generally
      in
      good condition, and are suitable and adequate for
      our
      business.





**Item
      3. LEGAL PROCEEDINGS.**





We
      are
      not presently subject to any material legal proceedings other than as set forth
      below:





11


On
      November 12, 2003, prior to the Merger with FMG, Phil & Kathy’s, Inc. d/b/a
      Alliance Distributors (“Alliance”) served a complaint against us seeking to
      recover the non-payment of open invoices approximating $2.0 million based upon
      an alleged breach of contract for the sale of pharmaceuticals. On December
      18,
      2003, we filed an answer and counterclaim. The counterclaim seeks to recover
      lost profits and other damages relating to the sale of twenty allegedly
      counterfeit bottles of Lipitor by Alliance to us, which we later sold to QK
      Healthcare, Inc. (“QK”). Alleging that the Lipitor was counterfeit, QK later
      sued us for breach of contract, violations of the implied warranty of
      merchantability and fraud. Accordingly, one of our subsidiaries, Valley Drug
      Company (“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 a lawsuit against Valley by QK in New York. We intend
      to vigorously defend Alliance’s breach of contract action and prosecute our
      counterclaim. At December 31, 2005, the amount that we recorded as a trade
      payable balance due Alliance on the above was approximately $1.5 million. Under
      our indemnification agreement with Alliance, pursuant to which Alliance is
      required to indemnify us for all losses, expenses and damages sustained by
      us as
      a result of product sold to us by Alliance, and our right to offset our losses,
      expenses and damages against any amounts due to Alliance, we reduced the payable
      to Alliance by the cost of the faulty Lipitor sold to us by Alliance plus the
      settlement and litigation expenses incurred by us directly as a result of the
      Lipitor, or an aggregate of $0.5 million. We have recorded the foregoing trade
      payable of $1.5 million as of December 31, 2005, and we believe this estimate
      is
      reasonable based on the information we have at this time; however, we cannot
      reasonably estimate the total future possible loss that we will sustain as
      a
      result of the Alliance complaint or the possible recovery through our
      counterclaim or Valley’s consolidated action.





On
      February 23, 2005, a former employee of DrugMax, James Hostetler, filed suit
      in
      the United States District Court for the Northern District of Illinois Eastern
      Division claiming DrugMax breached a compensation agreement. Specifically,
      Mr.
      Hostetler claims he is owed a commission of an unspecified amount as a result
      of
      the sale of securities consummated on December 2, 2004. We have filed a response
      and intend to defend ourselves vigorously. Management does not believe Mr.
      Hostetler is entitled to any such commissions as he played no role in the sale
      of these securities. As a result of the early stage of this proceeding, we
      cannot currently estimate its outcome and have made no provision in the
      accompanying consolidated financial statements for the resolution of the matter.





From
      time
      to time, we may become involved in additional litigation arising in the ordinary
      course of our business. In the opinion of management, after consultation with
      counsel, the disposition of these matters arising in the normal course of
      business is not likely to have a material adverse effect, individually or in
      the
      aggregate, on our financial position or results of operations.





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





On
      September 27, 2005, stockholders of the Company holding an aggregate of
      approximately 10,409,476 shares of our common stock (the “Majority
      Stockholders”), which constituted approximately 51.7% of the issued and
      outstanding shares of our common stock outstanding as of September 23,
      2005, approved by written consent in lieu of a special meeting an amendment
      to
      our Amended and Restated Articles of Incorporation to increase our authorized
      shares of common stock from 100,000,000 to 200,000,000. Previously, on
      September 7, 2005, our Majority Stockholders approved an amendment to
      increase our authorized shares of common stock from 45,000,000 to
      100,000,000.





The
      Annual Meeting of the Stockholders of the Company was held on November 16,
      2005.
      At the meeting, the following actions were taken by the stockholders:




·
            All
                of the Company’s directors were reelected as directors to serve until the
                next annual meeting and until their respective successors are elected
                and
                qualified or until their earlier resignation, removal from office
                or
                death. The votes cast for and against each were as follows:




**For**
            
            **Against**
            
            **Abstain**Edgardo
                A. Mercadante
            
            16,170,906
            
            
            
            39,631James
                E. Searson
            
            16,170,906
            
            
            
            39,631Philip
                P. Gerbino
            
            16,170,906
            
            
            
            39,631Peter
                J. Grua
            
            16,170,806
            
            
            
            39,731Mark
                T. Majeske
            
            16,170,885
            
            
            
            39,652Rakesh
                K. Sharma
            
            16,170,806
            
            
            
            39,731Jugal
                K. Taneja
            
            16,170,111
            
            
            
            40,426Laura
                L. Witt
            
            16,170,806
            
            
            
            39,731




12




·
            The
                proposal to ratify the appointment of Deloitte & Touche LLP as the
                Company’s independent registered public accounting firm for the fiscal
                year ending December 31, 2005 received the following votes:




**For**
            
            **Against**
            
            **Abstain**14,048,653
            
            2,159,883
            
            2,0001




13


**PART
      II**





**Item
      5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITY.**





Our
      common stock is traded on the Nasdaq Capital Market under the symbol “DMAX.” The
      following table sets forth the closing high and low bid prices for our common
      stock on the Nasdaq Capital Market for each calendar quarter during our last
      three fiscal years, as reported by Nasdaq. Prices represent inter-dealer
      quotations without adjustment for retail markups, markdowns or commissions
      and
      may not represent actual transactions.





**Common
                Stock****High**
            
            **Low**2003First
                Quarter
            
            $
            1.43
            
            $
            1.00Second
                Quarter
            
            $
            1.85
            
            $
            1.03Third
                Quarter
            
            $
            2.65
            
            $
            1.21Fourth
                Quarter
            
            $
            2.80
            
            $
            1.852004First
                Quarter
            
            $
            5.87
            
            $
            1.99Second
                Quarter
            
            $
            4.96
            
            $
            4.01Third
                Quarter
            
            $
            4.79
            
            $
            3.06Fourth
                Quarter
            
            $
            4.04
            
            $
            3.282005First
                Quarter
            
            $
            3.55
            
            $
            2.98Second
                Quarter
            
            $
            3.25
            
            $
            2.35Third
                Quarter
            
            $
            2.80
            
            $
            1.08Fourth
                Quarter
            
            $
            1.73
            
            $
            1.04





As
      of
      December 31, 2005, there were approximately 821 shareholders of record of
      our common stock and 65,740,436 shares of common stock outstanding.
      Historically, we have not declared or paid any cash dividends on our common
      stock. We currently intend to retain any future earnings to fund the development
      and growth of our business. Any future determination to pay dividends on our
      common stock will depend upon our results of operations, financial condition
      and
      capital requirements, applicable restrictions under any credit facilities or
      other contractual arrangements and such other factors deemed relevant by our
      Board of Directors. Our current credit facility prohibits the payment of
      dividends.





The
      Company is currently considering changing its name from DrugMax, Inc. to
      Familymeds Group, Inc. to better reflect the Company’s core business. The Board
      of Directors approved this change and the Company intends to seek shareholder
      approval at its next annual meeting. The Company has reserved the stock symbol
      “FMRX” in anticipation of this change.





**ITEM
      6. SELECTED FINANCIAL DATA**





The
      selected consolidated financial information below has been derived from
      DrugMax’s consolidated financial statements. On November 12, 2004, Familymeds
      Group, Inc. (“FMG”) merged with DrugMax, Inc. and for accounting purposes FMG
      was the acquirer. The historical information below is that of FMG and includes
      financial results for the acquired operations of DrugMax, Inc. for the
      post-Merger period subsequent to November 12, 2004. See Note 2 of the Notes
      to
      Consolidated Financial Statements on page 37, for a discussion of the basis
      of
      the presentation and significant accounting policies of the consolidated
      financial information set forth below. You should read this information in
      conjunction with DrugMax’s consolidated financial statements and related notes
      included elsewhere in this Form 10-K. During 2005, we sold or eliminated
      substantially all of the operations acquired in the Merger. Such operations
      are
      classified as discontinued operations below.





The
      data
      as of December 31, 2005 and January 1, 2005 and for the years ended December
      31,
      2005, January 1, 2005 and December 27, 2003 is derived from our audited
      consolidated financial statements included elsewhere herein and should be read
      in conjunction with those consolidated financial statements and the related
      notes contained therein. The data as of December 27, 2003, December 28, 2002
      and
      December 29, 2001 and for the years ended December 27. 2003, December 28, 2002
      and December 29, 2001 is derived from our audited consolidated financial
      statements not included elsewhere herein.





14





**Fiscal
                Years Ended****in
                thousands, except for share amounts**
            
            **December
                31,**
              **2005**
            
            **January
                1,**
              **2005**
            
            **December
                27,**
              **2003**
            
            **December
                28,**
              **2002**
            
            **December
                29,**
              **2001****(52
                weeks)****(1)**
            
            **(53
                weeks) (1)**
            
            **(52
                weeks)**
            
            **(52
                weeks)**
            
            **(52
                weeks) (2)(3)****Statements
                of Operations Data**Net
                revenues
            
            $
            216,103
            
            $
            223,962
            
            $
            218,015
            
            $
            223,513
            
            $
            264,180Gross
                margin
            
            
            42,435
            
            
            46,614
            
            
            47,418
            
            
            46,022
            
            
            46,695Selling,
                general and administrative expenses
            
            
            54,291
            
            
            46,202
            
            
            47,492
            
            
            47,799
            
            
            60,246Depreciation
                and amortization expense(4)
            
            
            4,413
            
            
            4,758
            
            
            5,297
            
            
            5,076
            
            
            9,918Impairments
                of long-lived assets(5)
            
            
            —
            
            
            260
            
            
            792
            
            
            593
            
            
            18,231Loss
                (gain) on disposal of fixed assets and intangible assets
            
            
            159
            
            
            (1,027
            )
            
            (365
            )
            
            (610
            )
            
            288Operating
                loss
            
            
            (16,428
            )
            
            (3,579
            )
            
            (5,798
            )
            
            (6,836
            )
            
            (41,988
            )Interest
                expense(6)
            
            
            (5,900
            )
            
            (5,654
            )
            
            (7,200
            )
            
            (4,026
            )
            
            (4,443
            )Interest
                income
            
            
            84
            
            
            43
            
            
            70
            
            
            13
            
            
            260Other
                income (expense)
            
            
            392
            
            
            605
            
            
            754
            
            
            1,443
            
            
            (41
            )Loss
                before cumulative change in accounting principles
            
            
            (21,852
            )
            
            (8,585
            )
            
            (12,174
            )
            
            (9,406
            )
            
            (46,212
            )Cumulative
                effect of changes in accounting principles(7)
            
            
            —
            
            
            —
            
            
            —
            
            
            (710
            )
            
            —Loss
                from continuing operations
            
            
            (21,852
            )
            
            (8,585
            )
            
            (12,174
            )
            
            (10,116
            )
            
            (46,212
            )Loss
                from discontinued operations (8)
            
            
            (33,005
            )
            
            (31,259
            )
            
            —
            
            
            —
            
            
            —Net
                loss
            
            
            (54,857
            )
            
            (39,844
            )
            
            (12,174
            )
            
            (10,116
            )
            
            (46,212
            )Preferred
                stock dividends
            
            
            (4,301
            )
            
            (10,796
            )
            
            (5,657
            )
            
            (5,657
            )
            
            (5,263
            )Net
                loss available to common stockholders
            
            $
            (59,158
            )
            $
            (50,640
            )
            $
            (17,831
            )
            $
            (15,773
            )
            $
            (51,475
            )**Common
                Share Data**Basic
                and diluted loss per share:Loss
                available to common shareholders before cumulative changes in accounting
                principles
            
            $
            (0.84
            )
            $
            (5.19
            )
            $
            (13.83
            )
            $
            (11.69
            )
            $
            (40.00
            )Cumulative
                effect of adoption of SFAS No. 141 and SFAS No. 142
            
            
            —
            
            
            —
            
            
            —
            
            
            (0.55
            )
            
            —Loss
                from continuing operations available to common
                shareholders
            
            
            (0.84)
            
            
            (5.19)
            
            
            (13.83)
            
            
            (12.24)
            
            
            (40.00)Loss
                from discontinued operations available to common
                shareholders
            
            
            (1.06)
            
            
            (8.38)
            
            
            —
            
            
            —
            
            
            —Net
                loss available to common shareholders
            
            $
            (1.90
            )
            $
            (13.57
            )
            $
            (13.83
            )
            $
            (12.24
            )
            $
            (40.00
            )Shares
                used in basic and diluted net loss per share(9)
            
            
            31,139
            
            
            3,731
            
            
            1,289
            
            
            1,289
            
            
            1,287Dividends
                declared
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —








15


**As
                of****December
                31,**
              **2005**
            
            
            **January
                1,**
              **2005**
            
            
            **December 27,**
              **2003**
            
            
            **December 28,**
              **2002**
            
            
            **December
                29,**
              **2001****Balance
                Sheet and Other Data**Working
                capital (deficit) (10)
            
            $
            (4,346
            )
            
            $
            (7,875
            )
            
            $
            (37,604
            )
            
            $
            4,683
            
            
            $
            (19,301
            )Total
                assets
            
            
            64,027
            
            
            
            95,598
            
            
            
            44,153
            
            
            
            49,319
            
            
            
            61,093Long-term
                accounts payable (11)
            
            
            —
            
            
            
            22,425
            
            
            
            —
            
            
            
            —
            
            
            
            —Revolving
                credit facility and current portion of
              long-term
                debt (10)
            
            
            41,888
            
            
            
            35,155
            
            
            
            37,696
            
            
            
            389
            
            
            
            26,797Long-term
                debt (12)
            
            
            18,185
            
            
            
            —
            
            
            
            —
            
            
            
            34,484
            
            
            
            4,800FMG
                redeemable preferred stock
            
            
            —
            
            
            
            —
            
            
            
            109,325
            
            
            
            103,668
            
            
            
            98,011Total
                stockholders’ (deficit) equity
            
            
            (11,294
            )
            
            
            5,855
            
            
            
            (133,888
            )
            
            
            (116,234
            )
            
            
            (100,712
            )Store
                locations:Corporate-owned
            
            
            77
            
            
            
            77
            
            
            
            82
            
            
            
            85
            
            
            
            93Franchised
            
            
            7
            
            
            
            8
            
            
            
            7
            
            
            
            7
            
            
            
            19




(1)
            Results
                for substantially all of the drug distribution operations subsequent
                to
                the November 12, 2004 Merger are included in discontinued operations.
                The
                effect of 53 weeks in the fiscal year ended January 1, 2005 was to
                increase revenues by $4.0 million.(2)
            In
                2001, FMG closed 21 underperforming stores and opened one location.
                At
                fiscal year-end 2001, FMG operated 93 corporate-owned locations.
                In
                December 2001, FMG decided to close its automated distribution
                facility.(3)
            Includes
                amortization of goodwill in the amount of $0.2 million in 2001 and
                $0.1
                million in 2000. In 2002, FMG adopted SFAS No. 142 (Goodwill and
                Other
                Intangible Assets) and thus, beginning in 2002, no longer amortizes
                goodwill.(4)
            Depreciation
                and amortization expense decreased from fiscal 2001 to fiscal 2002
                as a
                result of the reduction in operations in the e-commerce
                business.(5)
            Write-downs
                of long-lived assets in fiscal 2001 includes $4.8 million related
                to FMG’s
                automated distribution facility and mail order and e-commerce business,
                $3.0 million related to impairment of prescription files at
                underperforming locations and $10.4 million related to a strategic
                alliance agreement related to the e-commerce business.(6)
            Includes
                $1.0 million, $1.7 million and $4.3 million of non-cash interest
                in fiscal
                2005, 2004 and 2003, respectively. $4.0 million of the $4.3 million
                noncash interest expense in fiscal 2003 relates to interest on convertible
                notes issued to former FMG shareholders, which notes were converted
                to
                common stock in connection with the Merger.(7)
            During
                fiscal 2002, FMG adopted new accounting standards related to goodwill
                resulting in a charge of $0.9 million and negative goodwill resulting
                in a
                benefit of $0.2 million.(8)
            Included
                in loss from discontinued operations are operating losses of$5.7
                millionand $0.3 million, impairment write downs of goodwill and other intangible
                assets of $22.6 million and $31.0 million, and other exit losses,
                primarily representing estimated losses on accounts receivable, inventory
                and vendor chargebacks, of $4.7 million and $0 million, for fiscal
                years ended December 31, 2005 and January 1, 2005,
                respectively.(9)
            The
                weighted average shares used in the calculation of net loss per share
                have
                been retroactively restated to give effect to the Merger of DrugMax
                with
                FMG. The transaction was accounted for as a reverse Merger with FMG
                deemed
                the accounting acquirer. Accordingly, for periods prior to the Merger,
                the
                shares outstanding represent the number of shares that former FMG
                common
                shareholders would have received in the transaction, on an as-if
                converted
                basis, had the Merger consideration not been distributed to the preferred
                shareholders based on liquidation values. For periods subsequent
                to the
                Merger, shares outstanding represent actual weighted average shares
                outstanding.(10)
            December
                31, 2005 includes $36.3 million of debt under the revolving credit
                facility that has a maturity date of October 13, 2010, the current
                portion
                of two subordinated notes payable for $4.7 million and $0.9 million
                of
                promissory notes payable.(11)
            Represents
                the long-term portion of the $23.0 million of accounts payable that
                were
                converted into two subordinated notes payable on March 21,
                2005.(12)
            Represents
                the long-term portion outstanding on the two subordinated notes payable
                as
                of December 31, 2005.





**Item
      7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS.**





The
      following Management’s Discussion and Analysis of Financial Condition and
      Results of Operations should be read in conjunction with our consolidated
      financial statements and the related notes. This discussion contains
      forward-looking statements based upon our current expectations, such as our
      plans, objectives, expectations and intentions, that involve risks and
      uncertainties as set forth under “Cautionary Statement Regarding Forward-Looking
      Statements.” Our actual results and the timing of events could differ materially
      from those anticipated in these forward-looking statements as a result of many
      factors, including, but not limited to, those set forth in the following
      discussion and under Item I.A. - “Risk Factors” and elsewhere in this Form 10-K.





DrugMax,
      Inc. (“DrugMax,” the “Company,” or “we” and other similar pronouns) is a
      pharmacy and drug distribution provider formed by the merger on November 12,
      2004 of DrugMax, Inc. and Familymeds Group, Inc. (“FMG”) (the “Merger”).
      Subsequent to the Merger, our operations consisted of pharmacy operations,
      representing the prior FMG business, and drug distribution operations,
      representing the prior DrugMax business.





16


Since
      the
      Merger, our strategy has been to reduce our cost of goods sold by integrating
      our pharmacy operations and our drug distribution operations, reducing our
      cost
      of goods sold on generic pharmaceuticals, and increasing our generic and higher
      margin pharmaceutical sales to existing customers including physician groups,
      small hospitals and clinics. However, the low gross margin drug distribution
      operations continued to experience downward pressures on profit margins,
      particularly with regard to branded pharmaceuticals. Therefore, during the
      third
      quarter 2005, we determined that we would discontinue substantially all of
      our
      drug distribution operations by selling certain assets of that business and
      eliminating operations conducted out of the New Castle, Pennsylvania facility
      and St. Rose, Louisiana facilities related directly to the distribution of
      pharmaceuticals to independent pharmacies. Accordingly, we considered
      substantially all of the wholesale distribution business as discontinued
      operations for financial statement presentation purposes. In December 2005,
      we
      sold certain assets held by Valley Drug Company and the New Castle, Pennsylvania
      facility. We continue to purchase pharmaceuticals utilizing the authorized
      distributor agreements and distribute pharmaceuticals directly to physicians,
      medical clinics and other health care providers from the St. Rose, Louisiana
      facility, Valley Drug Company South. This facility was temporarily closed in
      September 2005 as a result of Hurricane Katrina and reopened in January 2006.





As
      of
      December 31, 2005, we operated 77 pharmacies, including one home health center
      and one non-pharmacy mail order center, in 14 states under the Arrow Pharmacy
      & Nutrition Center, Familymeds Pharmacy, and Worksite Pharmacy SM brand
      names. We work closely with doctors, patients, managed care providers, medical
      centers and employers to improve patient outcomes while delivering low cost
      and
      effective healthcare solutions.





***Drug
      Distribution Discontinued Operations***





Net
      revenues related to the discontinued operations were $103.6 million and $15.3
      million for the fiscal year ended December 31, 2005 and for the period November
      12, 2004 (the Merger date) to January 1, 2005, respectively. The loss from
      discontinued operations of $33.0 million and $31.3 million for the fiscal year
      ended December 31, 2005 and for the period November 12, 2004 (the Merger date)
      to January 1, 2005, respectively, represents the loss from operations of the
      discontinued operations of $5.7 million and $0.3 million, respectively and
      loss
      on disposal of the discontinued operations of $27.3 million and $31.0 million,
      respectively. The loss on disposal of discontinued operations includes goodwill
      and other intangible asset impairments (trademarks and customer list) of $22.6
      million and $31.0 million and other exit losses primarily representing estimated
      losses on accounts and notes receivable, inventory, and vendor chargebacks
      of
      $4.7 million and $0 million, for fiscal years ended December 31, 2005, and
      January 1, 2005, respectively.





As
      noted
      above, during the third quarter 2005, we determined that we would discontinue
      substantially all of our drug distribution operations by selling certain assets
      of that business and eliminating operations conducted out of the New Castle,
      Pennsylvania facility and St. Rose, Louisiana facilities related directly to
      the
      distribution of pharmaceuticals to independent pharmacies. Accordingly, in
      December 2005, Rochester Drug Cooperative (“RDC”) acquired select assets from
      Valley Drug Company, including a customer list, fixtures and equipment located
      in the Company’s New Castle, Pennsylvania facility. In connection with the sale,
      RDC assumed certain property leases, customer contracts and other miscellaneous
      contracts. The total purchase price for these select assets is $655,000, of
      which $405,000 was received by the closing and $250,000 is required to be paid
      if and when the Pennsylvania Industrial Development Authority (“PIDA”) consents
      to the assignment of the lease for the New Castle facility to RDC, as discussed
      below. The Company expects payment of the $250,000 during the second quarter
      of
      2006.




In
      addition, RDC agreed to assist the Company with the collection of customer
      accounts receivable associated with the purchased customer list which was
      transferred to RDC at closing. Further, the Company allocated Valley Drug
      Company’s pharmaceutical inventory to the Company’s Familymeds pharmacies and
      into its continuing distribution business. The Company intends to continue
      with
      that portion of the wholesale distribution business related to the distribution
      of pharmaceuticals directly to physicians, medical clinics, and other health
      care providers. The total estimated inventory allocated was approximately $7.8
      million. Proceeds from the transaction and amounts realized from the collection
      of accounts receivable and sale of inventory were used to decrease the Company’s
      borrowings under its credit facility with Wells Fargo Retail Finance,
      LLC.




In
      connection with the sale of these assets, the Company and its landlord, Becan
      Development LLC, agreed to amend the lease for the New Castle, Pennsylvania
      facility pursuant to the Amendment No. 1 to Lease. The amendment provides that
      the term of the lease be 5 years, commencing December 21, 2005, with 2
      additional 5-year options for renewal, and provides an option to purchase
      the premises from the landlord. RDC has agreed to enter into a lease assignment
      and assumption agreement for the amended New Castle lease contingent upon the
      Company and the landlord securing consents from the PIDA to such assignment.
      Until such time as the consents are obtained, the parties have agreed to operate
      under a sublease agreement. The Company’s obligation under the lease was
      approximately $200,000 annually.





Further
      as part of the discontinuance of the drug distribution business, the Company
      wrote off substantially all of the remaining goodwill related to that business
      resulting from the Merger. Of the $51.8 million of goodwill recorded as a result
      of the Merger, $31.0 million was considered impaired and written off as of
      fiscal year end 2004, and $19.4 million was written off as of fiscal year-end
      2005 as part of the discontinuance.







***Strategy***




***General*** ****




Our
      primary strategy is to build an integrated specialty drug pharmacy platform
      with
      multiple sales channels including: clinic and apothecary pharmacies, Worksite
      Pharmacies SM ,
      institutional “closed door” type pharmacies, a central fill mail order based
      pharmacy and a pharmaceutical distribution center focused on medical specialty
      sales. We believe this can be accomplished through the present base of
      operations, through additional organic opening of new pharmacies and by
      acquiring pharmacies. We believe the integration of these types of locations
      will uniquely enable us to supply specialty drugs and other pharmaceuticals
      to
      patients, physicians and other healthcare providers.




Our
      strategy is to locate specialty clinic and apothecary pharmacy operations near
      or in medical facilities. The strategy is driven by the location concept whereby
      situating a clinical or specialty type pharmacy near the point of acute or
      chronic care provides us with a “first capture” opportunity to service patients
      when they visit their physicians. This also enables us to collaborate with
      the
      physician in the therapeutic regimen and may provide opportunities for generic
      drug sales or alternative pharmaceutical therapy, which generally provide us
      with higher profit margins. Many of these patients or special patient groups
      require central fill and or mail order follow-up care that can be provided
      through our “closed door” pharmacy or mail order center located in Connecticut.
      We also supply online web based access to all or most of our services and
      products through our nationally known website www.familymeds.com.





17


We
      offer
      a comprehensive selection of branded and generic prescription and
      non-prescription pharmaceuticals, specialty injectables, generic biologics,
      compounded medicines, healthcare-related products and diagnostic products.
      These
      products are used for the treatment of acute or chronic medical conditions
      and
      may be purchased through our platforms. Also, we have recently placed
      significant emphasis on the injectable and orally administered specialty
      pharmaceuticals. We intend to increase pharmacy revenue through these “Specialty
      Pharmaceuticals,” which generally are more expensive and provide a higher gross
      profit.





The
      company strategy also includes selling specialty pharmaceuticals and healthcare
      products to physicians, home care providers and related healthcare providers
      including respiratory therapists and nurse practitioners that often
      re-administer these products to their patient immediately. We are executing
      this
      strategy by combining selling access through our existing physician
      relationships and medically based pharmacies with a sales force who actively
      pursues these practitioners as well as new potential practitioner customers.
      Our
      unique selling proposition to these practitioners is ease of obtaining product
      through same day delivery through our onsite pharmacies as well as our ability
      to supply the pharmaceutical to the physician already prepared and “ready to
      use.” As part of our service, we bill the physicians/patients payor/insurance
      carrier or Medicare under part B depending on the type of coverage each patient
      has. This strategy for distribution of pharmaceuticals will be ongoing and
      utilizes our wholesale authorized distribution agreements to obtain the drugs
      through the proper channel pricing and together with central and decentralized
      distribution to the practitioner customer depending on the customer
      needs.




***Pharmacy
      Operations*** ****




As
      of December 31, 2005, we operated 77 corporate pharmacies, including one central
      fill home healthcare product center and franchised seven pharmacies in 14
      states. 43 of our pharmacies are located at the point of care between physicians
      and patients, oftentimes inside medical office buildings or on a medical campus.
      The balance of our locations are usually nearby medical facilities though more
      retail accessible. The majority of our revenues from pharmacy operations come
      from the sale of prescription pharmaceuticals, which represented approximately
      94% of our net revenues for the fiscal year ended December 31, 2005 and fiscal
      year ended January 1, 2005. Our corporate pharmacies provide services to
      approximately 400,000 acute or chronically ill patients each year, many with
      complex specialty and medical product needs.




We
      operate our pharmacies under the trade names Familymeds Pharmacy (“Familymeds”),
      Arrow Pharmacy and Nutrition Centers (“Arrow”) and Worksite Pharmacy SM .
      Familymeds is primarily used for pharmacies outside of New England. The
      Familymeds locations were primarily originated by acquiring the base pharmacy
      business from HMO’s, hospitals and regional independent operators. The locations
      are primarily clinic size with a small footprint, usually less than 1,500 sq.
      ft. The Arrow trade name is used in New England where most of the pharmacies
      were opened as a start-up or re-acquired from former Arrow franchise operators
      who opened these legacy pharmacy operations as start-ups. These locations are
      primarily apothecary size, approximately 2,000 sq. ft. and may be more visible
      as retail type locations, though primarily nearby hospitals or medical campus
      locations. Our locations in Michigan and certain locations elsewhere throughout
      our trading area may have a larger footprint to accommodate a comprehensive
      inventory of nutritional and home medical supplies.





By
      our
      estimates, there are more than 5,000 locations nationwide at or near the point
      of care which may be available to open additional pharmacies. Because of our
      experience with operating pharmacies in similar locations, we believe we are
      uniquely positioned to target these sites and increase our core pharmacy market
      presence. We also believe that we can grow our pharmacy operations through
      selective acquisitions. The company is actively pursuing appropriate
      acquisitions along with additional capital resources. By increasing our store
      count, through acquisitions or the opening of new pharmacies at or near the
      point of medical care, we believe we can increase our customer base, expand
      our
      geographic reach and improve profitability by leveraging our existing
      infrastructure.





Our
      strategy also includes offering our customers or patients multiple sales
      channels by which they can purchase our products. We offer them the opportunity
      to purchase a broad array of health-related products online including a
      comprehensive selection of prescription medications, vitamins and nutritional
      supplements, home medical equipment, and health and beauty aids directly from
      our pharmacies, by mail order, and via the Internet. Familymeds.com is the
      foundation of our Internet offering. This website is one of the few sites
      certified as a Verified Internet Pharmacy Provider Site (VIPPS) by the National
      Association of Boards of Pharmacy (NABP). The VIPPS program is a voluntary
      certification program designed to approve and identify online pharmacies that
      are appropriately licensed and prepared to practice Internet pharmacy.
      Familymeds.com is the non-prescription Internet commerce partner for select
      prescription benefit managers (PBMs) including Medco Health. We will continue
      to
      pursue opportunities to partner with managed care and others providers to
      increase our sales through our Internet sales channel.





We
      operate and locate Worksite Pharmacies SM (pharmacies
      that service a single, defined population) for large employers who are seeking
      to control overall employee prescription drug benefit expenditures while
      maintaining high employee satisfaction through improved accessibility. Our
      Worksite Pharmacies SM offer
      prescription services exclusively to the employer’s covered population. We can
      deliver these services at or near the employer’s work site by opening, staffing
      and managing a pharmacy. Our initial results have proven that this strategy
      reduces healthcare costs for the employer. Our research has shown that many
      employers, especially large Fortune 500 companies are seeking more aggressive
      methods to control healthcare expenditures, especially the pharmacy component
      of
      benefits. We have identified key large employers, those with over 2,000
      employees in a single location, to be target opportunities for this type of
      Employer Sponsored Worksite Pharmacy SM .
      Currently, we have a Worksite Pharmacy SM in
      the
      employee center of the Mohegan Sun Casino in Connecticut and Scotts Company
      L.L.C headquarters in Merryville, Ohio. Combined, these employers have more
      than
      14,000 employees and dependents as potential patients.





We
      have
      developed programs designed to improve patient compliance and to reduce costs.
      We have three major programs, a prescription compliance program called Reliable
      Refill, a discount plan called Senior Save15 and an automated telephony system
      designed to notify patients of recalls, provide refill reminders and notify
      our
      customers of other important information. Reliable Refill is a compliance
      program that identifies prescriptions that are due to be filled and schedules
      them for filling before the patient has run out of the previous prescriptions.
      Our Senior Save15 program, introduced prior to the Medicare Modernization Act,
      is our own discount program that gives senior customers access to all of our
      prescription and over-the-counter products at discounted prices. Our programs
      are designed to improve medication therapy management among patients with
      chronic therapeutic needs especially the elderly population. Our data warehouse
      identifies these patients and allows us to target these patients with special
      needs. We believe our data warehouse and our medication therapy management
      programs uniquely position our company as a pharmacy provider.




18


***Electronic
      Prescription Solutions***





We
      are
      implementing electronic prescription solutions to include the ability to accept
      delivery of prescriptions through electronic prescribing software and kiosk
      technologies. Our pharmacies are able to accept delivery of electronic
      prescription orders and refill authorizations with secure, reliable transmission
      directly from physician practices. In certain locations such as medical clinics
      and medical office buildings where we do not have a full-service pharmacy,
      we
      are also installing kiosks that allow customers to transmit their prescriptions
      directly to us for pick up at one of our nearby pharmacies or direct delivery. **





***Medicare
      Part D***




Pharmacy
      sales trends are expected to continue to grow due, in part, to the Medicare
      Part
      D prescription drug benefit. As of January 1, 2006, Medicare beneficiaries
      have
      the opportunity to receive subsidized prescription drug coverage through the
      Medicare Part D program. The new drug benefit is delivered by competing plans,
      and our pharmacies have contracted with each of the major providers to ensure
      our customers can continue purchasing their prescriptions from our stores.
      While, the new Medicare drug benefit is entirely voluntary, we believe a
      significant portion of the Medicare population will enjoy this new benefit.
      While it is difficult to fully predict the impact on our business, we believe
      we
      are well positioned to capture additional prescription sales. However, we expect
      the gross margin from this business to be less than what the traditional
      prescription drug plans provide.





***Hurricane
      Katrina***




In
      September 2005, Hurricane Katrina resulted in the temporary closure of the
      warehouse facility located in St. Rose, Louisiana. The Company maintains
      insurance coverage, which provides for reimbursement from losses resulting
      from
      property damage, loss of product and losses from business interruption. The
      Company estimates approximately $0.2 million of inventory was damaged during
      the
      hurricane and that it incurred approximately $0.8 million of incremental costs
      related to closing the facility and relocating the inventory and operations
      to
      our New Castle facility. Additionally, provisions for bad debts of $0.5 million
      were recorded related to estimated losses resulting from customers whose
      businesses were affected by the hurricane and the related unamortized customer
      list asset of $0.5 million was also written off. These costs were expensed
      and
      included in loss from discontinued operations in the consolidated statement
      of
      operations. The Company continues to evaluate the extent of the loss from
      business interruption and is attempting to recover these costs through insurance
      claims. No amounts have been recorded related to amounts that may be received
      from insurance.





***Primary
      Supplier Relationship***





In
      December 2004, we entered into a new primary supplier agreement with D&K
      Healthcare Resources, Inc. (“D&K”) pursuant to which we are required to
      purchase primarily all of our products for sale in our pharmacies from D&K.
      The D&K agreement contains certain volume requirements and has an initial
      term of two years, through December 2006 and renews automatically for successive
      one-year periods unless either party provides the other party a written
      non-renewal notice. Although we purchase products from many different brand
      name
      and generic pharmaceutical manufacturers and while we believe that if we were
      to
      cease to be able to purchase products directly from D&K, we could secure the
      same products through other sources, including other distributors, there is
      a
      risk that our costs would increase if our primary supplier agreement is
      terminated. On August 30, 2005, D&K was acquired by McKesson Corporation and
      our agreement was assumed by McKesson. In December 2005, the agreement was
      amended to provide five day a week delivery of pharmaceuticals and other
      merchandise directly to our pharmacy locations.





**Comparison
      of Operating Results for Continuing Operations for the Fiscal Years ended
      December 31, 2005, January 1, 2005 and December 27, 2003.**





We
      refer
      to prescription products as Rx products and to the remaining products, such
      as
      over-the-counter medications, home medical equipment and home health appliances,
      as non-Rx products. While non-Rx reflects a smaller percentage of our overall
      revenues, the gross margin for non-Rx products is higher. The Rx portion of
      the
      pharmacy business is dependent upon a number of third party customers that
      pay a
      portion or all of the Rx cost on behalf of the customers, “Third Party
      Customers.” Prescriptions generated by Third Party Customers represented
      approximately 94% of pharmacy’s Rx sales in the fiscal year ended December 31,
      2005 and 95% for the fiscal year ended January 1, 2005.





For
      financial statement presentation purposes, the Company has
      reported substantially all of the wholesale distribution business as
      discontinued operations.




19


***Net
      Revenues***





Net
      revenue performance is detailed below:


**For
                  the Fiscal Year Ended****52
                  weeks**
              
              
              
              
              
              **53
                  weeks**
              
              
              
              
              
              **52
                  weeks****2005**
              
              
              **Change
                  %**
              
              
              **2004**
              
              
              **Change
                  %**
              
              
              **2003**
              
              
              **Change
                  %**Net
                  revenues (in millions)
              
              $
              216.1
              
              
              (3.5
              )%
              $
              224.0
              
              
              2.5
              %
              $
              218.0
              
              
              (2.5
              )%Net
                  revenues on a comparable 52 week basis (in millions) (1)
              
              
              216.1
              
              
              (1.8
              )%
              
              220.0
              
              
              0.1
              %
              
              218.0
              
              
              (2.5
              )%Rx
                  % of store net revenues (2)
              
              
              94.2
              %
              
              
              
              
              93.8
              %
              
              
              
              
              94.3
              %Third
                  party % of Rx net revenues
              
              
              93.9
              %
              
              
              
              
              94.8
              %
              
              
              
              
              94.0
              %Number
                  of corporate stores
              
              
              77
              
              
              
              
              
              77
              
              
              
              
              
              82Average
                  same store net revenue per store (in millions) (1)
              
              $
              2.8
              
              
              
              
              $
              2.9
              
              
              
              
              $
              2.7





*(1)*
            *The
                Company’s fiscal year is a 52 or 53 week period ending on Saturday nearest
                to December 31. Fiscal 2004 included 53 weeks. Fiscal 2005 and fiscal
                2003
                each included 52 weeks. To improve comparability, $4.0 million of
                additional revenue related to the 53**rd**week in fiscal 2004 was removed.*





*(2)*
            *Store
                net revenues are net of contractual allowances.*





**Fiscal 2005****Compared to****Fiscal
                2004**
            
            
            **Fiscal
                2004****Compared
                to****Fiscal
                2003**Net
                revenues increases (decreases) are as follows (in
                millions):Net
                effect of store openings/closings(1)
            
            $
            (2.7
            )
            $
            (2.9
            )Prescription
                sales (2)
            
            
            (2.7
            )
            
            2.3Effect
                of 53 weeks in 2004 vs. 52 weeks in 2003 and 2005(3)
            
            
            (4.0
            )
            
            4.0Non-Rx
                sales
            
            
            (0.2
            )
            
            2.1Physician
                Distribution (4)
            
            
            1.8
            
            
            0.5Franchise
                royalties
            
            
            (0.1
            )
            
            (0.1
            )Net
                (decrease) increase
            
            $
            (7.9
            )
            $
            5.9





*(1)*
            *The
                net effect of store openings/closings represents the difference in
                revenues by eliminating stores that were not open during the full
                periods
                compared. We closed five stores during fiscal 2003 that accounted
                for $3.2
                million of net revenues. We sold seven stores during fiscal 2004
                that
                accounted for $2.8 million of net revenue and opened two new stores
                during
                the year that added $0.2 million of net revenues.*





*(2)*
            *Prescription
                sales were negatively impacted during fiscal 2005 compared to fiscal
                2004
                due to**the
                disruptions to our supply chain resulting from Hurricane Katrina
                as well
                as higher purchasing costs due to our inability to buy on a more
                credit
                worthy basis.*





*(3)*
            *The
                Company’s fiscal year is a 52 or 53 week period ending on Saturday nearest
                to December 31. Fiscal 2004, which ended on January 1, 2005, included
                53
                weeks. Fiscal 2005 and fiscal 2003, which ended on December 31, 2005
                and
                December 27, 2003, respectively, each included 52 weeks.*





*(4)*
            *Represents
                post-Merger revenues from November 12, 2004 through January 1, 2005
                and
                for the entire fiscal year 2005 for the continuing portion of the
                drug
                distribution operations that relates to physician distribution.*




20


***Gross
      Margin***





Gross
      margin was $42.4 million or 19.6 % in fiscal 2005, a 52 week year. This compares
      to $46.6 million or 20.8% in fiscal 2004, a 53 week year, and $47.4 million
      or
      21.7% in fiscal 2003, a 52 week year. Fiscal 2005 reflects the adverse effect
      of
      the efforts of managed care organizations, pharmacy benefit managers and other
      third party payors to reduce their prescription costs. Also, we were negatively
      impacted during fiscal 2005 due to the disruption to our supply chain resulting
      from Hurricane Katrina as well as higher purchasing costs due to our inability
      to buy on a more credit worthy basis. In recent years, our industry has
      undergone significant changes driven by various efforts to reduce costs. As
      employers and managed care organizations continue to focus on the costs of
      branded and specialty pharmaceuticals, we expect there will continue to be
      negative pressure on gross margins. In addition, gross margin percentage is
      expected to be negatively impacted because of the recent addition of Medicare
      Part D and other efforts by third party payors to reduce reimbursement rates.
      Information that helps explain our gross margin trend is detailed
      below:


**Fiscal
                2005**
              **Compared
                to**
              **Fiscal
                2004**
            
            
            **Fiscal
                2004**
              **Compared
                to**
              **Fiscal
                2003**Gross
                margin increases (decreases) are as follows (in millions):Pharmacy
                Operations:Net
                effect of store openings/closings (1)
            
            
            (0.6
            )
            
            
            (0.6
            )Franchise
                royalties
            
            
            (0.1
            )
            
            
            (0.1
            )Prescription
                gross margin (2)
            
            
            (2.6
            )
            
            
            (1.2
            )Non-Rx
                gross margin
            
            
            (0.1
            )
            
            
            0.1Effect
                of 53 weeks in 2004 vs. 52 weeks in 2003 and 2005 (3)
            
            
            (0.9
            )
            
            
            0.9Physician
                Distribution Business
            
            
            0.1
            
            
            
            0.1Net
                decrease
            
            $
            (4.2
            )
            
            $
            (0.8
            )




*(1)*
            *The
                net effect of store openings/closings represents the difference in
                gross
                margin by eliminating stores that were not open during the full periods
                compared.*





*(2)*
            *Prescription
                gross margins were negatively impacted during fiscal 2005 compared
                to
                fiscal 2004 due to**the
                disruptions to our supply chain resulting from Hurricane Katrina
                as well
                as higher purchasing costs due to our inability to buy on a more
                credit
                worthy basis.*





*(3)*
            *The
                Company’s fiscal year is a 52 or 53 week period ending on Saturday nearest
                to December 31. Fiscal 2005 and fiscal 2003, which ended on December
                31,
                2005 and December 27, 2003, respectively, included 52 weeks. Fiscal
                2004,
                which ended on January 1, 2005, included 53 weeks.*





***Total
      Operating Expenses***





Operating
      expenses include selling, general and administrative (“SG&A”) expenses,
      depreciation and amortization expense, write-downs of long-lived assets, and
      the
      gain or loss on disposal of fixed assets and intangible assets. Intangible
      assets include the amounts allocated to prescription files for prescriptions
      acquired in previous purchase business combinations of the pharmacy operations.
      A prescription file refers to the actual prescription maintained by a pharmacy
      for each prescription filled. Each prescription file has monetary value to
      a
      pharmacy because when pharmacies and/or prescription files are sold, the
      customers are more likely to leave their accounts with the purchaser than to
      transfer their business to a third-party pharmacy, as such the prescription
      base
      is thought of as a repeatable source of revenue. Accordingly, when pharmacies
      are sold, the number of prescription files is taken into consideration when
      determining the purchase price of the pharmacy. Intangible assets also include
      goodwill, trademarks, and authorized distributor licenses. The authorized
      distributor licenses permit us to purchase pharmaceutical products directly
      from
      the manufacturers. Total operating expenses were $58.9 million or 27.2% of
      net
      revenues in fiscal 2005. This compares to $50.2 million or 22.4% of net revenues
      in fiscal 2004 and $53.2 million, or 24.4% of net revenues, in fiscal 2003.
      Information that helps explain our operating expense trend is detailed below:





**Fiscal
                2005**
              **Compared
                to**
              **Fiscal
                2004**
            
            
            **Fiscal
                2004**
              **Compared
                to**
              **Fiscal
                2003**Operating
                expenses increases (decreases) are as follows (in
                millions):Selling,
                general and administrative expenses(1)
            
            $
            8.1
            
            $
            (1.3
            )Depreciation
                and amortization expense(2)
            
            
            (0.3
            )
            
            (0.5
            )Impairments
                of long-lived assets(3)
            
            
            (0.3
            )
            
            (0.5
            )Gain
                on disposal of fixed assets and intangible assets
            
            
            1.4
            
            
            (0.7
            )Net
                increase (decrease)
            
            $
            8.9
            
            $
            (3.0
            )






21




*(1)*
            *The
                increase in selling, general and administrative expenses in 2005
                mainly
                relates to the Merger consummated and includes $6.1 million of noncash
                stock compensation expense and increased fees and expenses of $1.7
                million
                attributable to costs associated with being a public company. The
                decrease
                in selling, general and administrative expenses during fiscal 2004
                is
                primarily due to a reduction in the number of stores and
                employees.*





*(2)*
            *Depreciation
                and amortization expense was approximately $4.4 million, $4.8 million
                and
                $5.3 million for fiscal 2005, 2004 and 2003,
                respectively.*





*(3)*
            *During
                fiscal 2005, 2004 and 2002, we expensed approximately $0, $0.3 million
                and
                $0.8 million, respectively, related to the impairment of prescription
                file
                intangible assets and estimated lease obligations for sold stores.*





***Interest
      Expense***





Interest
      expense was $5.9 million, $5.7 million and $7.2 million for fiscal 2005, 2004
      and 2003, respectively. In connection with the Merger, DrugMax issued warrants
      to purchase 3,500,090 shares of DrugMax common stock at $2.61 per share to
      the
      former FMG stockholders, warrant holders and note holders. The warrants were
      allocated among the FMG stockholders, warrant holders and note holders in the
      same manner as the DrugMax common stock. DrugMax recorded noncash interest
      expense of approximately $1.7 million in fiscal 2004 related to the portion
      of
      the warrants issued to the former FMG note holders. The charge was based on
      the
      fair value of the warrants to purchase 704,324 shares at $2.61 per share issued
      to the FMG noteholders, using a Black Scholes valuation as of the Merger date.





***Income
      Taxes***





No
      income
      tax benefit has been recorded in any period presented due to the uncertainty
      of
      realization of any related deferred tax asset.





***Loss
      from Continuing Operations***




We
      incurred a loss from continuing operations of $21.9 million for the fiscal
      year
      ended December 31, 2005 versus $8.6 million for the fiscal year ended January
      1,
      2005 and $12.2 million for the fiscal year ended December 27, 2003. The increase
      in the loss from continuing operations in fiscal year 2005 compared to fiscal
      year 2004 results are primarily from $6.1 million of noncash stock compensation
      expense attributable to the Merger, $1.7 million of expenses attributable to
      costs associated with being a public company, and a $4.2 million reduction
      in
      gross margin resulting primarily from the effect of one less week of operations
      in fiscal year 2005 versus 2004 and overall reductions in revenue.





***Loss
      from Discontinued Operations***




The
      loss
      from discontinued operations of $33.0 million and $31.3 million for the fiscal
      year ended December 31, 2005 and for the period November 12, 2004 (the Merger
      date) to January 1, 2005, respectively, represents the loss from operations
      of
      the discontinued operations of $5.7 million and $0.3 million, respectively,
      and
      loss on disposal of the discontinued operations of $27.3 million and $31.0
      million, respectively. The loss on disposal of discontinued operations includes
      goodwill and other intangible asset impairments of $22.6 million and $31.0
      million and other exit losses primarily representing estimated losses on
      accounts receivable, inventory and vendor chargebacks, of $4.7 million and
      $0 million, for fiscal years ended December 31, 2005, and January 1, 2005,
      respectively.





N **et
      Loss Available to Common Stockholders Per Share**




Net
      loss
      available to common stockholders per basic and diluted share for the fiscal
      year
      ended December 31, 2005 was $1.90 compared to $13.57 for the fiscal year ended
      January 1, 2005 and $13.83 for the fiscal year ended December 27,
      2003.





Loss
      from
      continuing operations available to common shareholders per basic and diluted
      share for the fiscal year ended December 31, 2005 was $0.84, compared to losses
      from continuing operations available to common shareholders per basic and
      diluted share for the fiscal years ended January 1, 2005 and December 27, 2003
      of $5.19 and $13.83, respectively. The loss from discontinued operations per
      basic and diluted fiscal year ended December 31, 2005 and January 1, 2005 was
      $1.06 and $8.38, respectively.





Weighted
      average shares used in the calculation of net loss per share for the 2004 period
      have been restated to give effect to the Merger of DrugMax and FMG. The
      transaction was accounted for as a reverse merger, with FMG deemed the
      accounting acquirer. Accordingly, for periods prior to the Merger, the shares
      outstanding represent the number of shares that former FMG common shareholders
      would have received in the transaction, on an as-if converted basis, had the
      Merger consideration not been distributed to the preferred shareholders based
      on
      liquidation value, or approximately 1.3 million shares. For all other periods
      shares outstanding represent actual shares outstanding.




***Inflation
      and Seasonality***





Management
      believes that inflation had no material effect on the operations or our
      financial condition for fiscal 2005, 2004, and 2003. Management does not believe
      that our business is materially impacted by seasonality.




22


**LIQUIDITY
      AND CAPITAL RESOURCES**




**New
      Credit Facility**





On
      October 12, 2005, the Company entered into a Loan and Security Agreement with
      Wells Fargo Retail Finance, LLC (“WFRF”), pursuant to which WFRF will provide
      the Company with a senior secured revolving credit facility up to $65.0 million
      (the “New Credit Facility”). On that same date the Company terminated its $65
      million Amended and Restated Credit Agreement with General Electric Capital
      Corporation (“GECC”) and in connection therewith repaid all outstanding amounts
      due under the credit facility to GECC along with a $0.5 million termination
      fee.
      The $65.0 million of maximum availability under the New Credit Facility is
      reduced by a $7.0 million reserve. While the credit facility currently does
      not
      require compliance with financial covenants, the Company has the ability to
      reduce this reserve by $3.5 million by agreeing to implement one or more
      financial covenants. Available credit is based on eligible receivables,
      inventory and prescription files, as defined in and determined pursuant to
      the
      agreement, and may be subject to reserves as determined by the lender from
      time
      to time. Interest on the revolving line of credit is calculated at the Prime
      index rate plus an applicable Prime margin (as defined in the agreement), unless
      the Company or the lender chooses to convert the loan to a LIBOR-based loan.
      In
      each case, interest is adjusted quarterly. The applicable Prime index margin
      as
      of December 31, 2005 was 0.25%. As of December 31, 2005, the interest
      rate, including applicable margin, used to calculate accrued interest was 7.50%.
      Interest is payable monthly.





The
      New
      Credit Facility includes usual and customary events of default (subject to
      applicable grace periods) for facilities of this nature and provides that,
      upon
      the occurrence of an event of default, payment of all amounts payable under
      the
      New Credit Facility may be accelerated and/or the lenders’ commitments may be
      terminated. In addition, upon the occurrence of certain insolvency or bankruptcy
      related events of default, all amounts payable under the New Credit Facility
      shall automatically become immediately due and payable, and the lenders’
commitments shall automatically terminate.





The
      New
      Credit Facility includes an early termination fee of $650,000 if paid in full
      before October 12, 2008. The New Credit Facility is secured by substantially
      all
      assets of the Company. As of December 31, 2005, $36.3 million was outstanding
      on
      the line and $9.3 million was available for additional borrowings, based on
      eligible receivables and inventory.





The
      proceeds of the New Credit Facility were used to repay in full the Company’s
      prior line of credit with General Electric Capital Corporation (“GECC”) (the
“Senior Credit Facility”) and are also expected to be used to provide financing
      for working capital, letters of credit, capital expenditures, future
      acquisitions and/or other general corporate purposes.




**Sale
      of Securities**





On
      September 23, 2005 and September 26, 2005, we entered into securities purchase
      agreements to sell to certain qualified institutional buyers and accredited
      investors an aggregate of 44,093,432 shares of our common stock and warrants
      to
      purchase 22,046,715 shares of our common stock for an aggregate of $51.1
      million. The offering was executed in two traunches at market price as
      determined by the closing bid price on each day. A purchase agreement for the
      first traunch was executed on September 23, 2005, for an aggregate of $47.8
      million. The unit price of the common stock and corresponding warrant was
      $1.1525. The warrants are exercisable for a period of five years from the
      closing date at an exercise price of $1.09 per share. A purchase agreement
      for
      the second traunch was executed on September 26, 2005, for an aggregate of
      $3.3
      million. The unit price of the common stock and corresponding warrant was
      $1.2625. The warrants are exercisable for a period of five years from the
      closing date at an exercise price of $1.20 per share. The Company used a Black
      Scholes pricing model to determine the fair value of each warrant which was
      determined to be $0.0625.





The
      net
      proceeds from the sale of our common stock and warrants of $47.4 million, after
      fees and expenses of $3.7 million, were used to redeem the Series A convertible
      redeemable preferred stock for $17.0 million, to reduce accounts payable to
      our
      primary supplier which allowed us to continue existing credit terms, to
      increase cash reserves and availability under the New Credit Facility and for
      other general working capital purposes.





**Preferred
      Stock**





On
      December 2, 2004, for an aggregate purchase price of $17 million, we sold to
      certain qualified institutional buyers and accredited investors an aggregate
      of
      17,000 shares of Series A convertible redeemable preferred stock in separate
      transactions. In addition, the investors received warrants to purchase an
      aggregate of 1,378,374 shares of our common stock. The exercise price of each
      warrant is $4.25 per share; the warrants are exercisable into common stock
      and
      expire on the fifth anniversary of the closing. Holders of the Series A stock
      were entitled to receive cumulative dividends, before any dividends are paid
      to
      the common stockholders, at the rate per share of 7% per annum until the fourth
      anniversary, 9% per annum from the fourth anniversary of the closing until
      the
      fifth anniversary, 11% per annum from the fifth anniversary of the closing
      until
      the sixth anniversary and 14% per annum thereafter. The payment of dividends
      can
      be made by delivery of shares of common stock under certain circumstances.
      Except as provided in the certificate of designation, the shares of Series
      A
      stock did not have any voting rights. The holders of the Series A stock may
      at
      their option, from time to time, convert their shares into shares of common
      stock.





Effective
      April 20, 2005, the Company suspended sales under the previously filed
      registration statement to resell such securities. Under the terms of the
      registration agreement, the investors were entitled to liquidated damages until
      such time as the registration statement was declared effective. On July 7,
      2005,
      we amended the certificate of designation to reduce the conversion price from
      $3.70 to $2.80. In exchange, investors representing 95% of the preferred
      shareholders agreed to waive liquidated damages under the registration rights
      agreement through the date of the amendment and to amend the registration rights
      agreement to require the filing of a registration statement covering the
      registrable securities by July 8, 2005 and to require the effectiveness of
      such
      registration statement to be no later than October 1, 2005.





On
      September 26, 2005, the Company entered into agreements with its Series A
      Preferred Stock to have their shares of Series A Preferred Stock redeemed for
      cash upon the closing of the sale of the common stock and warrants described
      above. Accordingly, in connection with the closing of the private placement,
      on
      October 3, 2005 the Company redeemed the 17,000 shares of Series A Preferred
      Stock outstanding for 100% of the stated value or $17 million. In addition,
      the
      Company issued 488,070 shares of common stock, valued at $844,360, to certain
      of
      the holders of its Series A Preferred Stock in connection with the
      redemption.





23


In
      connection with the redemption, the exercise price of the 1,378,374 warrants
      previously issued to the purchasers of Series A Preferred Stock was reduced
      to
      $1.09 per share from $2.80 per share. This modification of warrants resulted
      in
      an increase to additional paid in capital of $0.6 million.





**Subordinated
      Note and Convertible Debenture**




On
      March
      22, 2005, we converted $23.0 million in accounts payable owed to
      AmerisourceBergen Drug Corporation (“ABDC”) (after having repaid $6.0 million on
      March 23, 2005 in connection with the closing of the new vendor supply
      agreement) into (a) a subordinated convertible debenture in the original
      principal amount of $11.5 million (the “Subordinated Convertible Debenture”) and
      (b) a subordinated promissory note in the original principal amount of $11.5
      million (the “Subordinated Note”).




The
      Subordinated Convertible Debenture and Subordinated Note are guaranteed by
      DrugMax and certain of DrugMax’s subsidiaries, including Valley Drug Company,
      Valley Drug Company South, Familymeds, Inc. and Familymeds Holdings, Inc.
      pursuant to Continuing Guaranty Agreements dated as of March 21, 2005. We also
      entered into a subordinated security agreement dated as of March 21, 2005,
      pursuant to which we agreed that upon the occurrence of certain defaults and
      the
      passage of applicable cure periods we shall be deemed at that point to have
      granted to ABDC a springing lien upon and a security interest in substantially
      all of our assets to secure the Subordinated Convertible Debenture and the
      Subordinated Note. Should this occur, we shall be deemed in default of our
      Senior Credit Facility. However, pursuant to a subordination agreement dated
      March 21, 2005, ABDC has agreed to subordinate the Subordinated Convertible
      Debenture, the Subordinated Note, the Guarantees and the Security Agreement
      to
      all “Senior Debt.” Senior Debt consists of all senior indebtedness now or
      hereafter owing, including indebtedness under the Senior Credit Facility and
      any
      debt incurred by us to replace or refinance such debt. On October 12, 2005,
      in
      connection with the New Credit Facility, ABDC executed an Assignment and
      Subordination Agreement with Wells Fargo Retail Finance, LLC. (“WFRF”) whereby
      the Subordination Agreement was assigned to WFRF and ABDC acknowledged the
      assignment.





Pursuant
      to the Subordinated Note, principal is due and payable in 20 successive
      quarterly installments each in the amount of $0.6 million beginning on December
      1, 2005 and continuing until September 1, 2010, on which date all outstanding
      amounts are required to be paid. The Subordinated Note bears interest at a
      variable rate equal to the prime rate plus 2.0% per annum. The interest rate
      adjusts on each quarterly payment date based upon the prime rate in effect
      on
      each such quarterly payment date; provided that in no event shall the interest
      rate in effect be less than 5.0% per annum or greater than 10% per annum.
      Interest accrued on the unpaid principal balance of the Subordinated Note is
      due
      and payable on each quarterly payment date and interest payments commenced
      on
      June 1, 2005. Interest of $0.8 million was expensed during the fiscal year
      ended
      December 31, 2005.





Pursuant
      to the Subordinated Convertible Debenture, principal is due and payable in
      19
      successive quarterly installments each in the amount of $0.6 million commencing
      on March 1, 2006 and continuing until August 15, 2010, on which date all
      outstanding amounts are required to be paid. Quarterly principal payments are
      payable in cash or in shares of common stock in an amount equal to $0.6 million
      divided by $3.4416 (the “Issue Price”). The Subordinated Convertible Debenture
      bears interest at a rate which adjust on each quarterly payment date and which
      is equal to (a) 10%, if the quarterly interest payment is made in common stock
      or (b) the prime rate on the date the quarterly interest payment is due plus
      1%
      per annum, if the quarterly interest payment is made in cash; provided that
      in
      no event shall the interest rate in effect be less than 5.0% per annum or
      greater than 10% per annum. Quarterly interest payments are required to be
      paid
      in common stock through February 28, 2006. Commencing March 1, 2006, quarterly
      interest payments may be paid in cash or common stock in an amount equal to
      the
      interest then due and owing divided by the Issue Price, or a combination
      thereof. If common stock is used to make principal and interest payments on
      the
      Subordinated Convertible Debenture, and the proceeds ABDC receives upon any
      sale
      of our common stock (or the proceeds ABDC would have received upon a sale in
      the
      event no shares are sold by ABDC) are less than the principal and interest
      due,
      we are required to pay such difference to ABDC in cash on the date of maturity
      of the Subordinated Convertible Debenture. Through December 31, 2005, ABDC
      could
      not sell any shares of the Company’s common stock received that, in the
      aggregate, exceed 25% of the average trading volume of our common stock for
      the
      preceding 10 trading days.





During
      the year ended December 31, 2005, 235,516 shares of common stock valued at
      $597,222 were issued for interest expense through December 1, 2005. An
      additional $95,834 of interest expense was accrued from December 1, 2005 to
      December 31, 2005.The sale of these shares of stock by ABDC may have a negative
      impact on the price of our common stock. As of December 31, 2005, we received
      notice from ABDC that a shortfall in the value received from the sale of
      securities received as payment of interest was $0.3 million. This amount is
      considered a “Deemed Payment” under the terms of the Subordinated Convertible
      Debenture and the amount is reflected as a liability in the condensed
      consolidated balance sheet as of December 31, 2005. The Company has accrued
      another “Deemed Payment” amount of $0.2 million relating to the December 1, 2005
      interest payment.





In
      connection with the Subordinated Convertible Debenture, DrugMax entered into
      a
      registration rights agreement dated March 21, 2005 with ABDC pursuant to which
      we agreed to file a registration statement with the SEC to register the resale
      of all common stock issuable to ABDC in connection with the Subordinated
      Convertible Debenture no later than May 30, 2005. Further on May 26, 2005,
      ABDC
      granted us a 45 day extension to file the registration statement. On July 7,
      2005, the Company filed a registration statement on Form S-1. The SEC declared
      the Form S-1 effective on August 10, 2005. See “Risk Factors.”





24


**Operating,
      Investing and Financing Activities:**







Following
      are the components of our operating, investing and financing activities for
      fiscal 2005 and 2004, using the direct cash flow method (in millions):


**Fiscal
                  2005**
              
              
              **Fiscal
                  2004**Cash
                  receipts
              
              $
              222.5
              
              $
              238.5Cash
                  paid to suppliers and employees
              
              
              (243.9
              )
              
              (234.4
              )Interest
                  expense paid
              
              
              (4.9
              )
              
              (3.7
              )Net
                  cash (used in) provided by operating activities
              
              
              (26.3
              )
              
              0.4Cash
                  paid to acquire property and equipment
              
              
              (1.7
              )
              
              (1.1
              )Proceeds
                  from sale of drug distribution
              
              
              0.4Proceeds
                  from sale of prescription files, net
              
              
              0.1
              
              
              1.1Net
                  cash used in investing activities
              
              
              (1.2
              )
              
              -Net
                  proceeds from sale of common stock
              
              
              47.4
              
              
              -Net
                  proceeds from Series A Convertible Preferred Stock
              
              
              -
              
              
              15.9Redemption
                  of Series A Convertible Preferred Stock
              
              
              (17.0
              )
              
              -Repayment
                  of term loan
              
              
              -
              
              
              (4.0
              )Proceeds
                  on financing obligations
              
              
              3.4
              
              
              -Repayment
                  of financing obligations
              
              
              (2.4
              )
              
              (11.6
              )Proceeds
                  from exercise of stock options
              
              
              0.5
              
              
              0.3Net
                  cash provided by financing activities
              
              
              31.9
              
              
              0.6Net
                  increase in cash and cash equivalents
              
              
              4.4
              
              
              1.0Cash
                  and cash equivalents, beginning of fiscal year
              
              
              2.3
              
              
              1.3Cash
                  and cash equivalents, end of fiscal year
              
              $
              6.7
              
              $
              2.3





**Operating
      Cash Flows**





Net
      cash
      (used in) provided by operating activities was ($26.3) million, $0.4 million
      and
      ($0.7) million for fiscal 2005, 2004 and 2003, respectively. During fiscal
      2005
      inventories decreased by $3.9 million and accounts payable decreased by $16.5
      million primarily related to the reduction in amounts owed to primary
      wholesalers. During 2004 our inventory levels increased due to our transition
      to
      a new primary supplier.





**Investing
      Cash Flows**





Net
      cash
      used in investing activities was $1.2 million, $0.0 million and $1.1 million
      for
      fiscal 2005, 2004, and 2003 respectively. Investing activities during fiscal
      2005 included capital expenditures of $1.7 million, proceeds from the sale
      of
      drug distribution of $0.4 million and proceeds from intangible assets from
      one
      store sold during the year for $0.1 million. Fiscal 2004 included capital
      expenditures of $1.1 million, and proceeds from intangible assets for seven
      stores that were sold during the year of $1.1 million. These stores were sold
      as
      part of our strategy to eliminate underperforming locations and to consolidate
      certain stores within existing markets. We currently have no plans to close
      additional stores; however, store performance is continuously evaluated and
      we
      may decide to close additional stores in the future. Net cash used in investing
      activities during fiscal 2003 was primarily due to the costs associated with
      opening of two new stores and the remerchandising and remodeling of several
      existing locations.





During
      fiscal 2005, approximately 32% of our total capital expenditures were for new
      store construction, 27% for store expansion and improvement and 41% for
      technology and other. During fiscal 2006, we plan to invest approximately $3.5
      million in capital improvements, which will include the opening of new
      locations, technology initiatives and remerchandising and remodeling projects
      at
      certain locations.





25




The
      following is a summary of our corporate-owned store activity for the years
      presented:




**Fiscal
                Year****2005**
            
            
            **2004**
            
            
            **2003**Total
                stores (beginning of year)
            
            
            77
            
            
            82
            
            
            85New
                stores
            
            
            1
            
            
            2
            
            
            2Closed
                stores
            
            
            (1
            )
            
            (7
            )
            
            (5
            )Total
                stores (end of year)
            
            
            77
            
            
            77
            
            
            82




26


**Financing
      Cash Flows**





Net
      cash
      provided by financing activities was $31.9 million and $0.6 million for fiscal
      2005 and 2004, respectively. The increase in financing cash flows was primarily
      related to the sale of securities described above for $47.4 million partially
      offset by the redemption of the $17 million convertible preferred stock. For
      fiscal 2004, financing cash flows resulted primarily from the December 2004
      sale
      of $17 million convertible preferred stock as described above. In December
      2004,
      the net proceeds of $15.9 million, after consideration of $1.1 million in fees
      from the convertible preferred stock sale were used in part to reduce trade
      payables in the ordinary course of our business, increases in our inventory
      levels as a result of the transition to a new supplier, payment of Merger
      related expenses and other working capital and general corporate purposes.





***Contractual
      Obligations***





The
      following table summarizes our contractual obligations as of December 31,
      2005:





**Payments
                due by period (4)****Total**
            
            **Less
                than 1**
              **year**
            
            **1-3
                years**
            
            **3-5
                years**
            
            **More
                than 5**
              **years**Debt
                (1)
            
            $
            60,072,201
            
            $
            5,636,189
            
            $
            9,442,104
            
            $
            44,993,908
            
            $
            —Capital
                lease obligations
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Purchase
                obligations (2)
            
            
            150,000,000
            
            
            150,000,000
            
            
            —
            
            
            —
            
            
            —Operating
                leases
            
            
            8,554,008
            
            
            2,887,036
            
            
            3,471,639
            
            
            1,439,569
            
            
            755,764Interest
                expense (3)
            
            
            19,332,317
            
            
            4,823,671
            
            
            8,179,004
            
            
            6,329,642
            
            
            —**Total**
            
            $
            237,958,526
            
            $
            163,346,896
            
            $
            21,092,747
            
            $
            52,763,119
            
            $
            755,764





*(1)*
            *As
                of December 31, 2005, $36.3 million was outstanding on our New Credit
                Facility, $22.9 million was outstanding on the ABDC notes payable
                and $0.9
                million was outstanding on the promissory notes
                payable.*





*(2)*
            *Purchase
                obligations represents the $150 million minimum purchase commitments
                determined on a 12 month basis required under our existing supply
                agreements.*





*(3)*
            *Estimated
                future interest expense for long-term debt, including the New Credit
                Facility, Subordinated Convertible Debenture and Subordinated Note.
                Interest on the New Credit Facility is based on the amounts outstanding
                and interest rate as of December 31, 2005. Interest on the Subordinated
                Convertible Note is based on the amortization schedule of the note
                using
                an interest rate of 10%. Interest on the Subordinated Note is based
                on the
                amortization schedule of the Note and uses the interest rate as of
                December 31, 2005.*





See
      “Debt,” “Leases” and “Commitments and Contingencies” in the accompanying notes
      to our consolidated financial statements for further information about the
      above
      items.





***Off-Balance
      Sheet Arrangements***





We
      do not
      make use of any off-balance sheet arrangements that currently have or that
      we
      expect are reasonably likely to have a material effect on our financial
      condition, results of operations or cash flows. We utilize operating leases
      for
      many of our store locations. We do not use special-purpose entities in any
      of
      our leasing arrangements.





***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 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 us 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 periods. On an on-going
      basis, we evaluate estimates and judgments, including the most significant
      judgments and estimate. We based our estimates and judgments on historical
      experience and on various other facts 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. Our critical accounting policies
      include: assessing merger goodwill and identifiable intangible assets for
      impairment, assessing other long-lived assets for impairment, evaluating the
      adequacy of the allowance for doubtful accounts, and estimating for inventory
      loss reserves.





**Goodwill
      and Identifiable Intangible Assets - Merger Related**




The
      Merger resulted in $51.8 million of goodwill and $5.6 million of other
      intangible assets. The values assigned to goodwill and intangibles, as well
      as
      their related useful lives, are subject to judgment and estimation by the
      Company. Goodwill and identifiable intangible assets related to the Merger
      were
      determined based on the purchase price allocation. The valuation of the
      identifiable intangible assets acquired was based on the estimated cash flows
      related to those assets, while the initial value assigned to goodwill was the
      residual of the purchase price over the fair value of all identifiable assets
      acquired and liabilities assumed. Judgments were required to estimate future
      cash flows in order to determine the fair values of the identifiable intangible
      assets acquired as well as estimate the useful lives for the identifiable assets
      to be amortized over. Useful lives for identifiable intangibles 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.




27


After
      goodwill is initially recorded, annual impairment tests are required, or more
      frequently if impairment indicators are present. The amount of goodwill cannot
      exceed the excess of the fair value of the related reportable unit (which is
      based on the Company’s stock price) over the fair value of reporting units
      identifiable assets and liabilities. Downward movement in the Company’s common
      stock price has a material effect on the fair value of goodwill in future
      measurement periods.




During
      the third quarter of 2005, we determined that we would discontinue substantially
      all of the drug distribution operations acquired in the Merger.





We
      completed impairment tests of the goodwill related to the Merger which resulted
      in impairment charges of $19.4 million in fiscal 2005 and $31.0 million in
      fiscal 2004. These charges are included in the loss from discontinued
      operations. Also during fiscal 2005, the Company recorded impairment charges
      of
      $3.2 million related to trademarks and customer list associated with the
      discontinued operations and is included in the loss form discontinued
      operations. Significant judgments and estimates were required in connection
      with
      the impairment test to determine the estimated future cash flows and fair value
      of the reporting unit. To the extent our estimates change in the future or
      our
      stock price decreases from January 1, 2005, further goodwill writedowns may
      occur. As of December 31, 2005, we had remaining goodwill of $1.4 million
      recorded and remaining other intangible assets of $1.9 million related to the
      Merger.





**Impairment
      of Other Long-lived Assets**





The
      Company reviews other long-lived assets, including property plant and equipment
      and prescription file intangible assets, to be held and used for impairment
      whenever events or changes in circumstances indicate that the carrying amount
      of
      an asset may not be recoverable. If the sum of the undiscounted expected future
      cash flows is less than the carrying amount of the related assets, the Company
      recognizes an impairment loss. Impairment losses are measured as the amount
      by
      which the carrying amount of the assets, including prescription file intangible
      assets, exceeds the future cash flows for the assets. For purposes of
      recognizing and measuring impairment of other long-lived assets, the Company
      evaluates assets at the store level for pharmacy operations.





Our
      impairment loss calculations contain uncertainty since we must use judgment
      to
      estimate future sales, profitability and cash flows. When preparing these
      estimates, we consider historical results and current operating trends and
      our
      consolidated revenues, profitability and cash flow results and forecasts. These
      estimates can be affected by a number of factors including, but not limited
      to,
      general economic conditions, the cost of real estate, the continued efforts
      of
      third party customers to reduce their prescription drug costs, the continued
      efforts of competitors to gain market share and consumer spending patterns.
      If
      these projections change in the future, we may be required to write-down our
      long-lived assets. Long-lived assets evaluated for impairment include property
      and equipment as well as intangible assets, which as of December 31, 2005 were
      approximately $5.0 million and $4.9 million, respectively, and $5.3 million
      and
      $10.6 million, respectively, at January 1, 2005.





**Trade
      Receivables - Allowance for Doubtful Accounts**





At
      December 31, 2005 and January 1, 2005, trade receivables reflected approximately
      $15.7 million and $24.5 million, respectively, of amounts due from various
      insurance companies, governmental agencies and individual customers. Of these
      amounts, there was approximately $2.8 million and $3.9 million reserved as
      of
      December 31, 2005 and January 1, 2005, respectively, for a balance of net trade
      receivables of $12.9 million and $20.6 million, respectively. Net trade
      receivables at December 31, 2005 include $2.6 million of net receivables from
      the discontinued operations. Any changes to the realization of this amount
      in future periods will be reflected in discontinued operations.  We use
      historical experience, market trends and other analytical data to estimate
      our
      allowance for doubtful accounts. Based upon these factors, the reserve at
      December 31, 2005 is considered adequate. Although we believe that the reserve
      estimate is reasonable, actual results could differ from our estimate, and
      such
      differences could be material. If the estimate is too low, we may incur higher
      bad debt expenses in the future resulting in lower net income or higher net
      losses. If the estimate is too high, we may experience lower bad debt expense
      in
      the future resulting in higher net income or lower net losses.





**Inventories**





Inventories
      consist of pharmaceuticals and other retail merchandise owned by us. Inventories
      are stated at the lower of cost (first-in, first-out method for pharmaceutical
      inventory and retail method for retail merchandise inventory) or market.
      Physical inventory counts are taken on a regular basis in each location to
      ensure that the amounts reflected in the consolidated financial statements
      are
      properly stated. We use historical data to estimate our inventory loss reserves
      and we have not made any material changes in the accounting methodology used
      to
      establish our inventory loss reserves during the past three years. If the
      estimate of inventory losses is too low we may incur higher cost of sales in
      the
      future resulting in lower net income or higher net losses. If the estimate
      of
      inventory losses incurred is too high, we may experience lower cost of sales
      in
      the future resulting in higher net income or lower net losses. Inventories
      as of
      December 31, 2005 and January 1, 2005 were approximately $30.6 million and
      $34.5
      million, respectively, net of approximately $2.1 million and $0.9 million of
      inventory loss reserves, respectively. Net inventories at December 31, 2005
      include $3.3 million of net inventories from the discontinued operations. Any
      changes to the realization of this amount in future periods will be reflected
      in
      discontinued operations.





***New
      Accounting Pronouncements***




In
      December 2004, SFAS No. 123(R), “Share-Based Payment,” was issued. This
      statement establishes standards for the accounting for transactions in which
      an
      entity exchanges its equity instruments for goods or services. The statement
      focuses primarily on accounting for transactions in which an entity obtains
      employee services in share-based payment transactions. The provisions of this
      statement are required to be adopted as of January 1, 2006. The Company is
      currently evaluating the potential impact as the amount is subject to variation
      based on the granting of stock compensation during 2006. Any
      changes to the realization of this amount in future periods will be reflected
      in
      discontinued operations.




28


***Impact
      of Inflation and Changing Prices***





The
      consolidated financial statements and related data presented in this Form 10-K
      have been prepared in conformity with accounting principles generally accepted
      in the United States of America, which require the measurement of financial
      position and operating results in terms of historical dollars, without
      considering changes in the relative purchasing power of money over time due
      to
      inflation. We believe that inflation has not had a material impact on our
      results of operations during the three years ended December 31, 2005.





**Item
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.**





As
      of
      December 31, 2005, $36.3 million and $10.9 million were outstanding on our
      revolving credit facility and Subordinated Note, respectively. These borrowings
      are at a variable rate of interest. Assuming $47.2 million was outstanding
      for a
      full year, a 1% change in interest rates would change our interest expense
      by
      $0.5 million annually.





We
      do not
      currently utilize derivative financial instruments to address market risk.




29


**Item
      8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA**


**DRUGMAX,
      INC. AND SUBSIDIARIES**




**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**Page**REPORT
                  OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
              31CONSOLIDATED
                  FINANCIAL STATEMENTS:Consolidated
                  Balance Sheets as of December 31, 2005 and January 1, 2005
              32Consolidated
                  Statements of Operations for the Fiscal Years Ended December 31,
                  2005,
                  January 1, 2005 and December 27, 2003
              33Consolidated
                  Statements of Changes in Stockholders’ (Deficit) Equity for the Fiscal
                  Years Ended December 31, 2005, January 1, 2005 and December 27,
                  2003
              34Consolidated
                  Statements of Cash Flows for the Fiscal Years Ended December 31,
                  2005,
                  January 1, 2005 and December 27, 2003
              35Notes
                  to Consolidated Financial Statements
              36




30


REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To
      the
      Board of Directors and Stockholders of


DrugMax,
      Inc.


Farmington,
      Connecticut




We
      have
      audited the accompanying consolidated balance sheets of DrugMax, Inc. and
      subsidiaries (the “Company”) as of December 31, 2005 and January 1, 2005, and
      the related consolidated statements of operations, stockholders' (deficit)
      equity, and cash flows for each of the three years in the period ended December
      31, 2005.  Our audits also included the financial statement schedule listed
      in the Index at Item 15. These consolidated financial statements and financial
      statement schedule are the responsibility of the Company's management.  Our
      responsibility is to express an opinion on these financial statements and
      financial statement schedule based on our audits.




We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States).  Those standards require that
      we plan and perform the audit to obtain reasonable assurance about whether
      the
      financial statements are free of material misstatement.  The Company is not
      required to have, nor were we engaged to perform, an audit of its internal
      control over financial reporting.  Our audits included consideration of
      internal control over financial reporting as a basis for designing audit
      procedures that are appropriate in the circumstances, but not for the purpose
      of
      expressing an opinion on the effectiveness of the Company's internal control
      over financial reporting.  Accordingly, we express no such
      opinion *.* An
      audit also includes examining, on a test basis, evidence supporting the amounts
      and disclosures in the financial statements, assessing the accounting principles
      used and significant estimates made by management, as well as evaluating the
      overall financial statement presentation.  We believe that our audits
      provide a reasonable basis for our opinion.




In
      our
      opinion, such consolidated financial statements present fairly, in all material
      respects, the financial position of DrugMax, Inc. and subsidiaries as of
      December 31, 2005 and January 1, 2005, and the results of their operations
      and
      their cash flows for each of the three years in the period ended December 31,
      2005, in conformity with accounting principles generally accepted in the United
      States of America. Also in our opinion, such financial statement schedule,
      when
      considered in relation to the basic consolidated financial statements taken
      as a
      whole, presents fairly, in all material respects, the information set forth
      therein.




The
      accompanying financial statements have been prepared assuming that the Company
      will continue as a going concern. As discussed in Note 1 to the consolidated
      financial statements, the Company's recurring losses from operations and
      stockholders' deficit raise substantial doubt about its ability to continue
      as a
      going concern.  Management's plans concerning these matters are also
      described in Note 1.  The financial statements do not include any
      adjustments that might result from the outcome of this uncertainty.





*/s/* Deloitte
      & Touche LLP


Hartford,
      Connecticut


March
      31,
      2006




31




**DRUGMAX,
      INC. AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**


December
      31, 2005 AND January 1,
      2005





**ASSETS**
              
              
              **December
                  31, 2005**
              
              
              **January
                  1, 2005**CURRENT
                  ASSETS:Cash
                  and cash equivalents
              
              $
              6,681,504
              
              $
              2,331,552Trade
                  receivables, net of allowance for doubtful accounts of $2,777,000
                  and
                  $3,897,000 in 2005 and 2004, respectively
              
              
              12,854,946
              
              
              20,570,053Inventories
              
              
              30,631,262
              
              
              34,525,247Prepaid
                  expenses and other current assets
              
              
              2,486,975
              
              
              1,965,515Total
                  current assets
              
              
              52,654,686
              
              
              59,392,367PROPERTY
                  AND EQUIPMENT—Net of accumulated depreciation and amortization of
                  $13,080,000 and $11,707,000 in 2005 and 2004, respectively
              
              
              4,958,854
              
              
              5,250,684GOODWILL
              
              
              1,354,602
              
              
              19,813,080OTHER
                  INTANGIBLE ASSETS—Net of accumulated amortization of $17,675,000 and
                  $15,350,000 in 2005 and 2004, respectively
              
              
              4,851,758
              
              
              10,570,061OTHER
                  NONCURRENT ASSETS
              
              
              206,697
              
              
              571,874TOTAL
              
              $
              64,026,597
              
              $
              95,598,066**LIABILITIES
                  AND STOCKHOLDERS’ EQUITY**CURRENT
                  LIABILITIES:Revolving
                  credit facility
              
              $
              36,251,510
              
              $
              32,870,787Promissory
                  notes payable
              
              
              915,137
              
              
              2,284,212Current
                  portion of obligations under capital leases
              
              
              -
              
              
              30,092Accounts
                  payable
              
              
              9,013,851
              
              
              26,132,491Accrued
                  expenses
              
              
              6,099,650
              
              
              5,949,342Current
                  portion of notes payable
              
              
              4,721,052
              
              
              -Total
                  current liabilities
              
              
              57,001,200
              
              
              67,266,924LONG-TERM
                  ACCOUNTS PAYABLE
              
              
              -
              
              
              22,425,000NOTES
                  PAYABLE
              
              
              18,184,502
              
              
              -OTHER
                  LONG-TERM LIABILITIES
              
              
              134,543
              
              
              50,854COMMITMENTS
                  AND CONTINGENCIESSTOCKHOLDERS’
                  (DEFICIT) EQUITY:Common
                  stock, $.001 par value, 200,000,000 and 45,000,000 shares authorized;
                  65,740,436 and 19,483,674 shares issued and outstanding for 2005
                  and 2004,
                  respectively
              
              
              65,741
              
              
              19,484Additional
                  paid in capital
              
              
              227,336,126
              
              
              175,499,012DrugMax
                  Series A Convertible Preferred Stock, $1,000 par value, 5,000,000
                  shares
                  authorized; none and 17,000 shares issued and outstanding for 2005
                  and
                  2004, respectively (involuntary liquidation value $17,000,000 in
                  2005)
              
              
              -
              
              
              14,026,902Accumulated
                  deficit
              
              
              (238,131,059
              )
              
              (177,841,211
              )Unearned
                  compensation
              
              
              (564,455
              )
              
              (5,848,899
              )Total
                  stockholders’ (deficit) equity
              
              
              (11,293,648
              )
              
              5,855,288TOTAL
              
              $
              64,026,597
              
              $
              95,598,066
  See
      notes
      to consolidated financial statements.




32


**DRUGMAX,
      INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**Fiscal
      Years ended December 31, 2005, January 1, 2005 and December 27,
      2003**


**Fiscal
                  Years Ended****December
                  31, 2005**
              
              
              **January
                  1, 2005**
              
              
              **December
                  27, 2003**NET
                  REVENUES
              
              $
              216,103,329
              
              $
              223,961,722
              
              $
              218,015,047COST
                  OF SALES
              
              
              173,667,969
              
              
              177,347,845
              
              
              170,597,432Gross
                  margin
              
              
              42,435,360
              
              
              46,613,877
              
              
              47,417,615SELLING,
                  GENERAL AND ADMINISTRATIVE EXPENSES
              
              
              54,291,588
              
              
              46,202,013
              
              
              47,492,008DEPRECIATION
                  AND AMORTIZATION EXPENSE
              
              
              4,412,541
              
              
              4,758,024
              
              
              5,297,625IMPAIRMENT
                  OF LONG -LIVED ASSETS
              
              
              -
              
              
              259,779
              
              
              791,653LOSS
                  (GAIN) ON DISPOSAL OF FIXED ASSETS AND INTANGIBLE ASSETS
              
              
              158,842
              
              
              (1,026,814
              )
              
              (365,382
              )OPERATING
                  LOSS
              
              
              (16,427,611
              )
              
              (3,579,125
              )
              
              (5,798,289
              )OTHER
                  (EXPENSE) INCOME :Interest
                  expense
              
              
              (5,900,547
              )
              
              (5,653,512
              )
              
              (7,199,746
              )Interest
                  income
              
              
              84,430
              
              
              43,084
              
              
              69,966Other
                  income
              
              
              391,433
              
              
              604,788
              
              
              753,954Total
                  other expense, net
              
              
              (5,424,684
              )
              
              (5,005,640
              )
              
              (6,375,826
              )LOSS
                  FROM CONTINUING OPERATIONS
              
              
              (21,852,295
              )
              
              (8,584,765
              )
              
              (12,174,115
              )LOSS
                  FROM DISCONTINUED OPERATIONS
              
              
              (33,005,023
              )
              
              (31,259,313
              )
              
              -NET
                  LOSS
              
              
              (54,857,318
              )
              
              (39,844,078
              )
              
              (12,174,115
              )FMG
                  Redeemable Preferred Stock Dividends
              
              
              -
              
              
              (10,665,274
              )
              
              (5,657,232
              )DrugMax
                  Preferred Stock Dividends
              
              
              (4,300,682
              )
              
              (130,375
              )
              
              -NET
                  LOSS AVAILABLE TO COMMON STOCKHOLDERS
              
              $
              (59,158,000
              )
              $
              (50,639,727
              )
              $
              (17,831,347
              )BASIC
                  AND DILUTED LOSS PER SHARE:Loss
                  from continuing operations available to common
                  shareholders
              
              $
              (0.84
              )
              $
              (5.19
              )
              $
              (13.83
              )Loss
                  from discontinued operations
              
              
              (1.06
              )
              
              (8.38
              )
              
              -Net
                  loss available to common stockholders
              
              $
              (1.90
              )
              $
              (13.57
              )
              $
              (13.83
              )WEIGHTED
                  AVERAGE SHARES OUTSTANDING:Basic
                  and Diluted Shares
              
              
              31,138,817
              
              
              3,731,494
              
              
              1,288,909


See
      notes
      to consolidated financial statements.




33
 
  **DRUGMAX,
        INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS' (DEFICIT)
      EQUITY**


**FISCAL
      YEARS ENDED December 31, 2005, January 1, 2005 and December 27,
      2003**





**Common
                  Stock**
              **DrugMax
                  Series A Convertible Preferred Stock**
              
              **Accumulated
                  Deficit**
              
              
              **Unearned
                  Compensation**
              
              
              **Total
                  Stockholders' (Deficit) Equity****Shares**
              
              
              **Amount**
              
              
              **Additional
                  Paid in Capital**
              
              
              **Shares**
              
              
              **Amount**BALANCE—December
                  28, 2002
              
              
              1,288,909
              
              $
              1,289
              
              $
              15,107,065
              
              
              -
              
              $
              -
              
              $
              (131,342,182
              )
              $
              -
              
              $
              (116,233,828
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (12,174,115
              )
              
              -
              
              
              (12,174,115
              )Dividends
                  accrued and accretion of issuance costs on Series A, B, D and E
                  Redeemable
                  Convertible Preferred Stock
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (5,657,232
              )
              
              -
              
              
              (5,657,232
              )Stock
                  compensation
              
              
              -
              
              
              -
              
              
              176,914
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              176,914BALANCE—December
                  27, 2003
              
              
              1,288,909
              
              
              1,289
              
              
              15,283,979
              
              
              -
              
              
              -
              
              
              (149,173,529
              )
              
              -
              
              
              (133,888,261
              )Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (39,844,078
              )
              
              -
              
              
              (39,844,078
              )Dividends
                  accrued and accretion of issuance costs on FMG Series A, B, D and
                  E
                  Redeemable Convertible Preferred Stock through Merger date
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (5,185,796
              )
              
              -
              
              
              (5,185,796
              )Stock
                  compensation related to vesting and exercise of FMG stock
                  options
              
              
              524,652
              
              
              525
              
              
              7,347
              
              
              -
              
              
              -
              
              
              -
              
              
              (7,872
              )
              
              -Dilution
                  of common shares
              
              
              (1,813,559
              )
              
              (1,814
              )
              
              (15,291,326
              )
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (15,293,140
              )Conversion
                  of FMG notes payable, including accrued interest, into DrugMax
                  common
                  stock
              
              
              2,106,982
              
              
              2,107
              
              
              7,997,893
              
              
              -
              
              
              -
              
              
              (54,357
              )
              
              -
              
              
              7,945,643Conversion
                  of certain FMG Redeemable Preferred Stock to DrugMax common stock
                  and
                  reversal of accrued dividends not converted
              
              
              8,363,525
              
              
              8,364
              
              
              106,291,222
              
              
              -
              
              
              -
              
              
              22,026,402
              
              
              -
              
              
              128,325,988Issuance
                  of warrants to note holders in connection with the Merger
              
              
              -
              
              
              -
              
              
              1,655,289
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,655,289Dividends
                  related to warrants issued to former FMG preferred shareholders
                  in
                  connection with the Merger
              
              
              -
              
              
              -
              
              
              5,479,478
              
              
              -
              
              
              -
              
              
              (5,479,478
              )
              
              -
              
              
              -Issuance
                  of common stock in connection with the Merger
              
              
              8,196,652
              
              
              8,197
              
              
              44,549,858
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              44,558,055Granting
                  of restricted stock and stock options in connection with the
                  Merger
              
              
              656,047
              
              
              656
              
              
              7,186,199
              
              
              -
              
              
              -
              
              
              -
              
              
              (7,186,855
              )
              
              -Exercise
                  of stock options
              
              
              160,466
              
              
              160
              
              
              295,642
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              295,802Other
                  stock compensation
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,345,828
              
              
              1,345,828Issuance
                  of warrants in connection with promissory notes
              
              
              -
              
              
              -
              
              
              170,973
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              170,973Issuance
                  of Series A Convertible Preferred Stock
              
              
              -
              
              
              -
              
              
              -
              
              
              17,000
              
              
              15,868,152
              
              
              -
              
              
              -
              
              
              15,868,152Issuance
                  of warrants in connection with Series A Convertible Preferred
                  Stock
              
              
              -
              
              
              -
              
              
              1,872,458
              
              
              -
              
              
              (1,872,458
              )
              
              -
              
              
              -
              
              
              -Dividends
                  accrued on DrugMax Series A Convertible Preferred Stock
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              31,208
              
              
              (130,375
              )
              
              -
              
              
              (99,167
              )BALANCE—January
                  1, 2005
              
              
              19,483,674
              
              
              19,484
              
              
              175,499,012
              
              
              17,000
              
              
              14,026,902
              
              
              (177,841,211
              )
              
              (5,848,899
              )
              
              5,855,288Net
                  loss
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (54,857,318
              )
              
              -
              
              
              (54,857,318
              )Issuance
                  of warrants to former FMG shareholders and note holders
              
              
              -
              
              
              -
              
              
              45,426
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              45,426Modifications
                  of options to DrugMax employees and directors
              
              
              -
              
              
              -
              
              
              59,000
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              59,000Exercise
                  of stock options
              
              
              332,360
              
              
              331
              
              
              527,429
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              527,760Restricted
                  stock issued to DrugMax employees and directors
              
              
              516,048
              
              
              516
              
              
              833,418
              
              
              -
              
              
              -
              
              
              -
              
              
              (833,934
              )
              
              -Forfeited
                  Merger-related restricted stock
              
              
              (15,250
              )
              
              (15
              )
              
              (56,410
              )
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              (56,425
              )Stock
                  compensation expense
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              6,118,378
              
              
              6,118,378Amortization
                  of DrugMax Series A Convertible Preferred Stock discount
              
              
              -
              
              
              -
              
              
              656,333
              
              
              -
              
              
              1,560,378
              
              
              (2,216,711
              )
              
              -
              
              
              -Dividends
                  on DrugMax Series A Convertible Preferred Stock
              
              
              606,587
              
              
              607
              
              
              1,000,976
              
              
              -
              
              
              280,872
              
              
              (1,239,611
              )
              
              -
              
              
              42,844Convertible
                  note interest payments made in common stock
              
              
              235,516
              
              
              236
              
              
              596,986
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              597,222Proceeds
                  from sale of common stock, net of $3,730,000 in costs
              
              
              44,093,432
              
              
              44,094
              
              
              47,330,084
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              47,374,178Redemption
                  of Preferred A Stock for cash and shares of DrugMax common
                  stock
              
              
              488,069
              
              
              488
              
              
              843,872
              
              
              (17,000
              )
              
              (15,868,152
              )
              
              (1,976,208
              )
              
              -
              
              
              (17,000,000
              )BALANCE—December
                  31, 2005
              
              
              65,740,436
              
              $
              65,741
              
              $
              227,336,126
              
              
              -
              
              $
              -
              
              $
              (238,131,059
              )
              $
              (564,455
              )
              $
              (11,293,648
              )




See
      notes
      to consolidated financial statements.





34




**DRUGMAX,
        INC. AND SUBSIDIARIES**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **FISCAL
        YEARS ENDED December 31, 2005, January 1, 2005 and December 27, 2003**
 **Fiscal
                    Years Ended****December
                    31, 2005**
                
                
                **January
                    1, 2005**
                
                
                **December
                    27, 2003**CASH
                    FLOWS FROM OPERATING ACTIVITIES:Net
                    loss
                
                $
                (54,857,318
                )
                
                (39,844,078
                )
                $
                (12,174,115
                )Adjustments
                    to reconcile net loss to net cash (used in) provided by operating
                    activities:Depreciation
                    and amortization
                
                
                4,412,541
                
                
                4,758,024
                
                
                5,297,625Stock
                    compensation expense
                
                
                6,118,378
                
                
                1,345,828
                
                
                176,914Noncash
                    interest expense
                
                
                1,008,045
                
                
                1,664,788
                
                
                4,280,000Impairments
                    of long-lived assets
                
                
                22,617,000
                
                
                31,259,794
                
                
                791,653Amortization
                    of deferred financing costs
                
                
                257,420
                
                
                288,000
                
                
                377,796Provision
                    for doubtful accounts
                
                
                1,275,190
                
                
                341,995
                
                
                615,465Loss
                    (gain) on disposal of fixed assets and intangible assets
                
                
                158,842
                
                
                (1,026,814
                )
                
                (365,382
                )Effect
                    of changes in operating assets and liabilities:Trade
                    receivables
                
                
                6,439,917
                
                
                (241,373
                )
                
                (318,883
                )Inventories
                
                
                3,893,985
                
                
                (2,099,728
                )
                
                188,046Prepaid
                    expenses and other current assets
                
                
                (926,460
                )
                
                (1,969,768
                )
                
                (118,788
                )Accounts
                    payable
                
                
                (16,543,640
                )
                
                3,528,796
                
                
                404,826Accrued
                    expenses
                
                
                (652,638
                )
                
                1,984,111
                
                
                (500,126
                )Other
                
                
                448,866
                
                
                403,461
                
                
                615,977Net
                    cash (used in) provided by operating activities
                
                
                (26,349,872
                )
                
                393,036
                
                
                (728,992
                )CASH
                    FLOWS FROM INVESTING ACTIVITIES:Purchases
                    of property and equipment, net
                
                
                (1,746,642
                )
                
                (1,135,588
                )
                
                (1,336,906
                )Proceeds
                    from sale of drug distribution operations
                
                
                405,000
                
                
                -
                
                
                -Proceeds
                    from sale of prescription files, net
                
                
                150,000
                
                
                1,103,487
                
                
                420,361Payments
                    for intangible assets
                
                
                -
                
                
                -
                
                
                (213,161
                )Net
                    cash used in investing activities
                
                
                (1,191,642
                )
                
                (32,101
                )
                
                (1,129,706
                )CASH
                    FLOWS FROM FINANCING ACTIVITIES:Proceeds
                    from sale of common stock, net of $3,730,000 in expense
                
                
                47,374,178
                
                
                -
                
                
                -Proceeds
                    (repayment) on revolving credit facility, net
                
                
                3,380,723
                
                
                (8,530,048
                )
                
                (995,306
                )Net
                    proceeds from Series A Convertible Preferred Stock
                
                
                -
                
                
                15,868,152
                
                
                -Repayment
                    of Series A Convertible Preferred Stock
                
                
                (17,000,000
                )
                
                -
                
                
                -Repayment
                    of term loan
                
                
                -
                
                
                (4,000,000
                )
                
                -Proceeds
                    from convertible subordinated notes
                
                
                -
                
                
                -
                
                
                4,000,000Repayment
                    of promissory notes payable
                
                
                (1,369,075
                )
                
                (2,334,478
                )
                
                (181,310
                )Repayment
                    of notes payable
                
                
                (575,000
                )
                
                -Repayment
                    of obligations under capital leases
                
                
                (30,092
                )
                
                (44,051
                )
                
                (193,720
                )Payment
                    of deferred financing costs
                
                
                (417,028
                )
                
                (591,854
                )
                
                (96,401
                )Proceeds
                    from exercise of stock options
                
                
                527,760
                
                
                295,802
                
                
                -Net
                    cash provided by financing activities
                
                
                31,891,465
                
                
                663,523
                
                
                2,533,263NET
                    INCREASE IN CASH AND CASH EQUIVALENTS
                
                
                4,349,952
                
                
                1,024,458
                
                
                674,565CASH
                    AND CASH EQUIVALENTS—Beginning of fiscal year
                
                
                2,331,552
                
                
                1,307,094
                
                
                632,529CASH
                    AND CASH EQUIVALENTS—End of fiscal year
                
                $
                6,681,504
                
                $
                2,331,552
                
                $
                1,307,094SUPPLEMENTAL
                    DISCLOSURES OF CASH FLOW INFORMATION:Cash
                    paid for interest
                
                $
                4,892,502
                
                $
                3,700,814
                
                $
                2,541,950Noncash
                    transactions—Payment
                    of DrugMax Series A preferred stock dividends in common stock
                
                $
                1,001,583
                
                $
                -
                
                $
                -Subordinated
                    Convertible Debenture interest payments made in common stock
                
                $
                597,222
                
                $
                -
                
                $
                -Increase
                    in Subordinated Convertible Debenture due to deemed payment
                    shortfall
                
                $
                480,554
                
                $
                -
                
                $
                -Note
                    receivable from sale of drug distribution operations
                
                $
                250,000
                
                $
                -
                
                $
                -Conversion
                    of accounts payable to subordinated notes payable
                
                $
                23,000,000
                
                $
                -
                
                $
                -Conversion
                    of notes payable and accrued interest into DrugMax Common
                    Stock
                
                $
                -
                
                $
                7,945,643
                
                $
                -Exercise
                    of FMG Series E Preferred Stock warrants into FMG Series E Preferred
                    Stock
                
                $
                -
                
                $
                4,000,000
                
                $
                -Issuance
                    of DrugMax common shares in connection with Merger
                
                $
                -
                
                $
                44,558,055
                
                $
                -Dividends
                    relating to warrants issued to FMG preferred shareholders
                
                $
                -
                
                $
                5,479,478
                
                $
                -Interest
                    expense relating to warrants issued to note holders
                
                $
                -
                
                $
                1,655,289
                
                $
                -Issuance
                    of warrants to promissory note holders
                
                $
                -
                
                $
                170,973
                
                $
                -Issuance
                    of warrants to Series A Convertible Preferred Stockholders
                
                $
                -
                
                $
                1,872,458
                
                $
                -
  See
          notes
          to consolidated financial statements.




35




**DRUGMAX,
      INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - FISCAL YEARS ENDED DECEMBER 31, 2005,**


**JANUARY
      1, 2005 AND DECEMBER 27, 2003**




**1.**
            **MERGER,
                DISCONTINUED OPERATIONS AND GOING
                CONCERN**





***Merger*** —On
      March
      19, 2004, Familymeds Group, Inc. (“FMG”) entered into an Agreement and Plan of
      Merger which was amended on July 1, 2004 and on October 11, 2004 (as amended,
      the “Merger Agreement”) with DrugMax, Inc. (“DrugMax”). Under the terms of the
      Merger Agreement, on November 12, 2004, FMG merged into DrugMax, and DrugMax
      became the surviving corporation in the merger (the “Merger”). The Merger was
      treated as a purchase of DrugMax by FMG for accounting purposes. Accordingly,
      for periods prior to the Merger, the information contained herein is the
      historical information of FMG.




The
      results of operations of DrugMax have been included in the Company’s
      consolidated statements of operations (primarily in discontinued operations
      as
      described below) since the date of acquisition. The excess of the purchase
      price
      over the estimated fair values of the underlying assets acquired and liabilities
      assumed of $50.8 million was allocated to goodwill. The allocation of the
      purchase price was finalized during the nine months ended October 1, 2005
      resulting in an increase of $963,523 in goodwill. In connection with the Merger,
      the Company terminated certain DrugMax employees. Included in a restructuring
      liability as of the Merger date was a severance obligation of approximately
      $966,000. The total amount of the severance obligation was reduced during 2005
      to $756,479, $613,000 of which had been paid as of December 31, 2005.
      Additionally, an accrued lease liability of $85,000 was recorded related to
      an
      office location that is no longer used by the Company.




The
      purchase price of approximately $44.6 million represents the fair value ($37.8
      million) of the shares of DrugMax common stock retained by the existing common
      stockholders of DrugMax, Inc., the value ($5.2 million) of outstanding DrugMax
      options which vested in connection with the Merger and $1.6 million of Merger
      costs.




In
      the
      Merger, the shareholders of FMG (along with certain FMG warrant holders and
      note
      holders) received an aggregate of 10,470,507 shares of the Company’s common
      stock along with warrants to purchase an additional 3,500,090 shares of the
      Company’s common stock. The exercise price of the warrants is $2.61 per share.
      In addition, in connection with the Merger, the Company issued an aggregate
      of
      656,047 shares of restricted common stock, along with options to purchase an
      additional 1,574,369 shares of common stock, to certain employees and directors
      of FMG who agreed to continue providing services post-Merger. The exercise
      price
      of the stock options is $0.57 per share. The noncash compensation charge
      recorded during the fiscal year ended December 31, 2005 and January 1, 2005
      relating to the restricted stock and stock options related to the Merger was
      $5,792,000 and $1,346,000, respectively, which was based on the provisions
      of
      the restricted stock and stock option agreements. During the fiscal year ended
      December 31, 2005, an additional 38,200 warrants were issued to former FMG
      shareholders. These additional warrants were valued at $45,426 which was
      reflected as an adjustment to goodwill during the fiscal year ended December
      31,
      2005.





***Discontinued
      Operations*** -
      In
      September 2005, Hurricane Katrina resulted in the temporary closure of the
      warehouse facility located in St. Rose, Louisiana. The Company maintains
      insurance coverage, which provides for reimbursement from losses resulting
      from
      property damage, loss of product and losses from business interruption. The
      Company estimates approximately $0.2 million of inventory was damaged during
      the
      hurricane and incurred approximately $0.8 million of incremental costs related
      to closing the facility and relocating the inventory and operations to the
      Company’s New Castle facility. Additionally, provisions for bad debts of $0.5
      million were recorded related to estimated losses resulting from customers
      whose
      businesses were affected by the hurricane and the related unamortized customer
      list asset of $0.5 million was also written off. These costs were expensed
      and
      included in loss from discontinued operations in the consolidated statement
      of
      operations for the year ended December 31, 2005. The Company is attempting
      to
      recover these costs through insurance claims. No amounts have been recorded
      related to the expected recovery from insurance.





During
      the third quarter of 2005, the Company determined that it would sell certain
      assets of its wholesale drug distribution business and discontinue a significant
      portion of the operations for the year ended December 31, 2005 conducted out
      of
      the New Castle, Pennsylvania facility. The Company will continue to purchase
      pharmaceuticals utilizing the authorized distributor agreements and distribute
      pharmaceuticals directly to physicians, medical clinics and other health care
      providers from the St. Rose, Louisiana facility. Revenues for this portion
      of
      the drug distribution operations were $2,345,000 for the year ended December
      31,
      2005 and are included in continuing operations.




In
      December 2005, Rochester Drug Cooperative (“RDC”) acquired certain assets from
      the Company’s wholly-owned subsidiary, Valley Drug Company, including a customer
      list, furniture, fixtures and equipment located at the Company’s New Castle,
      Pennsylvania facility. In connection with the sale, RDC assumed certain property
      leases, customer and other miscellaneous contracts. The total purchase price
      for
      these select assets was $655,000, of which $405,000 was received upon closing
      and $250,000 is required to be paid if and when the Pennsylvania Industrial
      Development Authority (“PIDA”) consents to a lease assignment of the New Castle
      facility to RDC. The Company expects payment of the $250,000 during the second
      quarter of 2006.




In
      addition, RDC agreed to assist with the collection of customer accounts
      receivable associated with the purchased customer list. Further, the Company
      transferred a portion of the New Castle, Pennsylvania pharmaceutical inventory
      to the Company’s retail pharmacies as well as a portion to its St. Rose,
      Louisiana facility for continued distribution to the Company’s retail pharmacies
      and for utilization in the remaining distribution business related to the
      distribution of pharmaceuticals directly to physicians and medical clinics.
      Total estimated inventory transferred to the pharmacies and St. Rose facility
      was approximately $7.2 million after a reserve of $1.4 million, primarily
      related to the inventory transferred to the St. Rose Facility, recorded in
      connection with the inventory transferred and is included in discontinued
      operations. Proceeds from the RDC transaction as well as amounts realized from
      the collection of accounts receivable and the sale of inventory were used to
      decrease the Company’s borrowings under its credit facility with Wells Fargo
      Retail Finance, LLC.




In
      connection with the sale of these assets, the Company and its landlord, Becan
      Development LLC, agreed to amend the lease for the New Castle, Pennsylvania
      facility. The amendment provides that the term of the lease be reduced to five
      years, commencing December 21, 2005, with two additional five-year options
      available for renewal, and provides for an option to purchase the premises
      from the landlord. RDC has agreed to enter into a lease assignment and
      assumption agreement for the amended New Castle lease contingent upon the
      Company and the landlord securing the necessary consents from the PIDA to such
      assignment. Until such time as the consents are obtained, the parties have
      agreed to operate under a sublease agreement. The Company’s total obligation
      under the amended lease is approximately $200,000 annually.





36


Further,
      as part of the discontinuance of substantially all of the drug distribution
      business, the Company recorded a goodwill impairment charge of $19.4 million
      during the year ended December 31, 2005. The Company also recorded a goodwill
      impairment charge of $31.0 million during the year ended January 1, 2005. As
      of
      December 31, 2005, remaining goodwill was $1.4 million.





Net
      revenues related to the discontinued operations were $103.6 million and $15.3
      million for the fiscal year ended December 31, 2005 and for the period November
      12, 2004 (the Merger date) to January 1, 2005, respectively. The loss from
      discontinued operations of $33.0 million and $31.3 million for the fiscal year
      ended December 31, 2005 and for the period November 12, 2004 (the Merger date)
      to January 1, 2005, respectively, represents the loss from operations of the
      discontinued operations of $5.7 million and $0.3 million, respectively and
      loss
      on disposal of the discontinued operations of $27.3 million and $31.0 million,
      respectively. The loss on disposal of discontinued operations includes goodwill
      and other intangible asset
      impairments (trademarks and customer list) of $2 2.6
      million and $31.0 million and other exit losses primarily representing estimated
      losses on accounts receivable, inventory and vendor chargebacks of $4.7 million
      and $0 million, for fiscal years ended December 31, 2005 and January 1, 2005,
      respectively.




***Going
        Concern***— The
        accompanying consolidated financial statements have been prepared assuming
        that
        the Company will continue as a going concern. As of December 31, 2005, the
        Company had a net stockholders' deficit of $11.3 million and has incurred
        net
        losses of $54.9 million, $39.8 million and $12.2 million for the years ended
        December 31, 2005, January 1, 2005 and December 27, 2003 .
        These
        matters raise substantial doubt about the Company's ability to continue as
        a
        going concern. During the fourth quarter of 2005, the Company completed certain
        transactions considered to be critical to achieving future growth and
        profitability. These include the sale of common stock for net proceeds of
        $47.4
        million, the refinancing of the senior credit facility with a new $65.0 million
        facility, which allows for additional borrowing availability, and the sale
        and
        discontinuation of substantially all of the Company’s distribution operations,
        which had incurred significant losses. Management believes that these
        transactions as well as other organizational and operational changes will
        allow
        the Company to continue as a going concern.





**2.**
            **BUSINESS
                AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





***Business*** —
As
      of
      December 31, 2005, the Company operated 77 pharmacies, including one home health
      center and one non-pharmacy mail order center, in 14 states under the Arrow
      Pharmacy & Nutrition Center, Familymeds Pharmacy, and Worksite
      Pharmacy SM brand
      names.





Prior
      to
      the Merger, the Company operated two drug distribution facilities under the
      Valley Drug Company and Valley Drug Company South names. During the third
      quarter of 2005, the Company determined that it would sell certain assets of
      the
      drug distribution business and eliminate operations conducted out of the New
      Castle, Pennsylvania facility and the St. Rose, Louisiana facility related
      to
      the distribution to independent pharmacies. Accordingly, as of October 1, 2005,
      the Company considered substantially all of the wholesale distribution business
      as discontinued operations for financial statement presentation purposes. In
      December 2005, the Company sold certain assets held by Valley Drug Company
      and
      exited the New Castle, Pennsylvania facility. The Company continues to operate
      a
      portion of the wholesale drug distribution business primarily related to the
      direct distribution of to physicians, medical clinics and other health care
      providers from the St. Rose, Louisiana facility. This facility was temporarily
      closed in September 2005 as a result of Hurricane Katrina and reopened in
      January 2006.





***Fiscal
      Periods*** —The
      Company reports on a 52-53 week fiscal year. Fiscal years 2005 and 2003 include
      52 weeks, while fiscal year 2004 includes 53 weeks.





***Principles
      of Consolidation*** —The
      consolidated financial statements include the accounts of the Company and its
      wholly-owned subsidiaries. All significant intercompany transactions have been
      eliminated in consolidation.





***Use
      of Estimates*** —The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities as of the
      date of the financial statements and the reported amounts of income and expenses
      during the reporting periods. Actual results could differ from those estimates.
      Management’s estimates relate primarily to assigning values and lives to
      intangible assets acquired in connection with the Merger, estimating impairments
      of long-lived assets and estimating the allowance for doubtful accounts and
      inventory reserves.




***Revenue
      Recognition*** —Revenues
      from pharmacy operations are comprised of both pharmacy sales in Company-owned
      locations and royalty revenues from franchised pharmacies. Revenues from
      pharmacy sales, net of contractual allowances from third-party payors, are
      recognized at the time of sale. The Company participates in various third-party
      provider networks and state Medicaid programs. Under a majority of these
      networks, revenue is adjudicated at the time of sale. However, for certain
      third-party providers and state Medicaid programs, revenue is reported at the
      net realizable amount and adjusted in future periods as final settlements are
      determined. Revenues from franchised pharmacies are based on a flat fee per
      location or a percentage of the revenues of the franchised pharmacy and are
      recognized in the period in which revenues are earned. The Company recognizes
      revenues from the mail order and e-commerce operations when products are shipped
      to customers, net of discounts. Revenues for the drug distribution operations
      are recognized when goods are shipped and title or risk of loss resides with
      unaffiliated customers or when services are provided. The Company has no sales
      incentive or rebate programs with its customers. Revenue is recorded net of
      sales returns and allowances.





***Vendor
      Rebates, Allowances and Chargebacks-*** Rebates
      and allowances are recorded as a component of cost of goods sold 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.





***Cash
      and Cash Equivalents*** —The
      Company considers investments with original maturities of three months or less
      to be cash equivalents.





37


***Inventories*** —Inventories
      consist of pharmaceuticals and other retail merchandise. Inventories are stated
      at the lower of cost (first-in, first-out method for pharmaceutical inventory
      and retail method for retail merchandise inventory) or market. Inventories
      are
      monitored for out of date or damaged products. Inventories are recorded net
      of a
      reserve for obsolescence of approximately $2,109,000 and $902,000 at December
      31, 2005 and January 1, 2005, respectively. The drug distribution operations
      accept return of product from its customers for product which is resaleable,
      in
      unopened containers and expires six months or more from the return date.





***Property
      and Equipment*** —Property
      and equipment is stated at cost less accumulated depreciation and amortization.
      Depreciation and amortization are computed using the straight-line method over
      the useful lives of the assets with a mid-month convention being applied to
      the
      first year assets are placed into service. Furniture and fixtures, computer
      equipment and software, excluding website software costs, are depreciated over
      useful lives of five years. Capitalized website software costs are amortized
      over three years. Leasehold improvements and equipment purchased under capital
      leases are amortized over the shorter of the useful life of the asset or the
      lease term. When fixed assets are retired or sold, the asset cost and related
      accumulated depreciation and amortization are eliminated and any resulting
      gain
      or loss is included in the consolidated statements of operations.





***Leases
      and Deferred Rent Payable-*** The
      Company leases pharmacy, distribution, administrative, marketing and customer
      service facilities. Leases are accounted for under the provisions of SFAS No.
      13, *Accounting
      for Leases* ,
      as
      amended, which requires that leases be evaluated and classified as operating
      or
      capital leases for financial reporting purposes. The lease term used for lease
      evaluation includes option periods only in instances in which the exercise
      of
      the option period can be reasonably assured and failure to exercise such options
      would result in an economic penalty.





For
      leases that contain rent escalations, the Company records the total rent payable
      during the lease term, as determined above, on a straight-line basis over the
      term of the lease and records the difference between the rents paid and the
      straight-line rent as a deferred rent payable. As of both December 31, 2005
      and
      January 1, 2005, a liability of approximately $0.1 million was recorded related
      to deferred rent payable.





***Impairment
      of Long-Lived Assets*** —The
      Company reviews long-lived assets, including property plant and equipment and
      intangible assets, to be held and used for impairment whenever events or changes
      in circumstances indicate that the carrying amount of an asset may not be
      recoverable. If the sum of the undiscounted expected future cash flows is less
      than the carrying amount of the related assets, the Company recognizes an
      impairment loss. Impairment losses are measured as the amount by which the
      carrying amount of the assets, including related intangible assets, exceeds
      the
      future cash flows for the assets. For purposes of recognizing and measuring
      impairment of long-lived assets, the Company evaluates assets at the store
      level
      for pharmacy operations. For purposes of measuring goodwill impairment, the
      drug
      distribution operations and pharmacy operations are considered separate
      reporting units.





***Goodwill*** —Goodwill
      represents the excess of acquisition cost over the fair value of the net assets
      acquired as a result of the Merger. Goodwill is not amortized, but is subject
      to
      impairment testing annually, or more frequently if events and circumstances
      indicate there may be impairment. The Company measures impairment based on
      a
      discounted cash flow method and a discount rate determined by management to
      be
      commensurate with the reporting unit risk. The Company completed impairment
      tests for goodwill related to the discontinued drug distribution reporting
      unit
      as of December 31, 2005 and January 1, 2005 and recorded write-downs of
      approximately $19.4 million and $31.3 million, respectively which are included
      in loss from discontinued operations in the accompanying consolidated statements
      of operations (see Note 6).





***Other
      Intangible Assets*** —Prescription
      file intangible assets were recorded at fair value in connection with store
      acquisitions. The Company amortizes prescription files on a straight-line basis
      over an estimated useful life of seven years. Authorized distributor licenses,
      trademarks and patents and a customer list were recorded in connection with
      the
      Merger. Authorized distributor licenses relate to contractual and
      non-contractual relationships with pharmaceutical manufacturers allowing direct
      access to purchase their products. These contracts are amortized on a
      straight-line basis over an estimated life of 15 years. Trademarks and patents
      are amortized on a straight-line basis over their estimated life of 15 years.
      The customer list was amortized on a straight-line basis over an estimated
      life
      of five years. Noncompete agreements relate to agreements with former
      storeowners who sold their pharmacies to the Company. These agreements are
      amortized on a straight-line basis over the lives of the agreements, generally
      two to five years. Royalty rights relate to the purchase of certain franchise
      license agreements and are amortized on a straight-line basis over an estimated
      life of 20 years. During fiscal year 2005, in connection with the discontinued
      operations, the Company recorded impairment charges of $2,700,000 related to
      trademarks and $495,000 related to the customer list.





Deferred
      financing costs are being amortized as interest expense on an effective yield
      basis over the terms of the related debt. Amortization of approximately
      $257,000, $288,000, and $378,000 for the fiscal years ended December 31, 2005,
      January 1, 2005 and December 27, 2003, respectively, was recorded as interest
      expense in the accompanying consolidated statements of operations.





***Store
      Opening and Closing Costs*** —Store
      opening costs are charged directly to expense when incurred, including rent
      expense during construction periods. When the Company makes a decision to close
      a store, the unrecoverable costs, including remaining lease obligations (net
      of
      estimated sublease rental income commencing in fiscal 2003 upon adoption of
      SFAS
      No. 146, *Accounting
      for Costs Associated with Exit or Disposal Activities* ),
      are
      charged to expense. SFAS No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets,* was
      adopted by the Company in fiscal 2003. SFAS No. 144 requires the results of
      operations of a component entity that is classified as held for sale or that
      has
      been disposed of to be reported as discontinued operations in the statement
      of
      operations if certain conditions are met. These conditions include commitment
      to
      a plan of disposal after the effective date of this statement, elimination
      of
      the operations and cash flows of the component entity from the ongoing
      operations of the company and no significant continuing involvement in the
      operations of the component entity after the disposal transaction. The stores
      closed in fiscal 2005 and 2004 did not meet the criteria to be classified as
      discontinued operations under SFAS No. 144.





***Concentration
      of Credit Risk*** —The
      Company’s receivables for the pharmacy operations are principally from
      third-party insurance plans and state Medicaid programs (collectively,
“Third-Party Customers”). The largest individual Third-Party Customer accounted
      for approximately 13%, 12% and 13% of the Company’s net revenues for the years
      ended December 31, 2005, January 1, 2005 and December 27, 2003, respectively.
      There is no other customer that represents over 10% of the Company’s net
      revenues for these periods. Total gross trade receivables for this customer
      were
      $1,843,000, $652,000, and $1,814,000 as of December 31, 2005, January 1, 2005
      and December 27, 2003, respectively.





38


***Advertising*** —Advertising
      costs are charged to expense as incurred and were approximately $1,202,000,
      $1,345,000 and $1,892,000 for the fiscal years ended December 31, 2005, January
      1, 2005 and December 27, 2003 respectively.





***Shipping
      and Handling Costs*** —Outbound
      shipping and handling costs are included in selling, general and administrative
      expenses in the accompanying consolidated statements of operations. Shipping
      and
      handling costs were approximately $1,630,000, $1,341,000 and $1,095,000 for
      the
      fiscal years ended December 31, 2005, January 1, 2005 and December 27, 2003,
      respectively.





***Income
      Taxes*** —The
      Company accounts for income taxes according to the provisions of SFAS No. 109, *Accounting
      for Income Taxes* .
      Under
      the asset and liability method, deferred tax assets and liabilities are
      recognized for the future tax effects attributable to operating loss
      carryforwards and to differences between the financial statement and tax bases
      of assets and liabilities and are measured using the enacted tax rates and
      laws
      that are expected to be in effect when the differences are expected to be
      reversed. Valuation allowances are established for deferred tax assets when
      realization is not likely.





***Per
      Share Information*** —For
      periods prior to the Merger, the weighted average shares outstanding have been
      computed based on the number of shares that former FMG common shareholders
      would
      have received in the transaction, on an as-if converted basis (i.e., if the
      preferred shareholders were converted to common prior to the Merger), had the
      Merger consideration not be distributed to the preferred shareholders based
      on
      liquidation values. Based on the exchange ratio, the FMG common shareholders
      would have received 1,288,909 shares of common stock. For the periods subsequent
      to the Merger, the total outstanding shares are based on actual shares
      outstanding. Potentially dilutive securities were not considered in any period
      presented since the effect would be anti-dilutive.




***Segment*** —The
      Company operated as one business segment for all periods presented.





***Stock-Based
      Compensation*** —The
      Company applies Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (“Opinion 25”), and its related interpretations in accounting for employee stock
      compensation and Emerging Issues Task Force (“EITF”) 96-18, *Accounting
      for Equity Instruments That Are Issued to Other Than Employees for Acquiring,
      or
      in Conjunction with Selling, Goods or Services* ,
      to
      account for options issued to nonemployees. Forfeitures are accounted for in
      the
      period the options are actually forfeited. Had compensation cost for the
      Company’s stock-based compensation plans been determined based on the fair value
      at the grant dates for awards consistent with the method of SFAS No. 123, *Accounting
      for Stock-Based Compensation* ,
      the
      Company’s net loss would have decreased to the pro forma amounts indicated
      below:


**Fiscal
                  Year Ended****December
                  31,**
              
              
              **January
                  1,**
              
              
              **December
                  27,****2005**
              
              
              **2005**
              
              
              **2003**Net
                  loss available to common shareholders, as reported
              
              $
              (59,158,000
              )
              $
              (50,639,727
              )
              $
              (17,831,347
              )Add:
                  Actual stock-based employee compensation expense
              
              
              6,118,378
              
              
              1,345,828
              
              
              176,914Less:
                  Pro forma stock-based employee contribution expense
              
              
              (6,580,111
              )
              
              (1,032,630
              )
              
              (132,238
              )Effect
                  of stock-based employee compensation expense determined under fair
                  method
                  valuation for all awards
              
              
              (461,733
              )
              
              313,198
              
              
              44,676Pro
                  forma net loss available to common shareholders
              
              $
              (59,619,733
              )
              $
              (50,326,529
              )
              $
              (17,786,671
              )Basic
                  and diluted net loss available to common shareholder per
                  share:As
                  reported
              
              $
              (1.90
              )
              $
              (13.57
              )
              $
              (13.83
              )Pro
                  forma
              
              $
              (1.91
              )
              $
              (13.49
              )
              $
              (13.80
              )




39


The
      fair
      value of each option grant has been for SFAS No. 123 purposes on the date of
      grant using the Black Scholes pricing model with the following
      assumptions:





**Fiscal
                Year Ended****December
                31,**
              **2005**
            
            **January 1,**
              **2005**
            
            **December 27,**
              **2003**Risk-free
                interest rate
            
            3.42% - 4.52%
            
            3.54% - 4.22%
            
            2.62% - 5.71%Expected
                life
            
            3 years
            
            3 years
            
            3 yearsVolatility
            
            58%
            
            48%
            
            —  %Dividend
                yield
            
            —  %
            
            —  %
            
            —  %Weighted
                average fair value of each option granted
            
            $1.77
            
            $3.50
            
            $0.67





**3.**
            **NEW
                ACCOUNTING PRONOUNCEMENTS**





In
      December 2004, SFAS No. 123(R), “Share-Based Payment,” was issued. This
      statement establishes standards for the accounting for transactions in which
      an
      entity exchanges its equity instruments for goods or services. The statement
      focuses primarily on accounting for transactions in which an entity obtains
      employee services in share-based payment transactions. The provisions of this
      statement are required to be adopted for annual periods beginning after
      June 15, 2005. The
      Company is currently evaluating the impact as the amount is subject to variation
      based on the granting of stock compensation during 2006 .
      Please
      see Note 7 to the Company’s consolidated financial statements for additional
      information regarding stock-based compensation.




**4.**
            **IMPAIRMENTS
                OF LONG-LIVED ASSETS**





During
      the fiscal years ended December 31, 2005 and January 1, 2005, the Company
      recorded goodwill impairment charges of $19,422,000 and $31,000,000,
      respectively (see Note 6) relating to discontinued operations. In addition,
      during the fiscal year ended December 31, 2005, the Company recorded an
      impairment charge of $3,195,000 related to trademarks for $2,700,000 and the
      customer list for $495,000 associated with the discontinued business. All of
      these charges are included in discontinued operations in the accompanying
      consolidated statements of operations.





During
      the fiscal years ended December 31, 2005, January 1, 2005 and December 27,
      2003,
      the Company approved the closure of one, seven and five underperforming stores,
      respectively, and as a result, the Company recorded impairments of long-lived
      assets of approximately $0, $0 and $182,000, respectively, primarily related
      to
      the prescription file intangible assets and equipment for these locations.
      Additionally, net lease obligations related to these stores of approximately
      $0,
      $179,000 and $180,000 were accrued, respectively and are included in write-downs
      of long-lived assets. During the fiscal years ended December 31, 2005, January
      1, 2005 and December 27, 2003, the Company had favorable settlements on lease
      obligations of approximately $0, $87,000 and $206,000, respectively. Revenues
      for stores closed were $0.8 million, $2.8 million and $1.7 million for the
      fiscal years ended December 31, 2005, January 1, 2005 and December 27, 2003,
      respectively. The operating loss for the stores closed was $0, $0.4 million
      and
      $0 for the fiscal years ended December 31, 2005, January 1, 2005 and December
      27, 2003, respectively. The Company also recorded impairment charges for
      prescription file intangible assets and property and equipment of approximately
      $0, $260,000, and $635,000 relating to underperforming and relocated stores
      during the fiscal years ended December 31, 2005, January 1, 2005, and December
      27, 2003.




40





**5.**
            **PROPERTY
                AND EQUIPMENT**





Property
      and equipment consists of:





**December
                31,**
              **2005**
            
            
            **January
                1,**
              **2005**Computer
                equipment and software
            
            $
            8,983,370
            
            $
            9,015,941Furniture,
                fixtures and equipment
            
            
            4,634,437
            
            
            5,073,425Leasehold
                improvements
            
            
            3,891,510
            
            
            2,692,100Equipment
                under capital lease obligations
            
            
            176,651
            
            
            176,651Construction
                in progress
            
            
            352,970
            
            
            —Total
            
            
            18,038,938
            
            
            16,958,117Less
                accumulated depreciation and amortization
            
            
            (13,080,084
            )
            
            (11,707,433
            )Property
                and equipment, net
            
            $
            4,958,854
            
            $
            5,250,684





Depreciation
      and amortization expense of the Company’s property and equipment was
      approximately $1,800,000, $2,188,000 and $2,270,000 for the fiscal years ended
      December 31, 2005, January 1, 2005 and December 27, 2003, respectively.





**6.**
            **GOODWILL**





Goodwill
      resulted from the Merger. Goodwill was tested for impairment during the fiscal
      years ended December 31, 2005 and January 1, 2005. The fair value of the
      reporting unit was estimated using future cash flows, and non-cash impairment
      charges of $19.4 million and $31.0 million, respectively, were recognized.
      The
      impairments relate to the discontinued operations of the drug distribution
      reporting unit and are included in the loss from discontinued
      operations.





The
      changes in the carrying value of goodwill for the fiscal years ended December
      31, 2005 and January 1, 2005 are as follows:





**Fiscal
                Year Ended**
              **December
                31,**
              **2005**
            
            
            **Fiscal
                Year Ended**
              **January
                1,**
              **2005**Goodwill,
              beginning of fiscal year
            
            $
            19,813,080
            
            $
            —Goodwill
                associated with Merger
            
            
            —
            
            
            50,813,095Adjustments
                to Goodwill:Additional
                contract costs relating to the Merger
            
            
            936,015
            
            
            —Merger
                expenses, including warrants issued to FMG shareholders related to
                the
                Merger
            
            
            131,363
            
            
            —Other
            
            
            (103,856
            )
            
            —Total
                Adjustments to Goodwill
            
            
            963,522
            
            
            —Goodwill
                impairment charge
            
            
            (19,422,000
            )
            
            (31,000,015
            )Goodwill,
                end of fiscal year
            
            $
            1,354,602
            
            $
            19,813,080





The
      Merger required the Company to enter into an agreement with a former officer
      and
      director which requires payments in excess of market value over a three year
      period. The incremental costs of approximately $936,000 over the term of the
      agreement were recorded as goodwill.  The
      remaining goodwill at December 31, 2005 of $1,354,602 is attributable to the
      ongoing business of direct distribution of pharmaceuticals to physicians,
      medical clinics, and other healthcare providers from the St. Rose
      facility.





41





**7.**
            **OTHER
                INTANGIBLE ASSETS**





Other
      intangible assets consist of:





**December
                31, 2005**
            
            
            **January
                1, 2005****Gross**
              **Carrying**
              **Amount**
            
            
            **Accumulated**
              **Amortization**
            
            
            **Gross**
              **Carrying**
              **Amount**
            
            
            **Accumulated**
              **Amortization**Prescription
                files
            
            $
            18,129,274
            
            $
            (16,254,650
            )
            $
            18,135,217
            
            $
            (14,124,284
            )Trademarks
                and copyrights
            
            
            818,127
            
            
            (331,677
            )
            
            3,518,127
            
            
            (102,438
            )Wholesale
                distributor contracts
            
            
            1,800,000
            
            
            (135,000
            )
            
            1,800,000
            
            
            (15,000
            )Noncompete
                agreements
            
            
            883,867
            
            
            (882,772
            )
            
            883,867
            
            
            (874,557
            )Customer
                list
            
            
            —
            
            
            —
            
            
            600,000
            
            
            (15,000
            )Other
            
            
            895,056
            
            
            (70,467
            )
            
            982,558
            
            
            (218,429
            )$
            22,526,324
            
            $
            (17,674,566
            )
            $
            25,919,769
            
            $
            (15,349,708
            )




During
      fiscal year ended December 31, 2005, the Company recorded impairment charges
      of
      $2,700,000 and $495,000 related to trademarks and the customer list,
      respectively, associated with the discontinued operations. These charges are
      included in the loss from discontinued operations in the consolidated statements
      of operations.





The
      weighted average amortization period for intangible assets is approximately
      7.3
      years as of December 31, 2005. Included in the loss from continuing operations
      is amortization expense related to other intangible assets of approximately
      $2,613,000, $2,570,000 and $3,027,000 for the fiscal years ended December 31,
      2005, January 1, 2005 and December 27, 2003, respectively.





Estimated
      future amortization expense for the succeeding five years is as follows:





**Fiscal
              Year Ending**
            
            
            **Amount**2006
            
            $
            1,700,9402007
            
            
            558,8572008
            
            
            447,3702009
            
            
            376,6832010
            
            
            301,147





**8.**
            **DEBT**





Debt
      at
      December 31, 2005 and January1, 2005 consisted of the following:


**December
                  31, 2005**
              
              
              **January
                  1, 2005**Revolving
                  credit facility
              
              $
              36,251,510
              
              $
              32,870,787Promissory
                  notes payable
              
              
              915,137
              
              
              2,284,212Subordinated
                  notes payable (1)
              
              
              22,905,554
              
              
              —Total
              
              $
              60,072,201
              
              $
              35,154,999Long-term
                  accounts payable, including current portion of $575,000(1)
              
              $
              —
              
              $
              23,000,000





*(1)*  *Represents
      accounts payable converted to subordinated notes payable on March 21, 2005.*





***Revolving
      Credit Facility***




On
      October 12, 2005, the Company entered into a Loan and Security Agreement with
      Wells Fargo Retail Finance, LLC (“WFRF”), pursuant to which WFRF will provide
      the Company with a senior secured revolving credit facility up to $65.0 million
      (the “New Credit Facility”). On that same date the Company terminated its $65
      million Amended and Restated Credit Agreement with General Electric Capital
      Corporation (“GECC”) and in connection therewith repaid all outstanding amounts
      due under the credit facility to GECC along with a $0.5 million termination
      fee.
      The $65.0 million of maximum availability under the New Credit Facility is
      reduced by a $7.0 million minimum reserve. While the credit facility currently
      does not require compliance with financial covenants, the Company has the
      ability to reduce this minimum reserve by $3.5 million by agreeing to implement
      one or more financial covenants. Available credit is based on eligible
      receivables, inventory and prescription files, as defined in and determined
      pursuant to the agreement, and may be subject to reserves as determined by
      the
      lender from time to time. Interest on the revolving line of credit is calculated
      at the Prime index rate plus an applicable margin (as defined in the agreement),
      unless the Company or the lender chooses to convert the loan to a LIBOR-based
      loan. In each case, interest is adjusted quarterly. The applicable margin as
      of
      December 31, 2005 was 0.25 %. As of December 31, 2005, the interest
      rate, including applicable margin, used to calculate accrued interest was 7.5%.
      Interest is payable monthly.





42


The
      New
      Credit Facility includes usual and customary events of default (subject to
      applicable grace periods) for facilities of this nature and provides that,
      upon
      the occurrence of an event of default, payment of all amounts payable under
      the
      New Credit Facility may be accelerated and/or the lenders’ commitments may be
      terminated. In addition, upon the occurrence of certain insolvency or bankruptcy
      related events of default, all amounts payable under the New Credit Facility
      shall automatically become immediately due and payable, and the lenders’
commitments shall automatically terminate.





The
      New
      Credit Facility includes an early termination fee of $650,000 if paid in full
      before October 12, 2008. The New Credit Facility is secured by substantially
      all
      assets of the Company. As of December 31, 2005, $36.3 million was outstanding
      on
      the line and $9.3 million was available for additional borrowings, based on
      eligible receivables and inventory.





The
      proceeds of the New Credit Facility were used to repay in full the Company’s
      prior line of credit with General Electric Capital Corporation (“GECC”) (the
“Senior Credit Facility”) and is also expected to be used to provide financing
      for working capital, letters of credit, capital expenditures, future
      acquisitions and/or other general corporate purposes.





***Subordinated
      Notes Payable***




On
      March
      22, 2005, the Company entered into the First Amendment to the GECC Senior Credit
      Facility (the “March 2005 Amendment”). The March 2005 Amendment provided for an
      increase in the reduction of permanent availability from $5.5 million to $7.5
      million and allowed the Company to convert the $23.0 million of accounts payable
      after consideration of a $6.0 million payment in March 2005 to AmerisourceBergen
      Drug Corporation (“ABDC”) into a subordinated convertible debenture in the
      original principal amount of $11,500,000 (the “Subordinated Convertible
      Debenture”) and a subordinated promissory note in the original principal amount
      of $11,500,000 (the “Subordinated Note”).




The
      Subordinated Note is due and payable in quarterly installments of $575,000,
      which began on December 1, 2005 and continues through September 1, 2010, on
      which date all outstanding amounts are due. The Subordinated Note bears interest
      at the prime rate plus 2.0% per annum (9.25% as of December 31, 2005), provided
      that in no event will the interest rate in effect be less than 5.0% per annum
      or
      greater than 10.0% per annum. Interest accrued on the Subordinated Note is
      payable quarterly and interest payments commenced June 1, 2005. Interest expense
      of $756,738 was recorded during the fiscal year ended December 31, 2005.





The
      Subordinated Convertible Debenture is due and payable in quarterly installments
      of $605,263 commencing on March 1, 2006 through August 15, 2010, on which date
      all outstanding amounts are due. Quarterly principal payments are payable in
      cash or in shares of common stock in an amount equal to $605,263 divided by
      $3.4416 (the “Issue Price”), at the Company’s option. The Subordinated
      Convertible Debenture bears interest at 10.0%, if the quarterly interest payment
      is made in common stock or the prime rate plus 1% per annum (8.25% as of
      December 31, 2005), if the quarterly interest payment is made in cash, provided
      that in no event will the interest rate in effect be less than 5.0% per annum
      or
      greater than 10.0% per annum. Quarterly interest payments are required to be
      paid in common stock through February 28, 2006. Commencing March 1, 2006,
      quarterly interest payments may be paid in cash or common stock in an amount
      equal to the interest then due and owing divided by the Issue Price, or a
      combination thereof. During the year ended December 31, 2005, 235,516 shares
      of
      common stock valued at $597,222 were issued for interest expense through
      December 1, 2005. An additional $95,834 of interest expense was accrued from
      December 1, 2005 to December 31, 2005.




If
      common
      stock is used to make principal or interest payments on the Subordinated
      Convertible Debenture, and the proceeds ABDC receives upon any sale of the
      Company’s common stock (or the proceeds ABDC would have received upon a sale in
      the event no shares are sold by ABDC) are less than the principal and interest
      due, the Company is required to pay such difference to ABDC in cash on the
      date
      of maturity of the Subordinated Convertible Debenture. As of December 31, 2005,
      the estimated shortfall in the value received from the sale of securities
      received as payment of interest was $480,554, which is considered a “Deemed
      Payment” under the terms of the Subordinated Convertible Debenture and is
      reflected as an increase in the carrying value of the Subordinated Convertible
      Debenture as of December 31, 2005. Through December 31, 2005, ABDC could not
      sell any shares of the Company’s common stock received that, in the aggregate,
      exceed 25% of the average trading volume of the Company’s common stock for the
      preceding 10 trading days.





In
      connection with the Subordinated Convertible Debenture, DrugMax entered into
      a
      registration rights agreement dated March 21, 2005 with ABDC pursuant to which
      the Company agreed to file a registration statement with the SEC to register
      the
      resale of all common stock issuable to ABDC in connection with the Subordinated
      Debenture no later than May 30, 2005. Further on May 26, 2005, ABDC granted
      the
      Company a 45 day extension to file the registration statement. On July 7, 2005,
      the company filed a registration statement on Form S-1. The SEC declared the
      Form S-1 effective on August 10, 2005. The Subordinated Debenture and
      Subordinated Note are guaranteed by DrugMax and certain of DrugMax’s
      subsidiaries, including Valley Drug Company, Valley Drug Company South,
      Familymeds, and Familymeds Holdings, Inc. (the “Debtors”) pursuant to Continuing
      Guaranty Agreements dated as of March 21, 2005. The Debtors also entered into
      a
      subordinated security agreement dated as of March 21, 2005, pursuant to which
      each of the Debtors agreed that upon the occurrence of certain defaults, each
      Debtor would be deemed at that point to have granted to ABDC a springing lien
      upon and a security interest in substantially all of its assets to secure the
      Subordinated Debenture and the Subordinated Note. However, pursuant to a
      subordination agreement dated March 21, 2005, the Subordinated Debenture, the
      Subordinated Note, the Guarantees and the Security Agreement are subordinated
      to
“Senior Debt.” Senior Debt consists of all senior indebtedness now or hereafter
      owing, including indebtedness under the Senior Credit Facility and any debt
      incurred by the Company to replace or refinance such debt. On October 12, 2005,
      in connection with the New Credit Facility, ABDC executed an Assignment and
      Subordination Agreement with Wells Fargo Retail Finance, LLC. (“WFRF”) whereby
      the Subordination Agreement was assigned to WFRF and ABDC acknowledged the
      assignment.





43


**9.**
            **CAPITAL
                STOCK**





***DrugMax
      Common Stock*** —The
      number of authorized shares of common stock was increased from 24 million to
      45
      million shares on November 12, 2004. In connection with the Merger, the
      shareholders of FMG (along with certain FMG warrant holders and note holders)
      received an aggregate of 10,470,507 shares of DrugMax common stock. On
      September 7, 2005, stockholders of the Company approved an amendment to
      increase our authorized shares of common stock from 45 million to 100 million.
      Then, on September 27, 2005, the Company’s authorized shares of common
      stock increased from 100 million to 200 million. Authorized common stock
      consists of 200 million shares of common stock, $.001 par value as of December
      31, 2005.





On
      August
      27, 2003, DrugMax adopted the DrugMax, Inc. 2003 Restricted Stock Plan (“the
      Restricted Stock Plan”). Prior to the Merger, DrugMax had not issued any
      restricted shares under the Restricted Stock Plan. On November, 12, 2004, the
      number of shares authorized under the Restricted Stock Plan was increased from
      1.5 million shares to 3.5 million shares. In connection with the Merger, DrugMax
      issued an aggregate of 656,047 shares of restricted DrugMax common stock to
      certain employees and directors of FMG. The restricted stock was scheduled
      to
      vest on March 25, 2005 or upon such time as a registration statement is declared
      effective. On March 23, 2005, certain of the restricted stock agreements were
      amended to change the vesting to June 15, 2005 or upon such time as a
      registration statement is declared effective by the SEC. The compensation charge
      recorded during the years ended December 31, 2005 and January 1, 2005 relating
      to the restricted stock was $1,561,864 and $809,125, respectively, which was
      based on the vesting provisions of the original restricted stock agreements.





During
      fiscal year ended December 31, 2005, the Company issued 516,048 shares of
      restricted stock to directors and employees. The shares issued to directors
      vested one-third upon the date of grant and one-third on each anniversary
      thereof. The employee shares vest two-thirds upon the first anniversary of
      the
      grant and one-third upon the second anniversary of the grant. Compensation
      expense of $269,478 was recorded during the fiscal year ended December 31,
      2005
      related to these shares.





***DrugMax
      Preferred Stock*** —
The
      number of authorized shares was increased from two million to five million
      preferred shares at the annual meeting on November 12, 2004, of which 17,000
      shares have been designated as Series A Convertible Preferred Stock. On December
      2, 2004, for an aggregate purchase price of $17 million, the Company sold to
      certain qualified institutional buyers and accredited investors an aggregate
      of
      17,000 shares of Series A convertible redeemable preferred stock (the “Series
      A”). These shares were convertible into an aggregate of 4,594,591 shares of the
      Company’s common stock, based upon an initial conversion price of $3.70 per
      share. However, in an amendment to the certificate of designation, on July
      7,
      2005, the conversion price was reduced from $3.70 per share to $2.80 per share
      and the Series A stock became convertible into an aggregate of 6,071,425 shares
      of DrugMax common stock. In addition, the investors received warrants to
      purchase an aggregate of 1,378,374 shares of DrugMax common stock. The exercise
      price of the warrants was $4.25 per share upon issuance. The exercise price
      was
      reduced to $1.09 upon the redemption of the Series A. The warrants are
      exercisable into common stock and expire on the fifth anniversary of the
      closing. The fair value of the warrants was originally estimated at $1,872,000
      based on Black Scholes valuation. The modification of the warrant exercise
      price
      resulted in an increase in the fair value of the warrants of $656,000 to
      $2,528,000 which is being recorded as additional preferred stock dividends
      over
      the ten-year estimated life of the DrugMax Series A convertible redeemable
      preferred stock. In connection with the redemption of the Series A
      convertible preferred stock, on October 3, 2005, the unamortized discount
      was fully amortized and recorded as an increase to the accumulated deficit
      in the consolidated statement of changes in stockholders’ (deficit)
      equity.





The
      Company filed a registration on Form S-3 to register the resale of the shares
      of
      common stock issuable upon the conversion of the Series A stock and the exercise
      of the warrants. The Company was required to maintain the registration effective
      until all of such shares have been sold or may be sold without volume
      restrictions pursuant to rule 144. The Form S-3 was declared effective by the
      SEC on January 19, 2005. The Company’s agreement with the preferred stockholders
      contained a provision to the effect that if the registration statement ceased
      for any reason to remain continuously effective or the holders were not
      permitted to utilize the prospectus therein to resell such registrable
      securities for 10 consecutive calendar days but no more than an aggregate of
      15
      calendar days during any 12-month period (the “Event Date”), then in addition to
      any other rights the holders may have, the Company shall pay to each holder
      an
      amount in cash equal to 2% of the aggregate purchase price paid by such holder
      as partial liquidated damages. Such amounts were to be payable on the Event
      Date
      and on each monthly anniversary of the Event Date until such time as the
      registration statement became effective or until the holders are permitted
      to
      utilize the prospectus to resell securities.





Effective
      April 20, 2005, the Company suspended sales under the previously filed
      registration statement to resell such securities. Under the terms of the Series
      A, the investors were entitled to liquidated damages until such time as the
      registration statement became effective. On July 7, 2005, the Company amended
      the certificate of designation to reduce the conversion price of the Series
      A
      from $3.70 to $2.80 per share. In exchange, investors representing 95% of the
      Series A shareholders agreed to waive liquidated damages under the registration
      rights agreement through the date of the amendment and to amend the registration
      rights agreement to require the filing of a registration statement covering
      the
      registrable securities by July 8, 2005 and to require the effectiveness of
      such
      registration statement to be no later than October 1, 2005. On July 7, 2005,
      the
      Company filed a registration statement on Form S-1. The SEC declared the Form
      S-1 effective on August 10, 2005. The amount of the liquidated damages owed
      as
      of July 2, 2005, $1.0 million, substantially all of which was waived by the
      shareholders, was recorded as additional DrugMax preferred stock dividends
      for
      the three months ended July 2, 2005. A total of $1.1 million was accrued through
      July 7, 2005 related to liquidated damages and reversed during the three months
      ended October 1, 2005. The revised conversion price does not represent a
      beneficial conversion feature.





The
      Series A contained an increasing-rate dividend as follows: 7% per annum until
      the fourth anniversary; 9% per annum from the fourth until the fifth
      anniversary; 11% per annum from the fifth until the sixth anniversary and 14%
      per annum thereafter. In accordance with SEC Staff Accounting Bulletin Topic
      5, *Miscellaneous
      Accounting* ,
      Section
      Q, the Company has recorded dividends in amounts equal to a consistent effective
      rate over the life of the preferred stock.





44


On
      October 3, 2005, the Company redeemed the Series A convertible redeemable
      preferred stock for cash of $17.0 million and 488,069 shares of common stock
      valued at $844,360. The common stock issued is reflected as an additional
      dividend on the Series A convertible redeemable preferred
      stock.





***FMG
      Redeemable Convertible Preferred Stock*** —
Prior
      to the Merger, FMG had outstanding Series A, B, C, D and E Preferred Stock.
      In
      connection with the Merger, DrugMax issued 8,363,525 shares of DrugMax common
      stock to certain FMG preferred shareholders which were allocated to FMG’s
      preferred shareholders based on liquidation preferences. Based on the
      ten-day-weighted stock price of $3.7969 as of November 12, 2004, the FMG Series
      E shareholders received DrugMax stock equal to their full liquidation
      preference, the FMG Series C preferred shareholders and FMG Series D preferred
      shareholders received DrugMax stock equal to approximately 7% of their
      liquidation preferences and the FMG Series A preferred shareholders, FMG Series
      B preferred shareholders and FMG common shareholders received no consideration
      for their shares.





DrugMax
      also issued warrants to purchase 3,500,090 shares of DrugMax common stock at
      $2.61 per share to the former FMG stockholders and note holders. The warrants
      were allocated among the FMG stockholders, note holders in the same manner
      as
      the DrugMax common stock and warrants to purchase 1,950,692 shares were
      allocated to former FMG preferred stockholders. The fair value of the warrants
      issued to the former FMG preferred shareholders of $5,479,478 based on a Black
      Scholes valuation was recorded as a preferred stock dividend prior to the
      Merger.


Following
      is a summary of FMG liquidation preferences and the shares received by FMG
      note
      holders and preferred stockholders in the Merger:





**DrugMax**
              **Common
                Shares**
              **Received**
            
            
            **Liquidation**
              **Value
                as of**
              **Merger
                Date**
            
            
            **Carrying
                Value as**
              **of
                Merger Date**Noteholders,
                including accrued interest
            
            
            2,106,982
            
            $
            8,000,000
            
            $
            8,000,000Series
                E Preferred Stockholders, after warrant exercise
            
            
            6,974,711
            
            
            26,482,280
            
            
            17,860,084Series
                D Preferred Stockholders
            
            
            952,732
            
            
            3,617,426
            
            
            54,618,760Series
                C Preferred Stockholders
            
            
            436,082
            
            
            1,655,762
            
            
            24,999,995Series
                B Preferred Stockholders
            
            
            —
            
            
            —
            
            
            14,687,967Series
                A Preferred Stockholders
            
            
            —
            
            
            —
            
            
            8,159,182Total
            
            
            10,470,507
            
            $
            39,755,468
            
            $
            128,325,988





Dividends
      on FMG preferred stock were accrued through the Merger date. Following is a
      summary of the terms and conditions of the FMG preferred stock prior to the
      Merger:





FMG
      Series E Redeemable Convertible Preferred Stock—On June 22, 2001, FMG issued to
      existing investors 988,441 shares of Series E Redeemable Convertible Preferred
      Stock (“FMG Series E Preferred Stock”) at a purchase price of $9.87 per share
      for aggregate proceeds of $9,755,913. In connection with this transaction,
      FMG
      incurred $180,924 of professional fees and closing costs, which were offset
      against the proceeds. The carrying amount of the FMG Series E Preferred Stock
      was increased by periodic accretion, using the effective interest method, with
      charges to accumulated deficit. For the fiscal years ended January 1, 2005
      and
      December 27, 2003, $40,616, and $44,308, respectively, of expenses were
      accreted. The Series E Preferred Stock accrued dividends at 8% per annum, was
      senior to all other classes of stock, had certain special voting rights and
      had
      an initial liquidation value of $9.87 per share. In exchange for the commitment
      and funding of the Notes (see Note 7), FMG issued certain note holders warrants
      to purchase 438,249 shares of FMG Series E Preferred Stock at an exercise price
      of $9.87 per share. The fair value of the warrants as of the date of issuance
      was $54,354 using the Black-Scholes model. These warrants were exercised into
      438,249 shares of FMG Series E Preferred Stock on a cashless basis prior to
      the
      Merger.





FMG
      Series E Preferred Stock was senior to all other Series of preferred stock
      and
      had to have 100% of their liquidation preference satisfied prior to distribution
      to the other Series of preferred stock. As of the Merger, November 12, 2004,
      Series E was convertible into common stock at $14.81 per share. The Series
      E
      Preferred Stock accrued dividends at 8% per annum, and had certain special
      voting rights. Upon a liquidation event, Series E preferred shareholders were
      entitled to receive the greater of the value of two times the liquidated value
      plus accrued dividends or the amount received on an “as converted” basis. The
      holders had the right to require the Company to redeem the Series E Preferred
      Stock in August 2005.




FMG
      Series D Redeemable Convertible Preferred Stock—In July 2000, FMG issued to an
      investor group1,542,188 shares of Series D Redeemable Convertible Preferred
      Stock (“FMG Series D Preferred Stock”), with a par value of $0.01 at a purchase
      price of $18.37 per share for gross proceeds of $28,330,000. In connection
      with
      this transaction, FMG incurred approximately $1,843,000 of professional fees
      and
      closing costs, which were offset against the proceeds. The carrying amount
      of
      the FMG Series D Preferred Stock was increased by periodic accretion, using
      the
      effective interest method, with charges to accumulated deficit. For the fiscal
      years ended January 1, 2005 and December 27, 2003, $333,898, and $364,252 of
      expenses were accreted, respectively.





In
      connection with the FMG Series D Preferred Stock issuance, $10,000,000 of
      convertible promissory notes issued in March 2000 were converted into FMG Series
      D Preferred Stock in fiscal 2000 at $17.45 per share. Upon conversion, the
      note
      holders received 573,017 shares of FMG Series D Preferred Stock and exercised
      the nondetachable warrants for an additional 102,564 shares of FMG Series D
      Preferred Stock at a price of $9.75 per share for $1,000,000.





45


The
      Series D Preferred Stock was convertible into common stock at any time and
      would
      automatically convert into common stock upon the closing of an initial public
      offering with gross proceeds of at least $30,000,000. The FMG Series D Preferred
      Stock accrued dividends at 8% per annum, had certain special voting rights
      and
      had an initial liquidation value of $18.37 per share. Due to the absence of
      certain events, including an underwritten public offering of FMG’s stock, not
      occurring within 18 months, the FMG Series D Preferred Stock shareholders’
conversion price was adjusted. The adjusted conversion price entitled such
      shareholder to the number of common shares issuable upon conversion of the
      Series D. The change in the conversion ratio had no accounting implications
      since the conversion terms did not represent a beneficial conversion feature.
      Additionally, in the event of an underwritten public offering, dividends would
      become payable in cash. Upon liquidation or redemption, the Series D Preferred
      Stock shareholders were entitled to the liquidation value, including any unpaid
      dividends. The holders of FMG Series D Preferred Stock had the right to require
      the Company to redeem the stock in August 2005. FMG Series D and C Preferred
      Stock were senior to FMG Series B and A Preferred Stock, but were subordinate
      to
      FMG Series E Preferred Stock. Series D and C shared pari passu after
      satisfaction of the Series E in connection with the Merger.





FMG
      Series C Convertible Preferred Stock—On May 14, 1999, FMG issued to an investor
      group 2,564,102 shares of Series C Convertible Preferred Stock (“FMG Series C
      Preferred Stock”), with a par value of $0.01 at a purchase price of $9.75 per
      share for aggregate proceeds of $25,000,000. In connection with this transaction
      FMG incurred $344,475 of professional fees and closing costs, which were offset
      against the proceeds. The FMG Series C Preferred Stock shareholders were
      entitled to convert each share of FMG Series C Preferred Stock into that number
      of fully paid and nonassessable shares of common stock as is determined by
      dividing the initial conversion price of $14.63 by the conversion price in
      effect at the time of conversion. The conversion rate was subject to adjustment
      for the effects of dilution. The FMG Series C Preferred Stock shareholders
      were
      entitled to certain special voting rights, preferential liquidation rights
      (initial liquidation value of $9.75 per share) and anti-dilutive provisions.
      Dividends did not accrue on the Series C Preferred Stock. Additionally, the
      Series C Preferred Stock was convertible into common stock at any time and
      would
      automatically convert into common stock upon the occurrence of an initial public
      offering at a price per share that implies that the Company has a pre-money
      value of at least $100,000,000 and where the aggregate proceeds to the Company
      are at least $30,000,000.





FMG
      Series B Redeemable Convertible Preferred Stock—On June 8, 1998, FMG issued to
      an investor group 2,042,105 shares of Series B Redeemable Convertible Preferred
      Stock (“FMG Series B Preferred Stock”), with a par value of $0.01 at a purchase
      price of $4.75 per share for aggregate proceeds of $9,700,000. In connection
      with this transaction, FMG incurred approximately $225,000 of professional
      fees
      and closing costs, which were offset against the proceeds. The carrying amount
      of the FMG Series B Preferred Stock was increased by periodic accretion, using
      the effective interest method, with charges to accumulated deficit. For the
      Fiscal Years ended January 1, 2005 and December 27, 2003, $30,266, and $33,017
      of expenses were accreted. The FMG Series B Preferred Stock accrued dividends
      at
      an annual rate of 8% of liquidation value, as defined, with an initial
      liquidation value of $4.75 per share. Concurrent with the FMG Series C
      Convertible Preferred Stock issuance, the conversion price of the FMG Series
      B
      Preferred Stock was adjusted to $7.83 per share and the existing 2,042,105
      FMG
      Series B Preferred Stock shares were exchanged for 1,858,239 shares of FMG
      Series B Preferred Stock with a liquidation value of $5.22 per share, plus
      unpaid dividends. Upon liquidation or redemption, the Series B Preferred Stock
      shareholders are entitled to the liquidation value, plus accrued but unpaid
      dividends. Under certain liquidation circumstances, the cumulative unpaid
      dividend is increased to a rate of 12% of liquidation value.





The
      FMG
      Series B Preferred Stock shareholders were entitled to convert each share of
      FMG
      Series B Preferred Stock into that number of fully-paid and nonassessable shares
      of common stock determined by dividing the initial conversion price of $7.83
      by
      the conversion price in effect at the time of conversion. The conversion rate
      was subject to adjustment for the effects of dilution. Additionally, the Company
      had the option to convert each share of Series B Preferred Stock into common
      stock upon the occurrence of an initial public offering with aggregate gross
      proceeds to the Company of at least $15,000,000 and at a price per share of
      at
      least three times the then conversion price. Upon such conversion, all accrued
      dividends will be canceled. The holders of Series B Preferred Stock, subject
      to
      the consent of both the Series C and Series D Preferred Stock shareholders,
      also
      have the right to require the Company to redeem 25% of the Series B Preferred
      Stock outstanding immediately prior to the fifth anniversary of the Series
      B
      Preferred Stock issuance and on the sixth, seventh and eighth anniversaries.
      The
      Series B Preferred Stock shareholders were entitled to certain special voting
      rights, registration rights and anti-dilutive provisions.





FMG
      Series B and A were subordinate to all other Series of FMG preferred stock.
      If a
      liquidation amount remained after all other FMG preferred shareholders were
      100%
      satisfied, Series B and A would have shared pari passu up to the amount of
      their
      respective liquidation preferences.





FMG
      Series A Redeemable Convertible Preferred Stock—On December 18, 1996, FMG issued
      to an investor group 900,000 shares of Series A Redeemable Convertible Preferred
      Stock (“FMG Series A Preferred Stock”) with a par value of $0.01 at a purchase
      price of $5.55 per share for aggregate proceeds of approximately $5,000,000.
      In
      connection with this transaction, FMG incurred approximately $189,000 of
      professional fees and closing costs, which were offset against the proceeds.
      The
      carrying amount of the FMG Series A Preferred Stock was increased by periodic
      accretion, using the effective interest method, with charges to accumulated
      deficit. Conversion and dividend features are calculated for FMG Series A
      Preferred Stock in the same manner as the FMG Series B Preferred Stock with
      the
      exception of the following:





•
            FMG
                Series A Preferred Stock initial conversion price was $8.33 per share;
                and•
            FMG
                Series A Preferred Stock liquidation value was adjusted from $5.55
                per
                share to $5.69 per share in conjunction with the FMG Series B Preferred
                Stock issuance.





To
      redeem
      a FMG Series A Preferred Stock shareholder in 1998, the Company purchased
      468,406 shares of FMG Series A Preferred Stock for $1,749,337. Voting rights,
      redemption rights, registration rights and anti-dilutive provisions were
      identical to Series B Preferred Stock shares.





***FMG
      Common Stock*** -Immediately prior to the Merger there were 2,485,653 voting and non-voting
      common shares of FMG issued and outstanding.




46




**10.**
            **EMPLOYEE
                BENEFITS**





The
      Company has three 401(k) defined contribution plans that cover eligible
      full-time employees, including the Familymeds 401(k) plan (the “Familymeds
      Plan”) and two DrugMax 401(k) Plans (the “DrugMax Plans”) that existed prior to
      the Merger for DrugMax employees. During fiscal 2005, 2004 and 2003, Familymeds,
      Inc. contributed 50% of an employee’s pre-tax contribution up to a maximum of 4%
      of an employee’s eligible compensation to the Familymeds Plan. During the fiscal
      years ended December 31, 2005, January 1, 2005 and December 27, 2003, the
      Company contributed approximately $230,000, $271,000 and $367,000, respectively,
      to the Familymeds Plan.





Company
      contributions to the primary DrugMax 401(k) Plans are discretionary. The Company
      made no contributions to the DrugMax 401(k) Plan for the period subsequent
      to
      the Merger.





**11.**
            **INCOME
                TAXES**





The
      Company incurred net operating losses for the fiscal years ended December 31,
      2005, January 1, 2005 and December 27, 2003. Accordingly, no benefit for income
      taxes has been recorded due to uncertainty of realization.





The
      components of deferred income tax assets (liabilities) at December 31, 2005
      and
      January 1, 2005 are as follows:







**December
                  31,**
                **2005**
              
              **January
                  1,**
                **2005**Deferred
                  Tax Assets (Liabilities)Trade
                  receivables
              
              $
              1,187,742
              
              $
              1,504,358Inventories
              
              
              502,696
              
              
              1,446,565Accrued
                  expenses
              
              
              452,984
              
              
              687,986Property
                  and equipment
              
              
              15,664
              
              
              (65,486
              )Intangible
                  assets
              
              
              9,472,166
              
              
              230,556Tax
                  effect of net operating loss carryforwards
              
              
              56,425,450
              
              
              46,402,632Stock
                  options
              
              
              2,442,501
              
              
              -Other
              
              
              159,780
              
              
              (82,627
              )Total
              
              
              70,658,983
              
              
              50,123,984Valuation
                  allowance
              
              
              (70,658,983
              )
              
              (50,123,984
              )Total,
                  net
              
              $
              -
              
              $
              -




A
      valuation allowance has been established for the full amount of the net deferred
      tax asset as of December 31, 2005 and January 1, 2005 which, based upon
      available evidence, will likely not be realized.





Following
      is a reconciliation of the statutory income tax rate to the effective income
      tax
      rate for the fiscal years ended December 31, 2005, January 1, 2005, and December
      27, 2003:




**Fiscal
                  Year Ended****December
                  31, 2005**
              
              **January
                  1, 2005**
              
              **December
                  27, 2003**Statutory
                  rate
              
              
              (34)%
              
              
              (34)%
              
              
              (34)%State
                  income tax rate benefit, net of federal effect
              
              
              (5)%
              
              
              (5)%
              
              
              (5)%Change
                  in valuation allowance
              
              
              39%
              
              
              39%
              
              
              39%Effective
                  tax rate
              
              
              —%
              
              
              —%
              
              
              —%





At
      December 31, 2005, the Company had net operating loss carryforwards (“NOL’s”)
      for federal and state income tax purposes of approximately $144 million and
      $90
      million, respectively, that are available, other than as described below, to
      offset future taxable income and expire from 2016 through 2025. As a result
      of
      changes in the Company’s ownership, usage of the Company’s NOL’s is limited. As
      of December 31, 2005, approximately $138 million of the federal NOL carryforward
      is subject to a usage limitation of approximately $2.2 million per year. The
      amount of NOL’s that may not be available for usage prior to expiration due to
      NOL usage limitations is approximately $94 million.





47





**12.**
            **STOCK
                OPTIONS**





As
      of
      January 1, 1998, FMG adopted its 1998 Non-Qualified Stock Option Plan. The
      plan
      was amended July 1, 1999, and the FMG’s 1999 Non-Qualified Stock Option Plan
      (“the FMG 1999 Non-Qualified Stock Option Plan”) was adopted. The majority of
      options issued under the FMG 1999 Non-Qualified Stock Option Plan vested evenly
      over a three-year period and expired after five years. On April 25, 2000, FMG
      adopted its 2000 Stock Option Plan (“the FMG 2000 Plan”). Options were granted
      under the FMG 2000 Plan to employees, directors or consultants. Immediately
      prior to the Merger, FMG vested all outstanding stock options that had not
      terminated by their own terms prior to the Merger and issued one share of FMG
      non-voting common stock for each such outstanding FMG option on a one-for-one
      basis resulting in the issuance of 524,652 common shares. A compensation charge
      of $7,872 was recorded during the fiscal year ended January 1, 2005 related
      to
      the exchange which represented to estimated fair value of the shares issued.
      Accordingly, at the time of the Merger, no options to purchase FMG common stock
      remained outstanding.





On
      August
      13, 1999, DrugMax adopted its 1999 Incentive and Non-Statutory Stock Option
      Plan
      (the “DrugMax 1999 Plan”). On June 5, 2002, the first amendment to the DrugMax
      1999 Plan was adopted. In connection with the Merger, on November 12, 2004,
      the
      number of shares authorized under the DrugMax 1999 Plan was increased from
      two
      to six million shares. Prior to the Merger, options were granted under the
      DrugMax 1999 Plan to employees and directors of DrugMax. As a result of the
      Merger on November 12, 2004, all of such options immediately vested.





In
      connection with the Merger, DrugMax issued options to purchase 1,574,369 shares
      of DrugMax common stock at $0.57 per share to certain employees and directors
      of
      FMG that remained employees and directors of DrugMax after the Merger. The
      options vested immediately and are exercisable on January 4, 2006. A
      compensation charge is being recorded over the period the options become
      exercisable. Accordingly, $4,230,650 and $528,831 of stock compensation expense
      was recorded during the years ended December 31, 2005 and January 1, 2005,
      respectively, related to the options issued in connection with the Merger that
      had exercise prices less than their fair value.





During
      fiscal year ended December 31, 2005, 1,618,970 stock options were granted to
      directors and employees of DrugMax. The majority of these grants vest evenly
      over three years. All stock options were granted at fair market value and thus
      no expense was recorded relating to these grants.





Stock
      option activity for the DrugMax 1999 Plan is as follows:




**Number
                of Shares**
            
            
            **Weighted
                Average Exercise Price**Options
                outstanding as of the Merger Date
            
            
            2,226,412
            
            
            3.77Granted
                to FMG employees in connection with the Merger
            
            
            1,574,369
            
            
            0.57Forfeited
            
            
            (32,100
            )
            
            5.41Exercised
            
            
            (160,466
            )
            
            1.84Shares
                under option at January 1, 2005
            
            
            3,608,215
            
            
            2.37Granted
            
            
            1,618,970
            
            $
            1.77Forfeited
            
            
            (1,124,065
            )
            $
            3.88Exercised
            
            
            (332,360
            )
            $
            1.62Shares
                under option at December 31, 2005
            
            
            3,770,760
            
            $
            1.80Shares
                exercisable at December 31, 2005
            
            
            1,208,516
            
            $
            3.37





48





**Options
                Outstanding**
            
            
            **Options**
              **Exercisable****Exercise
                Prices**
            
            
            **Number**
              **Outstanding
                at**
              **December
                31,**
              **2005**
            
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual**
              **Life
                (Years)**
            
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            
            **Number**
              **Exercisable
                at**
              **December
                31, 2005**$0.57-$2.00
            
            
            2,736,935
            
            
            8.8
            
            $
            0.91
            
            
            320,8822.52-4.00
            
            
            819,091
            
            
            5.7
            
            
            3.04
            
            
            672,9005.00-13.00
            
            
            214,734
            
            
            3.3
            
            
            7.75
            
            
            214,7343,770,760
            
            
            
            
            
            
            
            
            1,208,516





The
      weighted average contractual life of options outstanding at December 31, 2005
      was 7.8 years.




49





**13.**
            **RELATED
                PARTY TRANSACTIONS**





The
      Arrow
      Employee Benefit Trust (the “Trust”) was created to purchase group medical
      insurance for FMG, franchisees and certain affiliates. Use of the Trust was
      terminated effective May 17, 2004.The Board of Trustees of the Trust was
      composed of certain officers of the Company along with certain franchisees.
      The
      Company paid approximately $1,539,779 and $3,164,000 in insurance premiums
      and
      administrative fees to the Trust for the Fiscal Years ended January 1, 2005
      and
      December 27, 2003, respectively.





In
      October 2001, prior to the Merger, the Company executed a commercial lease
      agreement (the “Lease”) with an entity controlled by certain directors and
      officers of the Company at the time. The Lease is for an initial period of
      five
      years with a base monthly lease payment of $15,000, and an initial deposit
      of
      $15,000. Management believes the terms of this agreement are comparable to
      those
      that the Company would have received from an unrelated, third party. In
      connection with the sale of select assets from Valley Drug Company located
      in
      New Castle, Pennsylvania to Rochester Drug Cooperative (“RDC”), the lease was
      amended. The amendment provides that the term of the lease be five years,
      commencing December 21, 2005, with two additional five-year options for renewal,
      and provides an option to purchase the premises from the landlord. RDC has
      agreed to enter into a lease assignment and assumption agreement for the amended
      New Castle lease contingent upon the Company and the landlord securing consents
      from the Pennsylvania Industrial Development Authority (“PIDA”) to such
      assignment. Until such time as the consents are obtained, the parties have
      agreed to operate under a sublease agreement.





In
      January 2004, prior to the Merger, the Company executed a second commercial
      lease agreement (the “Second Lease”) with an entity controlled by certain
      directors and officers of the Company at the time. The Second Lease is for
      an
      initial period of fifteen years with a base monthly lease payment of $17,000.
      During the fiscal year ended December 31, 2005, the Company recorded rent
      expense of $204,000 related to the Second Lease. Management believes the terms
      of this agreement are comparable to those that the Company would have received
      from an unrelated, third party.





**14.**
            **COMMITMENTS
                AND CONTINGENCIES**





***Operating
      Leases*** —The
      Company leases its headquarter office space under an operating lease expiring
      in
      2007 with a renewal option through 2012. The Company also leases space for
      its
      pharmacies, distribution centers, vehicles, furniture and fixtures and office
      equipment under various operating leases. Certain leases include renewal
      options. Rent expense on these operating leases was approximately $3,503,000,
      $3,375,000 and $3,328,000 for the fiscal years ended December 31, 2005, January
      1, 2005 and December 27, 2003, respectively.


Minimum
      lease payments under these leases are as follows, excluding renewal options:





**Fiscal
                Years**2006
            
            $
            2,887,0362007
            
            
            2,042,4792008
            
            
            1,429,1602009
            
            
            997,0562010
            
            
            442,513Thereafter
            
            
            755,764Total
            
            $
            8,554,008





***Legal
      Matters-*** On
      November 12, 2003, Phil & Kathy’s, Inc. d/b/a Alliance Distributors
      (“Alliance”) served a complaint against the Company seeking to recover the
      non-payment of open invoices approximating $2.0 million 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 sale of twenty allegedly counterfeit
      bottles of Lipitor by Alliance to the Company, which the Company later sold
      to
      QK Healthcare, Inc. (“QK”). Alleging that the Lipitor was counterfeit, QK later
      sued the Company for breach of contract, violations of the implied warranty
      of
      merchantability and fraud. Accordingly, the Company’s subsidiary, 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
      a lawsuit against Valley by QK in New York. At March 31, 2005, the amount that
      the Company recorded as a trade payable balance due Alliance on the above was
      approximately $1.5 million. Under an indemnification agreement with Alliance,
      pursuant to which Alliance is required to indemnify the Company for all losses,
      expenses and damages sustained by the Company as a result of product sold to
      the
      Company by Alliance, and the Company’s right to offset its losses, expenses and
      damages against any amounts due to Alliance, the Company reduced the payable
      to
      Alliance by the cost of the faulty Lipitor sold to the Company by Alliance
      plus
      the settlement and litigation expenses incurred by the Company directly as
      a
      result of the Lipitor, or an aggregate of $0.5 million. The Company has recorded
      the foregoing trade payable of $1.5 million as of December 31, 2005 and believes
      this estimate is reasonable based on the information it has at this time;
      however, the Company cannot reasonably estimate the total future possible loss
      that it will sustain as a result of the Alliance complaint or the possible
      recovery through its counterclaim or Valley’s consolidated action.





On
      February 23, 2005, a former employee of the Company, James Hostetler, filed
      suit
      in the United States District Court for the Northern District of Illinois
      Eastern Division claiming the Company breached a compensation agreement.
      Specifically, Mr. Hostetler claims he is owed a commission of an unspecified
      amount as a result of the sale of securities consummated on December 2, 2004.
      The Company filed its response and intends to defend itself vigorously.
      Management does not believe Mr. Hostetler is entitled to any such commissions
      as
      he played no role in the sale of these securities. As a result of the early
      stage of this proceeding, the Company cannot currently estimate its outcome
      and
      has made no provision in the accompanying consolidated financial statements
      for
      the resolution of the matter.





50


From
      time
      to time, the Company may become involved in additional litigation arising in
      the
      ordinary course of our business. In the opinion of management, after
      consultation with counsel, the disposition of these matters arising in the
      normal course of business is not likely to have a material adverse effect,
      individually or in the aggregate, on our financial position or results of
      operations.





**15.**
            **QUARTERLY
                FINANCIAL INFORMATION (UNAUDITED)**





51




**Three
                Months
                Ended****April
                2,**
            
            **July
                2,**
            
            **October
                1,**
            
            **December 31,****2005**
            
            
            **2005**
            
            
            **2005**
            
            
            **2005*****Dollars
                in thousands, except per share amounts*****Fiscal
                2005:**Net
                revenues
            
            $
            57,201
            
            $
            54,715
            
            $
            51,755
            
            $
            52,432Gross
                margin
            
            
            11,943
            
            
            11,033
            
            
            9,877
            
            
            9,582Operating
                loss
            
            
            (3,202
            )
            
            (4,107
            )
            
            (4,656
            )
            
            (4,463
            )Loss
                from continuing operations (1)
            
            
            (3,770
            )
            
            (5,421
            )
            
            (6,342
            )
            
            (6,319
            )Loss
                from discontinued operations
            
            
            (1,226
            )
            
            (1,744
            )
            
            (8,193
            )
            
            (21,842
            )Net
                loss
            
            
            (4,996
            )
            
            (7,165
            )
            
            (14,535
            )
            
            (28,161
            )Net
                loss available to common shareholders
            
            
            (5,627
            )
            
            (8,788
            )
            
            (14,134
            )
            
            (30,609
            )Net
                loss per share available to common shareholders, basic and
                diluted
            
            $
            (0.29
            )
            $
            (0.44
            )
            $
            (0.71
            )
            $
            (0.47
            )Shares
                used in basic and diluted loss per share
            
            
            19,653
            
            
            19,918
            
            
            20,047
            
            
            65,032Dividends
                per common share
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —




**Three
                  Months Ended****March
                  28,**
              
              
              **June
                  27,**
              
              
              **September
                  26,**
              
              
              **January
                  1,****2004**
              
              
              **2004**
              
              
              **2004**
              
              
              **2005*****Dollars
                  in thousands, except per share amounts*****Fiscal
                  2004:**Net
                  revenues
              
              $
              56,219
              
              $
              55,808
              
              $
              53,449
              
              $
              58,486Gross
                  margin
              
              
              11,716
              
              
              11,672
              
              
              10,893
              
              
              12,333Operating
                  loss
              
              
              (291
              )
              
              (145
              )
              
              (855
              )
              
              (2,288
              )Loss
                  from continuing operations
              
              
              (884
              )
              
              (865
              )
              
              (1,803
              )
              
              (5,033
              )Loss
                  from discontinued operations (1)
              
              
              -
              
              
              -
              
              
              -
              
              
              (31,259
              )Net
                  loss
              
              
              (884
              )
              
              (865
              )
              
              (1,803
              )
              
              (36,292
              )Net
                  loss available to common shareholders
              
              
              (2,188
              )
              
              (2,389
              )
              
              (2,858
              )
              
              (43,205
              )Net
                  loss per share available to common shareholders, basic and
                  diluted
              
              $
              (1.70
              )
              $
              (1.85
              )
              $
              (2.22
              )
              $
              (3.90
              )Shares
                  used in basic and diluted loss per share (2)
              
              
              1,289
              
              
              1,289
              
              
              1,289
              
              
              11,086Dividends
                  per common share
              
              $
              —
              
              $
              —
              
              $
              —
              
              $
              —




(1)
            During
                the third quarter of 2005, the Company determined that it would
                discontinue substantially all of the drug distribution operations
                acquired
                in the Merger on November 12, 2004. Accordingly, these operations
                are
                reflected as discontinued for financial statement purposes for all
                periods
                presented since the date acquired. The loss from discontinued operations
                for the three months ended January 1, 2005 includes a goodwill impairment
                charge of $31.0 million. The loss from discontinued operations for
                the
                three months ended October 1, 2005 includes $5.3 million of estimated
                losses primarily related to accounts receivable and other asset
                impairments. The loss from discontinued operations for the three
                months
                ended December 31, 2005 includes a goodwill impairment charge of
                $19.4
                million and other exit losses, primarily representing estimated
                losses on accounts receivable, inventory and vendor chargebacks, of
                $1.6 million.





52





(2)
            The
                weighted average shares used in the calculation of net loss per share
                have
                been retroactively restated to give effect to the Merger of DrugMax
                with
                FMG. The transaction was accounted for as a reverse Merger, with
                FMG
                deemed the accounting acquirer. Accordingly, for periods prior to
                the
                Merger, the shares outstanding represent the number of shares that
                former
                FMG common shareholders would have received in the transaction, on
                an
                as-if converted basis, had the Merger consideration not be distributed
                to
                the preferred shareholders based on liquidation values. For periods
                subsequent to the Merger, shares outstanding represent actual shares
                outstanding.





**16.**
            **SUBSEQUENT
                EVENTS**





On
      January 1, 2006, the Familymeds, Inc. Master 401(k) Savings and Retirement
      Plan
      and the DrugMax, Inc. 401(k) Plan were transitioned into one plan
      under Fidelity Investments.  The name of plan was changed to The
      401(k) Savings and Retirement Plan.  Fidelity Investments became
      the trustee and record-keeper, as well as the investment provider for the
      newly adopted Plan.  Plan assets from both plans were transferred on
      January 4, 2006 to Fidelity Investments.





On
      March
      31, 2006, the Company entered into a new employment agreement with Edgardo
      A.
      Mercadante, Chairman of the Board, President and Chief Executive Officer. The
      initial term of Mr. Mercadante’s agreement terminates on November 30, 2008,
      and is subject to successive, automatic one-year renewals, unless one party
      notifies the other of its desire not to renew the agreement. The agreement
      provides an initial salary of approximately $346,000, which represents no change
      from fiscal year ended December 31, 2005, and for bonuses as determined by
      the
      board of directors. For
      2006,
      the employment agreement requires, if the Company achieves the performance
      levels set by the board, that Mr. Mercadante receive a cash bonus equal to
      100%
      of his salary. Additionally, at the end of the first year of the initial term
      of
      the employment agreement, the Company is required to issue to Mr. Mercadante
      stock options and restricted stock at fair market value and comparable in
      amounts to those issued to a chief executive officer and chairman of the board
      of directors of a comparable publicly traded corporation.The agreement
      also contains standard termination provisions for disability, for cause, and
      for
      good reason, and it also contains confidentiality and non-competition provisions
      that prohibit Mr. Mercadante from disclosing certain information belonging
      to the Company and from competing against the Company. If the employment
      agreement is terminated other than for cause prior to November 30, 2009, or
      if the Company fails to renew the agreement at least through November 30,
      2009, the Company is required to continue to pay to Mr. Mercadante (or to
      his estate in the event of termination due to his death) two year’s severance
      equal to the amount of the compensation and other benefits to which he was
      entitled at the time of termination, subject to the terms of the
      agreement.





53


**Item
      9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE.**





None.





**Item
      9A. CONTROLS AND PROCEDURES**




**Conclusion
      Regarding the Effectiveness of Disclosure Controls and
      Procedures.** We
      carried out an evaluation, under the supervision and with the participation
      of
      our Chief Executive Officer and Chief Financial Officer, of the effectiveness
      of
      the design and operation of our disclosure controls and procedures as of the
      end
      of the period covered by this report pursuant to Exchange Act Rule 13a-15.
      Our
      disclosure controls and procedures include, without limitation, controls and
      procedures designed to ensure that information required to be disclosed by
      us in
      reports that we file or submit pursuant to the Securities Exchange Act of 1934,
      as amended, are accumulated and communicated to our management, including our
      Chief Executive Officer and Chief Financial Officer, as appropriate to allow
      timely decisions regarding required disclosure.  Based on this evaluation,
      our Chief Executive Officer and Chief Financial Officer concluded that our
      disclosure controls and procedures were effective as of the end of the period
      covered by this report.  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 in reaching a reasonable level
      of assurance, management necessarily was required to apply its judgment in
      evaluating the cost-benefit relationship of possible controls and procedures.




**Changes
      in Internal Control Over Financial Reporting.** There
      has been no change in our internal control over financial reporting during
      the
      fourth quarter of 2005 that has materially affected, or is reasonably likely
      to
      materially affect, our internal control over financial reporting.





**Item 9B.
      OTHER INFORMATION**




No
      events
      have occurred which would require disclosure under this Item.





54




**PART
      III**




**Item
      10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Management—Directors and Executive Officers” in
      our definitive Proxy Statement to be used in connection with our Annual Meeting
      of Stockholders, which we expect to file with the Securities and Exchange
      Commission on or before April 30, 2006.





**Item
      11. EXECUTIVE COMPENSATION.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Management—Compensation of Executive Officers
      and Directors” in our definitive Proxy Statement to be used in connection with
      our Annual Meeting of Stockholders, which we expect to file with the Securities
      and Exchange Commission on or before April 30, 2006.





**Item
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Management—Security Ownership of Management and
      Others and Related Stockholder Matters” in our definitive Proxy Statement to be
      used in connection with our Annual Meeting of Stockholders, which we expect
      to
      file with the Securities and Exchange Commission on or before April 30, 2006.





**Item
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Certain Relationships and Related Transactions”
in our definitive Proxy Statement to be used in connection with our Annual
      Meeting of Stockholders, which we expect to file with the Securities and
      Exchange Commission on or before April 30, 2006.





**Item
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.**





The
      information required by this Item is incorporated herein by reference to the
      information under the heading “Principal Account Fees and Services” in our
      definitive Proxy Statement to be used in connection with our Annual Meeting
      of
      Stockholders, which we expect to file with the Securities and Exchange
      Commission on or before April 30, 2006.




55




**PART
      IV**





**Item
      15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K**





(a)
            Documents
                filed as part of this report:





1.
            Consolidated
                Financial Statements and Report of Deloitte & Touche LLP





The
      consolidated financial statements included in Part II, Item 8 of this Annual
      Report on Form 10-K are filed as part of this Report.





2.
            Financial
                Statement Schedule.





Schedule
      II- Valuation and Qualifying Accountsfor the fiscal years ending December 31, 2005, January 1, 2005, and
      December 27, 2003 - Page 57.




56




**SCHEDULE
      II**


**VALUATION
      AND QUALIFYING ACCOUNTS**


**FOR
      THE FISCAL YEARS ENDED DECEMBER 31, 2005, JANUARY 1, 2005, AND DECEMBER 27,
      2003**


Balance,
              
              
              Charged
                  tobeginning
                  of
              
              
              cost
                  and
              
              
              Balance
                  from
              
              
              
              
              
              Balance
                  atyear
              
              
              expenses
              
              
              Merger
              
              
              Deductions
              
              
              end
                  of yearAllowance
                  for Doubtful Accounts:Fiscal
                  year ended December 31, 2005
              
              $
              3,896,519
              
              $
              1,275,190
              (1)
              $
              —
              
              $
              (2,394,330
              )
              $
              2,777,319Fiscal
                  year ended January 1, 2005
              
              
              1,717,851
              
              
              341,995
              
              
              2,182,942
              
              
              (346,769
              )
              
              3,896,519Fiscal
                  year ended December 27, 2003
              
              
              3,100,641
              
              
              615,465
              
              
              —
              
              
              (1,998,255
              )
              
              1,717,851Inventory
                  Reserve:Fiscal
                  year ended December 31, 2005
              
              
              902,585
              
              
              3,090,778
              (2)
              
              —
              
              
              (1,884,622
              )
              
              2,108,741Fiscal
                  year ended January 1, 2005
              
              
              1,045,588
              
              
              659,352
              
              
              285,900
              
              
              (1,088,255
              )
              
              902,585Fiscal
                  year ended December 27, 2003
              
              
              1,374,240
              
              
              531,835
              
              
              —
              
              
              (860,487
              )
              
              1,045,588Valuation
                  Allowance for Deferred Tax Asset:Fiscal
                  year ended December 31, 2005
              
              
              50,123,984
              
              
              20,534,999
              
              
              —
              
              
              —
              
              
              70,658,983Fiscal
                  year ended January 1, 2005
              
              
              46,529,330
              
              
              3,594,654
              
              
              —
              
              
              —
              
              
              50,123,984Fiscal
                  year ended December 27, 2003
              
              
              41,645,492
              
              
              4,883,838
              
              
              —
              
              
              —
              
              
              46,529,330





*(1)
      Includes $1,138,567 related to discontinued operations.*


*(2)
      Includes $1,377,620 related to discontinued operations.*




57





**3.
      Exhibits**




2.1
                  Agreement
                      and Plan of Merger between DrugMax, Inc. and Familymeds Group,
                      Inc. dated
                      March 19, 2004, as amended. (5)2.2
                  First
                      Amendment to Agreement and plan of Merger between DrugMax,
                      Inc. and Family
                      Meds Group, Inc., dated July 1, 2004. (13)2.3
                  Second
                      Amendment to Agreement and plan of Merger between DrugMax,
                      Inc. and Family
                      Meds Group, Inc., dated October 11, 2004. (7)2.4
                  Asset
                      Purchase Agreement between Valley Drug Company and Rochester
                      Drug
                      Cooperative dated December 22, 2005 (11)3.1
                  Amended
                      and Restated Articles of Incorporation of DrugMax, Inc. filed
                      November 12,
                      2005. (8)3.2
                  Amended
                      and Restated Bylaws, dated February 24, 2005. (13)3.3
                  Certificate
                      of Designation, creating Series A Preferred Stock (9)3.4
                  Amendment
                      to Certificate of Amendment relating to Series A Preferred
                      Stock
                      (15)4.1
                  Specimen
                      of Stock Certificate. (1)10.1
                  Employment
                      Agreement by and between DrugMax, Inc. and Edgardo A. Mercadante
                      dated as
                      of March 31, 2006 *10.2
                  Employment
                      Agreement by and between DrugMax, Inc. and Jugal K. Taneja
                      dated as of
                      December 12, 2004 (14)10.3
                  Employment
                      Agreement by and between DrugMax, Inc. and James E. Searson
                      dated May 23,
                      2005 (14)10.4
                  DrugMax.com,
                      Inc. 1999 Incentive and Non-Statutory Stock Option Plan.
                      (1)10.5
                  Amendment
                      No. 1 to DrugMax, Inc. 1999 Incentive and Non-Statutory Stock
                      Option Plan,
                      dated June 5, 2002. (2)10.6
                  Loan
                      and Security Agreement between DrugMax and Wells Fargo Retail
                      Finance, LLC
                      dated October 12, 2005 (18)10.7
                  DrugMax,
                      Inc. 2003 Restricted Stock Plan dated August 27, 2003.
                      (4)10.8
                  Commercial
                      Lease between Becan Development LLC and Valley Drug Company,
                      dated January
                      1, 2004. (6)10.9
                  Amendment
                      No. 1 to Lease between Becan Development LLC and Valley Drug
                      Company,
                      dated December 22, 2005 (11)10.10
                  Sublease
                      between Valley Drug Company, Rochester Drug Company and Becan
                      Development,
                      LLC dated December 27, 2005
                      (11)
 10.11
                Commercial
                  Lease between River Road Real Estate, LLC and DrugMax, Inc. dated
                  October
                  18, 2001.(6)10.12
                Prime
                    Warehouse Supplier Agreement among Familymeds, Inc. and D&K Healthcare
                    Resources, Inc. dated December 28, 2004 (12).10.13
                Subordinated
                    Convertible Debenture in the original principal amount of $11,500,000
                    dated March 21, 2005 (12).10.14
                Subordinated
                    Promissory Note in the original principal amount of $11,500,000
                    dated
                    March 21, 2005 (12).10.15
                Registration
                    Rights Agreement among DrugMax, Inc. and AmerisourceBergen Drug
                    Corporation dated March 21, 2005 (12).10.16
                Security
                    Agreement among DrugMax, Inc., Valley Drug Company, Valley Drug
                    Company
                    South, Familymeds, Inc. and AmerisourceBergen Drug Corporation
                    dated March
                    21, 2005 (12)10.17
                Form
                    of Securities Purchase Agreement among DrugMax, Inc. and various
                    Investors, dated as of September 23, 2005 (16)10.18
                Form
                    of Securities Purchase Agreement among DrugMax, Inc. and various
                    Investors, dated as of September 26, 2005 (16)10.19
                Form
                    of Common Stock Purchase Warrant issued in connection with Securities
                    Purchase Agreement dated as of September 23, 2005 (17)10.20
                Form
                    of Common Stock Purchase Warrant issued in connection with Securities
                    Purchase Agreement dated as of September 26, 2005 (17)10.21
                Form
                    of Registration Rights Agreement executed in connection with
                    Securities
                    Purchase Agreement dated as of September 23, 2005 (17)10.22
                Form
                    of Registration Rights Agreement executed in connection with
                    Securities
                    Purchase Agreement dated as of September 26, 2005
                    (17)


58




21.0
            Subsidiaries
              of DrugMax, Inc.(13)23.0
            Consent
              of Deloitte & Touche LLP.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. *32.0
            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 DrugMax’s Form 10-KSB/A, filed July 14, 2000, File No.
                0-24362.





(2)
            Incorporated
                by reference to DrugMax’s Form 10-KSB, filed July 1, 2002.





(3)
            Incorporated
                by reference to DrugMax’s Form 10-K/A, filed July 29, 2003.





(4)
            Incorporated
                by reference to DrugMax’s Definitive Proxy Statement filed September 8,
                2003.





(5)
            Incorporated
                by reference to DrugMax’s Form 10-K, filed July 14, 2004.





(6)
            Incorporated
                by reference to DrugMax’s Form 10-K/A, filed October 1, 2004.





(7)
            Incorporated
                by reference to DrugMax’s Definitive Proxy Statement filed October 12,
                2004.





(8)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed November 18, 2004. Incorporated
                by reference to DrugMax’s Form 10-K, filed July 14, 2004. Incorporated by
                reference to DrugMax’s Form 8-K, filed November 18, 2004.





(9)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed December 8, 2004.(10)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed December 15, 2004.(11)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed February 21,
                2005.





(12)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed March 25, 2005.(13)
            Incorporated
                by reference to DrugMax’s Form 10-K, filed April 19,
                2005.(14)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed on June 13,
                2005.(15)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed on July, 7,
                2005.(16)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed September 27,
                2005.(17)
            Incorporated
                by reference to DrugMax’s Form 8-K, filed October 5,
                2005.(18)
            Incorporated
              by reference to DrugMax's Form S-1, filed November 2,
              2005.




59




**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.




**DRUGMAX,
                INC.**Date: March
              31, 2006
            By:
            /s/ *Edgardo
              Mercadante*Edgardo
                Mercadante, President, Chief Executive Officer and
              Chairman
                of the Board




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant in the
      capacities and on the dates indicated.




**Signatures**
                
                **Title**
                
                **Date***/s/
                    Edgardo A. Mercadante*
                
                Chairman
                    of the Board, President, Chief Executive Officer and
                    Director
                
                March
                    31, 2006Edgardo
                    A. Mercadante*/s/
                    James E. Searson*
                
                Senior
                    Vice President, Chief Financial Officer, Principal Accounting
                    Officer, and
                    Director
                
                March
                    31, 2006James
                    E. Searson*/s/
                    Philip P. Gerbino*
                
                Director
                
                March
                    31, 2006Philip
                    P. Gerbino*/s/
                    PeterJ. Grua*
                
                Director
                
                March
                    31, 2006Peter
                    J. Grua*/s/
                    Mark T. Majeske*
                
                Director
                
                March
                    31, 2006Mark
                    T. Majeske*/s/
                    Rakesh K. Sharma*
                
                Director
                
                March
                    31, 2006Rakesh
                    K. Sharma*/s/
                    Jugal K. Taneja*
                
                Director
                
                March
                    31, 2006Jugal
                    K. Taneja*/s/
                    Laura L. Witt*
                
                Director
                
                March
                    31, 2006Laura
                    L. Witt




60