**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

----

 

**FORM 10-Q**

 

| **(Mark One)**                               |
|----------------------------------------------|
|                                         |   |
| **ý**                                   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                         |   |
|                                         | **For the quarterly period ended July 31, 2004** |
|                                         |   |
| **o**                                        | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                         |   |
|                                         | **For the transition period from                                        to                                     ** |
|                                         |   |
| **Commission File Number  1-8366** |

 

**POLYDEXPHARMACEUTICALS LIMITED**

(Exact Name of Registrant as Specified in Its Charter)

 
| **Commonwealth of the Bahamas**                                                                    | ** ** | **None**                              |
|----------------------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or Other Jurisdiction of Incorporation or Organization)                                     |       | (I.R.S. Employer  Identification No.) |
|                                                                                               |       |                                  |
| **421 Comstock Road, Toronto, Ontario,  Canada**                                              | ** ** | **M1L 2H5**                      |
| (Address of Principal Executive Offices)                                                           |       | (Zip Code)                            |
|                                                                                               |
| Registrant’s Telephone Number, Including Area  Code    **(416) 755-2231** |
|                                                                                               |
|                                                                                               |
| Former Name, Former Address and Former Fiscal Year, if Changed Since  Last Report                  |

 

Indicate bycheck whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.      Yes ý      No o

 

Indicate bycheck whether the registrant is an accelerated filer (as defined in ExchangeAct Rule 12b-2).      Yes o      No ý

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common shares,as of the latest practicable date.

 

| Common Shares, $.0167 Par Value |   | 3,042,296 shares                    |
|---------------------------------|--------|-------------------------------------|
| (Title of Class)                |   | (Outstanding at September 10, 2004) |

 

 

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**POLYDEX PHARMACEUTICALS LIMITED**

 

**TABLE OF CONTENTS**

 
| **PART I**   | **FINANCIAL  INFORMATION**                                                                                               | ** ** |
|--------------|--------------------------------------------------------------------------------------------------------------------------|------------|
|         | ** **                                                                                                               | ** ** |
| Item 1       | CONSOLIDATED FINANCIAL STATEMENTS  (UNAUDITED)                                                                           |       |
|         |                                                                                                                     |       |
|         | Consolidated Balance Sheets July 31, 2004  and January 31, 2004                                                     |       |
|         |                                                                                                                     |       |
|         | Consolidated Statements of Operations and  Comprehensive Income (Loss) Three and Six months ended July 31, 2004 and 2003 |       |
|         |                                                                                                                     |       |
|         | Consolidated Statements of Shareholders’  Equity Six months ended July 31, 2004 and 2003                            |       |
|         |                                                                                                                     |       |
|         | Consolidated Statements of Cash Flows Six  months ended July 31, 2004 and 2003                                           |       |
|         |                                                                                                                     |       |
|         | Notes to  Consolidated Financial Statements (Unaudited)                                                                  |       |
|         |                                                                                                                     |       |
| Item 2       | MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS                              |       |
|         |                                                                                                                     |       |
| Item 3       | QUANTITATIVE AND QUALITATIVE DISCLOSURES  ABOUT MARKET RISK                                                              |       |
|         |                                                                                                                     |       |
| Item 4       | CONTROLS AND PROCEDURES                                                                                                  |       |
|         | ** **                                                                                                               | ** ** |
| **PART  II** | **OTHER  INFORMATION**                                                                                                   | ** ** |
| ** **   | ** **                                                                                                               | ** ** |
| Item 4       | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                      |       |
|         |                                                                                                                     |       |
| Item 6       | EXHIBITS AND REPORTS ON FORM 8-K                                                                                         |       |
|         |                                                                                                                     |       |
|         | Signatures  and Certifications                                                                                           |       |

 

----

 

**PART I**

**FINANCIAL INFORMATION**

 

**Item 1****.  Consolidated FinancialStatements (unaudited).**

 

**POLYDEX PHARMACEUTICALS LIMITED**

 

ConsolidatedBalance Sheets (Unaudited)

(Expressed in UnitedStates dollars)

 
| ** **                                | ** ** | **July 31  2004** | ** ** | **January 31  2004** | ** ** |
|-------------------------------------------|------------|-------------------|------------|----------------------|------------|
|                                      |       |              |       |                 |       |
| **Assets**                                |       |              |       |                 |       |
|                                      |       |              |       |                 |       |
| Current assets:                           |       |              |       |                 |       |
| Cash and cash equivalents (note 3)        |       | $                 | 3,586,838  |                 | $          | 59,455 |   |
| Trade accounts receivable                 |       | 681,126           |       | 503,864              |       |
| Inventories:                              |       |              |       |                 |       |
| Finished goods                            |       | 1,072,709         |       | 943,373              |       |
| Work-in-process                           |       | 88,478            |       | 107,008              |       |
| Raw materials                             |       | 190,740           |       | 176,058              |       |
|                                      |       |              |       |                 |       |
| Inventories                               |       | 1,351,927         |       | 1,226,439            |       |
| Prepaid expenses and other current assets |       | 130,060           |       | 42,730               |       |
| Deferred tax assets                       |       | —            |       | 267,500              |       |
| Assets subject to sale agreement          |       | —            |       | 4,285,666            |       |
|                                      |       |              |       |                 |       |
|                                      |       | 5,749,951         |       | 6,385,654            |       |
|                                      |       |              |       |                 |       |
| Property, plant and equipment, at cost    |       |              |       |                 |       |
| Land and buildings                        |       | 1,388,210         |       | 1,391,141            |       |
| Machinery and equipment                   |       | 7,024,838         |       | 6,982,088            |       |
|                                      |       | 8,413,048         |       | 8,373,229            |       |
| Less accumulated depreciation             |       | (5,351,582        | )          | (5,124,887           | )          |
| Property, plant and equipment, net        |       | 3,061,466         |       | 3,248,342            |       |
| Patents and intangible assets, net        |       | 72,976            |       | 85,511               |       |
| Investments available for sale (note 4)   |       | 1,127,239         |       | —               |       |
| Due from shareholder                      |       | 753,546           |       | 791,006              |       |
|                                      |       |              |       |                 |       |
|                                      |       | $                 | 10,765,178 |                 | $          | 10,510,513 |   |

 

1

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| ** **                                                  | ** ** | **July 31  2004** | ** ** | **January 31  2004** | ** ** |
|-------------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
|                                                        |       |              |       |                 |       |
| **Liabilities and Shareholders’ Equity**               |       |              |       |                 |       |
|                                                        |       |              |       |                 |       |
| Current liabilities:                                        |       |              |       |                 |       |
| Bank indebtedness                                           |       | $                 | 135,420    |                 | $          | 165,609 |   |
| Accounts payable                                            |       | 368,554           |       | 515,092              |       |
| Accrued liabilities                                         |       | 183,367           |       | 163,463              |       |
| Payroll and related taxes payable                           |       | 123,378           |       | 173,583              |       |
| Customer deposits                                           |       | 95,913            |       | 100,925              |       |
| Income taxes payable                                        |       | 276,030           |       | 923                  |       |
| Liabilities subject to sale agreement                       |       | —            |       | 880,564              |       |
| Current portion of long-term debt                           |       | 66,251            |       | 281,015              |       |
| Current portion of capital lease  obligations               |       | 151,093           |       | 161,253              |       |
|                                                        |       |              |       |                 |       |
|                                                        |       | 1,400,006         |       | 2,442,427            |       |
|                                                        |       |              |       |                 |       |
| Long-term debt                                              |       | 11,631            |       | 45,517               |       |
| Capital lease obligations                                   |       | 214,039           |       | 284,950              |       |
| Due to shareholder                                          |       | 683,011           |       | 683,234              |       |
| Deferred income taxes                                       |       | 236,067           |       | 147,054              |       |
|                                                        |       |              |       |                 |       |
|                                                        |       | 1,144,748         |       | 1,160,755            |       |
|                                                        |       |              |       |                 |       |
| Total liabilities                                           |       | 2,544,754         |       | 3,603,182            |       |
|                                                        |       |              |       |                 |       |
| Shareholders’ equity:                                  |       |              |       |                 |       |
| Capital stock                                               |       |              |       |                 |       |
| Authorized:                                                 |       |              |       |                 |       |
| 100,000 Class A preferred shares of par  value $0.10 each   |       |              |       |                 |       |
| 899,400 Class B preferred shares of par  value $0.0167 each |       |              |       |                 |       |
| 10,000,000 common shares of par value  $0.0167 each         |       |              |       |                 |       |
| Issued and outstanding:                                     |       |              |       |                 |       |
| 899,400 Class B preferred shares                            |       | 15,010            |       | 15,010               |       |
| 3,042,296 common shares (January 31, 2004 -  3,027,796)     |       | 50,676            |       | 50,434               |       |
| Contributed surplus                                         |       | 23,289,506        |       | 23,236,498           |       |
| Deficit                                                     |       | (15,010,841       | )          | (16,284,268          | )          |
| Accumulated other comprehensive loss                        |       | (123,927          | )          | (110,343             | )          |
|                                                        |       |              |       |                 |       |
|                                                        |       | 8,220,424         |       | 6,907,331            |       |
|                                                        |       |              |       |                 |       |
|                                                        |       | $                 | 10,765,178 |                 | $          | 10,510,513 |   |

 

See accompanying notes

 

2

----

 

**POLYDEX PHARMACEUTICALS LIMITED**

 

ConsolidatedStatements of Operations and Comprehensive Income (Loss) (Unaudited)

(Expressed inUnited States dollars)

 
| ** **                                                           | ** ** | **Quarter Ended  July 31  2004** | ** ** | **Quarter Ended  July 31  2003** | ** ** | **Year to Date  July 31  2004** | ** ** | **Year to Date  July 31  2003** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Sales                                                                |       | $                                | 1,338,409  |                             | $          | 3,058,369                       |       | $                               | 3,860,203  |   | $ | 6,354,887 |   |
| Cost of goods sold                                                   |       | 864,549                          |       | 2,373,364                        |       | 2,511,178                       |       | 4,891,594                       |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
|                                                                 |       | 473,860                          |       | 685,005                          |       | 1,349,025                       |       | 1,463,293                       |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Expenses:                                                            |       |                             |       |                             |       |                            |       |                            |       |
| General and administrative                                           |       | 278,381                          |       | 538,879                          |       | 710,577                         |       | 963,857                         |       |
| Depreciation                                                         |       | 117,307                          |       | 148,701                          |       | 234,801                         |       | 291,058                         |       |
| Research and development                                             |       | 16,636                           |       | 12,333                           |       | 30,060                          |       | 21,772                          |       |
| Interest expense                                                     |       | 19,608                           |       | 34,204                           |       | 50,299                          |       | 69,576                          |       |
| Selling and promotion                                                |       | 23,459                           |       | 38,185                           |       | 48,626                          |       | 82,398                          |       |
| Foreign exchange (gain) loss                                         |       | (26,493                          | )          | 32,206                           |       | (11,133                         | )          | 224,383                         |       |
| Amortization                                                         |       | 2,008                            |       | 5,545                            |       | 12,535                          |       | 11,091                          |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
|                                                                 |       | 430,906                          |       | 810,053                          |       | 1,075,765                       |       | 1,664,135                       |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Income (loss) before the following                                   |       | 42,954                           |       | (125,048                         | )          | 273,260                         |       | (200,842                        | )          |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Other income (expense):                                              |       |                             |       |                             |       |                            |       |                            |       |
| Gain on sale of assets (note 5)                                      |       | —                           |       | —                           |       | 1,859,471                       |       | —                          |       |
| Other income (expense), net                                          |       | 21,753                           |       | (55,701                          | )          | 6,681                           |       | (194,695                        | )          |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
|                                                                 |       | 21,753                           |       | (55,701                          | )          | 1,866,152                       |       | (194,695                        | )          |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Income (loss) before income taxes                                    |       | 64,707                           |       | (180,749                         | )          | 2,139,412                       |       | (395,537                        | )          |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Provision for income taxes                                           |       | 51,948                           |       | 56,056                           |       | 865,985                         |       | 130,838                         |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Net income (loss) for the period                                     |       | 12,759                           |       | (236,805                         | )          | 1,273,427                       |       | (526,375                        | )          |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Unrealized gain (loss) on investments  available for sale            |       | (4,211                           | )          | —                           |       | (4,211                          | )          | —                          |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Currency translation adjustment                                      |       | 204,717                          |       | 43,763                           |       | (9,373                          | )          | 487,136                         |       |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Comprehensive income (loss) for the period                           |       | $                                | 213,265    |                             | $          | (193,042                        | )          | $                               | 1,259,843  |   | $ | (39,239 | ) |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Per share information:                                               |       |                             |       |                             |       |                            |       |                            |       |
| Earnings (loss) per common share:                                    |       |                             |       |                             |       |                            |       |                            |       |
| Basic                                                                |       | $                                | 0.00       |                             | $          | (0.08                           | )          | $                               | 0.42       |   | $ | (0.17 | ) |
| Diluted                                                              |       | $                                | 0.00       |                             | $          | (0.08                           | )          | $                               | 0.42       |   | $ | (0.17 | ) |
|                                                                 |       |                             |       |                             |       |                            |       |                            |       |
| Weighted average number of common shares  outstanding for the period |       | 3,037,463                        |       | 3,027,796                        |       | 3,032,629                       |       | 3,027,796                       |       |

 

See accompanying notes

 

3

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**POLYDEX PHARMACEUTICALS LIMITED**

 

ConsolidatedStatements of Shareholders’ Equity (Unaudited)

(Expressed inUnited States dollars)

 
| ** **                                         | ** ** | **Six Months Ended  July 31  2004** | ** **  | **Six Months Ended  July 31  2003** | ** ** |
|----------------------------------------------------|------------|-------------------------------------|-------------|-------------------------------------|------------|
|                                               |       |                                |        |                                |       |
| Preferred Shares:                                  |       |                                |        |                                |       |
| Balance, beginning and end of period               |       | $                                   | 15,010      |                                | $          | 15,010 |   |
|                                               |       |                                |        |                                |       |
| Common Shares:                                     |       |                                |        |                                |       |
| Balance, beginning of period                       |       | $                                   | 50,434      |                                | $          | 50,434 |   |
| Common share options exercised                     |       | 242                                 |        | —                              |       |
|                                               |       |                                |        |                                |       |
| Balance, end of period                             |       | $                                   | 50,676      |                                | $          | 50,434 |   |
|                                               |       |                                |        |                                |       |
| Contributed Surplus:                               |       |                                |        |                                |       |
| Balance, beginning of period                       |       | $                                   | 23,236,498  |                                | $          | 23,224,128 |   |
| Common share options exercised                     |       | 53,008                              |        | —                              |       |
|                                               |       |                                |        |                                |       |
| Balance, end of period                             |       | $                                   | 23,289,506  |                                | $          | 23,224,128 |   |
|                                               |       |                                |        |                                |       |
| Deficit:                                           |       |                                |        |                                |       |
| Balance, beginning of period                       |       | $                                   | (16,284,268 | )                                   | $          | (16,278,269 | ) |
| Net income (loss) for the period                   |       | 1,273,427                           |        | (526,375                            | )          |
|                                               |       |                                |        |                                |       |
| Balance, end of period                             |       | $                                   | (15,010,841 | )                                   | $          | (16,804,644 | ) |
|                                               |       |                                |        |                                |       |
| Accumulated Other Comprehensive Loss:              |       |                                |        |                                |       |
| Balance, beginning of period                       |       | $                                   | (110,343    | )                                   | $          | (986,776 | ) |
| Unrealized loss on investments available  for sale |       | (4,211                              | )           | —                              |       |
| Currency translation adjustment for the  period    |       | (9,373                              | )           | 487,136                             |       |
|                                               |       |                                |        |                                |       |
| Balance, end of period                             |       | $                                   | (123,927    | )                                   | $          | (499,640 | ) |

 

See accompanying notes

 

4

----

 

**POLYDEX PHARMACEUTICALS LIMITED**

 

ConsolidatedStatements of Cash Flows (Unaudited)

(Expressed inUnited States dollars)

 
| ** **                                                             | ** ** | **Six Months Ended  July 31  2004** | ** ** | **Six Months Ended  July 31  2003** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
|                                                                   |       |                                |       |                                |       |
| Cash provided by (used in):                                            |       |                                |       |                                |       |
|                                                                   |       |                                |       |                                |       |
| Operating activities:                                                  |       |                                |       |                                |       |
| Net income (loss) for the period                                       |       | $                                   | 1,273,427  |                                | $          | (526,375 | ) |
| Add (deduct) items not affecting cash:                                 |       |                                |       |                                |       |
| Depreciation and amortization                                          |       | 247,336                             |       | 302,149                             |       |
| Imputed interest on long-term debt                                     |       | 11,853                              |       | 12,664                              |       |
| Deferred income taxes                                                  |       | 589,352                             |       | 99,153                              |       |
| Gain on sale of veterinary products  business                          |       | (1,859,471                          | )          | —                              |       |
| Unrealized loss on commercial paper  available for sale                |       | (1,184                              | )          | —                              |       |
| Accrued interest on investments available  for sale                    |       | (2,427                              | )          | —                              |       |
| Net change in non-cash working capital  balances related to operations |       | (298,196                            | )          | 308,581                             |       |
|                                                                   |       |                                |       |                                |       |
|                                                                   |       | (39,310                             | )          | 196,172                             |       |
|                                                                   |       |                                |       |                                |       |
| Investing activities:                                                  |       |                                |       |                                |       |
| Additions to property, plant and equipment  and patents                |       | (56,611                             | )          | (130,211                            | )          |
| Decrease in due from shareholder                                       |       | 37,460                              |       | 34,958                              |       |
| Acquisition of investments available for  sale                         |       | (1,116,255                          | )          | —                              |       |
| Proceeds from sale of veterinary products  business                    |       | 4,599,218                           |       | —                              |       |
|                                                                   |       |                                |       |                                |       |
|                                                                   |       | 3,463,812                           |       | (95,253                             | )          |
|                                                                   |       |                                |       |                                |       |
| Financing activities:                                                  |       |                                |       |                                |       |
| Repayment of long-term debt                                            |       | (260,503                            | )          | (105,039                            | )          |
| Repayment of capital lease obligations                                 |       | (79,306                             | )          | (28,845                             | )          |
| Increase (decrease) in due to shareholder                              |       | (223                                | )          | 1,386                               |       |
| Increase (decrease) in bank indebtedness                               |       | (30,189                             | )          | 255,809                             |       |
|                                                                   |       |                                |       |                                |       |
|                                                                   |       | (370,221                            | )          | 123,311                             |       |
|                                                                   |       |                                |       |                                |       |
| Effect of exchange rate changes on cash and  cash equivalents          |       | 161,029                             |       | 149,597                             |       |
|                                                                   |       |                                |       |                                |       |
| Increase in cash and cash equivalents during  the period               |       | 3,215,310                           |       | 373,827                             |       |
|                                                                   |       |                                |       |                                |       |
| Cash and cash equivalents, beginning of  period                        |       | 371,528                             |       | 280,748                             |       |
|                                                                   |       |                                |       |                                |       |
| Cash and cash equivalents, end of period                               |       | $                                   | 3,586,838  |                                | $          | 654,575 |   |

 

See accompanying notes

 

5

----

 

**1.**              Basis ofPresentation:

 

The information containedin the interim consolidated financial statements is condensed from that whichwould appear in annual consolidated financial statements.  The interim consolidated financial statementsincluded herein should be read in conjunction with the audited financialstatements, and notes thereto, and other financial information contained in the2004 Annual Report on Form 10-K for the fiscal year ended January 31, 2004 asfiled by Polydex Pharmaceuticals Limited (the “Company”) with the Securitiesand Exchange Commission.  The unauditedinterim consolidated financial statements as of July 31, 2004 and 2003 includeall normal recurring adjustments which management considers necessary for afair presentation.  The results ofoperations for the interim periods are not necessarily indicative of theresults that may be expected for the entire fiscal year.  The interim consolidated financial statementsinclude the accounts and transactions of the Company and its majority ownedsubsidiaries in which the Company has equal to or more than a 50% ownershipinterest and exercises control.

 

**2.**              SignificantAccounting Policies:

** **

**Basis of consolidation**

** **

The interimconsolidated financial statements include the accounts of the Company and itssubsidiaries.  All inter-company accountsand transactions have been eliminated on consolidation.

 

**Use of estimates**

** **

The preparation ofconsolidated financial statements in conformity with United States generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the interimconsolidated financial statements and the reported amounts of revenue andexpenses during the reporting period. Actual results could differ from these estimates.

 

**Cash and cash equivalents**

** **

**Cashand cash equivalents include cash and short-term deposits with maturities ofless than three months at the date of purchase.**

** **

**Inventories**

** **

Inventories of rawmaterials are stated at the lower of cost and net realizable value, cost beingdetermined on a first-in, first-out basis. Work-in-process and finished goods are valued at the lower of cost andnet realizable value, and include the cost of raw materials, direct labour andoverhead expenses.

 

**Investments available for sale**

 

Investments available for saleconsist of commercial paper and medium term fixed income investments and arestated at fair market value based on quoted market prices.  Interest income is included in other incomein the statement of operations as it is earned. Changes in market values during the holding period are reported asunrealized gain (loss) on investments available for sale and are included inother comprehensive income.

 

**Property, plant and equipment andpatents and intangible assets**

** **

Property, plantand equipment are recorded at cost less accumulated depreciation.  Depreciation is provided on a straight-linebasis over the estimated useful lives of the assets as follows:

 
| Buildings                |   | 15 years      |
|--------------------------|--------|---------------|
| Machinery and  equipment |   | 3 to 10 years |

 

Patents andintangible assets are recorded at cost and are amortized on a straight-linebasis over their estimated useful lives of ten years.  Intangible assets consist of intellectualproperty, government licenses and government license applications.

 

6

----

 

Useful life is theperiod over which the asset is expected to contribute to the Company’s futurecash flows.  The Company reviews therecoverability of its long-lived assets when events or changes in circumstancesoccur that indicate that the carrying value of the asset may not berecoverable.  The assessment of possibleimpairment is based on the Company’s ability to recover the carrying value ofthe asset from the expected future pre-tax cash flows of the relatedoperations.  If these cash flows are lessthan the carrying value of such asset, an impairment loss is recognized for thedifference between estimated fair value and carrying value.

 

Costs related toplant refurbishments and equipment upgrades that represent improvements toexisting facilities are capitalized. Costs related to repair and maintenance of buildings and equipment areexpensed.  The Company has no majorplanned maintenance activity.

 

**Revenue recognition**

** **

The majority ofrevenue is from sales of bulk manufactured products.  There was also revenue from finished dosagemanufactured products up to March 4, 2004, at which time the Company’s investmentin the Vet Labs – Sparhawk Joint Venture was sold (see note 5).  Revenue is recognized when title and risk ofownership of products pass to the customer. Title and risk of ownership pass to the customer pursuant to theapplicable sales contract, either upon shipment of product or upon receipt bythe customer.

 

Product sold inbulk quantities is tested, prior to release for shipment, to ensure that itmeets customer specifications, and in many cases, customers receive samples fortheir own testing.  Approval is obtainedfrom the customer prior to shipping. Further purchases by a customer of a bulk product with the samespecifications do not require approvals. Returns of bulk product are rare and generally are not accepted.

 

No testing andapproval is required for finished dosage product because of its nature.  Returns of finished dosage product are rareand generally are not accepted.

 

**Shipping and handling costs**

** **

Shipping andhandling costs incurred by the Company for shipment of products to customersare included in cost of goods sold.

 

**Research and development**

** **

Research anddevelopment costs are expensed as incurred and are stated net of investment taxcredits earned.

 

**Foreign currency translation**

** **

The functionalcurrency of the Company’s Canadian operations has been determined to be theCanadian dollar.  All asset and liabilityaccounts of the Company have been translated into United States dollars usingthe current exchange rates at the interim consolidated balance sheetdates.  Revenue and expense items aretranslated using the average exchange rates for the year.  The resulting gains and losses have beenreported separately as accumulated other comprehensive loss withinshareholders’ equity.

 

**Stockoptions**

** **

The Company haselected to follow Statement of Financial Accounting Standards No. 123,“Accounting for Stock-Based Compensation” [“SFAS 123”].  Under SFAS 123, compensation expense isrecognized on the date of grant, based on the fair value of the optionsgranted.

 

7

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**Earnings (loss) per common share**

** **

Basic earnings(loss) per common share are computed using the weighted average number ofcommon shares outstanding of 3,032,629 for the six months ended July 31, 2004(2003 - 3,027,796).  Diluted earnings(loss) per common share are computed using the weighted average number ofcommon shares outstanding adjusted for the incremental shares, using thetreasury stock method, attributed to outstanding options to purchase commonstock.  Incremental shares of 30,854 andnil at July 31, 2004 and July 31, 2003, respectively, were used in thecalculation of diluted earnings (loss) per common share.  Options to purchase 3,885 and 431,550 commonshares at July 31, 2004 and July 31, 2003, respectively, were not included inthe computation of diluted earnings (loss) per common share because theireffect was anti-dilutive.

 

**3.**              Cash and Cash Equivalents:

** **

**Cash and cash equivalents consistof the following:**

 
| ** **       | ** ** | **July 31  2004** | ** ** | **January 31  2004** | ** ** |
|------------------|------------|-------------------|------------|----------------------|------------|
| ** **       | ** ** | ** **        | ** ** | ** **           | ** ** |
| Cash             |       | $                 | 326,681    |                 | $          | 59,455 |   |
| Commercial paper |       | 3,257,333         |       | —               |       |
|             |       | $                 | 3,584,014  |                 | $          | 59,455 |   |

 

**The commercial paper bears interestat rates of approximately 2% and expiry dates extending up to three months.**

** **

**4.****              InvestmentsAvailable For Sale:**

** **

Investments available for saleconsist of Canadian medium term fixed income instruments with maturity datesextending from one to three years. Investments available for sale are stated at fair market value based onquoted market prices.  An unrealized lossof $3,027 has been included in accumulated other comprehensive loss.

** **

**5.**              Stock-based Employee Compensation:

** **

The Companymaintains an incentive share option plan for management personnel for optionsto purchase up to 1,000,000 common shares. The Company also issues options to certain consultants for servicesprovided to the Company.

 

All optionsgranted have terms of five years and vest immediately.  At July 31, 2004, the Company had 83,435options outstanding at exercise prices ranging from $2.50 to $7.72 and aweighted average exercise price of $4.62. The options, which are immediately exercisable and expire on datesbetween January 11, 2005 and January 31, 2009, entitle the holder of an optionto acquire one common share of the Company.

 

The Company usesthe fair value method in accordance with SFAS 123 to account for awards ofstock-based employee compensation.  Nostock-based employee compensation expense was recorded during the period fromFebruary 1, 2004 to July 31, 2004, because there were no options granted duringthis period.  Similarly, no stock-basedemployee compensation expense was recorded during the period from February 1,2003 to July 31, 2003, because there were no options granted during thisperiod.

 

**6.**              The Vet Labs –Sparhawk Joint Venture:

** **

In 1992,Veterinary Laboratories, Inc. (“Vet Labs”) and Sparhawk Laboratories, Inc.(“Sparhawk”) entered into the Vet Labs – Sparhawk Joint Venture (the “JointVenture”) for the manufacture and sale of veterinary pharmaceuticalproducts.  Vet Labs and Sparhawk eachowned 50% of the Joint Venture.

 

8

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On January 13,2004, the Company entered into an Asset Purchase Agreement with Sparhawk.  Pursuant to this Asset Purchase Agreement,the Company agreed to sell the finished product veterinary pharmaceuticalbusiness, including substantially all of the assets of Vet Labs, to Sparhawkfor $5,500,000 in cash. Effective March 4, 2004, this sale was completed.  Simultaneously, on March 4, 2004, Chemdex,Inc. (“Chemdex”), a wholly-owned subsidiary of the Company, advanced $350,000to Sparhawk in exchange for a promissory note bearing interest at 13% per annumand a warrant to purchase 4% of the equity of Sparhawk for no additionalconsideration.  The promissory note isdue in full on March 4, 2009.  Interestis payable annually, but can be deferred and added to the principal balance ofthe promissory note each year at Sparhawk’s discretion.  The warrant expires at the earlier of paymentin full of the promissory note or 10 years from date of issue.  The warrant becomes exercisable the day afterthe fifth anniversary from the date of issue. Pursuant to a definitive supply agreement [the “Supply Agreement”]entered into on March 4, 2004, Chemdex agreed to supply ferric hydroxide andhydrogenated dextran solution to Sparhawk on an exclusive basis in the UnitedStates for 10 years.  Chemdex alsogranted to Sparhawk an exclusive license to use the drug master file tomanufacture 10% bulk Iron Dextran for veterinary use, and the use of certainequipment during the 10-year period of the Supply Agreement.  Pursuant to definitive agreements, theCompany made customary representations, warranties and indemnities and agreedto a full release of all claims against Sparhawk arising from the Joint Venturelitigation.  Similarly, Sparhawk agreedto a full release of all claims against the Company arising from the JointVenture litigation.

 

The sale resultedin a gain of $2,209,471, of which $1,859,471 was recognized in the consolidatedstatement of operations and $350,000 was deferred.  The deferred gain of $350,000 relates to thepromissory note receivable from Sparhawk as Sparhawk is thinly capitalized andhighly leveraged.  The Company willmonitor the financial position of Sparhawk and will recognize this deferredgain at such time as Sparhawk’s cash flows from operations are sufficient tofund debt service on a full accrual basis.

 

**7.****             ****Segmented Information:**

 

All operations are carried out through Dextran ProductsLimited (“Dextran”) in Canada and through Chemdex in the United States.  The operations of Chemdex represent theveterinary products business.  Each ofDextran and Chemdex operates as a strategic business unit offering different products.  Each subsidiary comprises a reportablesegment as follows:

 
| Dextran - | manufactures and sells bulk quantities of dextran and  several of its derivatives to large pharmaceutical companies throughout the  world.                                                                                                                                                                |
|-----------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |                                                                                                                                                                                                                                                                                                      |
| Chemdex - | manufactures and sells veterinary pharmaceutical  products and specialty chemicals in the United States.  The primary customers are distributors and  private labelers, who in turn sell to the end user of the products.  The majority of this business was sold on  March 4, 2004 *[note 5]*. |

 

9

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| ** **                                  | ** ** | **Three Months  Ended  July 31  2004** | ** ** | **Three Months  Ended  July 31  2003** | ** ** | **Six Months  Ended  July 31  2004** | ** ** | **Six Months  Ended  July 31  2003** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
|                                        |       |                                   |       |                                   |       |                                 |       |                                 |       |
| **Sales:**                                  |       |                                   |       |                                   |       |                                 |       |                                 |       |
| Dextran                                     |       | $                                      | 1,333,866  |                                   | $          | 1,333,004                            |       | $                                    | 2,863,690  |   | $ | 2,631,945 |   |
| Less:   intercompany sales elimination |       | 101,735                                |       | 91,819                                 |       | 201,666                              |       | 174,740                              |       |
|                                        |       | 1,232,131                              |       | 1,241,185                              |       | 2,662,024                            |       | 2,457,205                            |       |
| Chemdex                                     |       | 106,278                                |       | 1,817,184                              |       | 1,198,179                            |       | 3,897,682                            |       |
| Total consolidated sales                    |       | $                                      | 1,338,409  |                                   | $          | 3,058,369                            |       | $                                    | 3,860,203  |   | $ | 6,354,887 |   |
|                                        |       |                                   |       |                                   |       |                                 |       |                                 |       |
| **Income (loss) before income  taxes:**     |       |                                   |       |                                   |       |                                 |       |                                 |       |
| Dextran                                     |       | $                                      | 145,832    |                                   | $          | 115,935                              |       | $                                    | 415,111    |   | $ | 149,276 |   |
| Chemdex                                     |       | 9,890                                  |       | (89,437                                | )          | 1,990,281                            |       | (227,505                             | )          |
| Total pre-tax income (loss)  from segments  |       | 155,722                                |       | 26,498                                 |       | 2,405,392                            |       | (78,229                              | )          |
| Less:   Unallocated corporate expenses |       | 91,015                                 |       | 207,247                                |       | 265,980                              |       | 317,308                              |       |
| Total consolidated pre-tax  income (loss)   |       | $                                      | 64,707     |                                   | $          | (180,749                             | )          | $                                    | 2,139,412  |   | $ | (395,537 | ) |
|                                        |       |                                   |       |                                   |       |                                 |       |                                 |       |
| **Total revenue by significant  customer:** |       |                                   |       |                                   |       |                                 |       |                                 |       |
| Customer A                                  |       | $                                      | 285,254    |                                   | $          | 252,370                              |       | $                                    | 531,937    |   | $ | 592,001 |   |
|                                        |       |                                   |       |                                   |       |                                 |       |                                 |       |
| **Sales revenue by product  group:**        |       |                                   |       |                                   |       |                                 |       |                                 |       |
| Bulk dextran and derivatives                |       | $                                      | 1,338,409  |                                   | $          | 1,241,185                            |       | $                                    | 2,768,302  |   | $ | 2,457,205 |   |
| Sterile injectible veterinary  products     |       | —                                 |       | 1,119,988                              |       | 663,629                              |       | 2,167,063                            |       |
| Oral and topical veterinary products        |       | —                                 |       | 697,196                                |       | 428,272                              |       | 1,730,619                            |       |
| Total consolidated sales                    |       | $                                      | 1,338,409  |                                   | $          | 3,058,369                            |       | $                                    | 3,860,203  |   | $ | 6,354,887 |   |

 
| ** **                 | ** ** | **July 31, 2004** | ** ** | **January 31, 2004** | ** ** |
|----------------------------|------------|-------------------|------------|----------------------|------------|
|                       |       |              |       |                 |       |
| **Assets:**                |       |              |       |                 |       |
| Dextran                    |       | $                 | 9,738,904  |                 | $          | 5,045,899 |   |
| Chemdex                    |       | 159,230           |       | 4,281,084            |       |
|                       |       |              |       |                 |       |
| Total assets from segments |       | 9,898,134         |       | 9,326,983            |       |
| Corporate assets           |       | 871,299           |       | 1,183,530            |       |
| Total consolidated assets  |       | $                 | 10,769,433 |                 | $          | 10,510,513 |   |

 

10

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**8.****             ****Recent Accounting Pronouncements:**

 

In December 2003,the FASB issued FASB Interpretation [“FIN”] No. 46R, “Consolidation of VariableInterest Entities an interpretation of ARB No. 51” [the “Interpretation”],which is a revision of FIN No. 46 originally issued in January 2003.  The Interpretation introduces a newconsolidation model - the variable interests model - which determines control[and consolidation] based on potential variability in gains and losses of theentity being evaluated for consolidation. It also requires application infinancial statements of public entities for periods ending after December 15,2003 for special purpose entities, and in financial statements for periodsending after March 15, 2004 for other types of variable interest entities.  The Company does not have any interests inspecial purpose entities, and will account for any variable interest entitiesin accordance with the Interpretation. The adoption of this Interpretation hadno impact on the Company’s consolidated financial statements.

 

11

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**Item 2****.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*The Company’s fiscal year ends on January 31stof each year.  In this report, fiscalyear 2005 refers to the Company’s fiscal year ended January 31, 2005.  The following discussion should be read inconjunction with the April 30, 2004 interim consolidated financial statementsand notes thereto included elsewhere in this report.  Operating results for the first quarter endedApril 30, 2004 are not necessarily indicative of the results that may beexpected for the fiscal year ended January 31, 2005.  For further information, refer to theconsolidated financial statements and footnotes thereto included in theCompany’s annual report on Form 10-K for the fiscal year ended January 31,2004.*  *The Company’s financialstatements are prepared in accordance with United States generally acceptedaccounting principles.  All amounts arein United States dollars, unless otherwise denoted.*

 

**Overview**

 

The Company is engaged in the research, development,manufacture and marketing of biotechnology-based products for the humanpharmaceutical market, and also manufactures bulk pharmaceutical intermediatesfor the worldwide veterinary pharmaceutical industry.  The Companyconducts its business operations through its subsidiaries, which operate asstrategic business units:  Dextran Products and Chemdex.

 

***Dextran Products Business***

 

The manufacture and sale of bulk quantities of dextranand derivative products for sale to large pharmaceutical companies throughoutthe world is conducted through a Canadian subsidiary, Dextran Products.

 

*Management Objectives for Fiscal 2005*.  In fiscal year 2005, managementintends to focus on the core businesses of Dextran Products that havehistorically been the backbone of the Company.  Opportunities to implementdistribution chains for existing dextran products in untapped markets, such asIndia, China and Russia are being explored by management.  Expanding currentmarket opportunities and the potential for new market penetration has ledmanagement to make plant refurbishment

 

12

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and the expansion of production capacity a priorityfor fiscal 2005 with respect to Dextran Products operations.

 

Research and development of the Company’s humanpharmaceutical products is coordinated at the Dextran Products facility. Ushercell, the Company’s leading human pharmaceutical compound, is a highmolecular weight Cellulose Sulphate envisioned for topical vaginal useprimarily in the prevention of transmission of AIDS and other sexuallytransmitted diseases, as well as unplanned pregnancies.  Multiple clinicaltrials have been completed, and additional trials have commenced or are beingactively planned, to evaluate various aspects of the use of Cellulose Sulphateas a contraceptive gel with antiviral capabilities.  The Company alsointends to significantly explore the use of Ushercell as a treatment forBacterial Vaginosis (BV), the most common vaginal disorder amongreproductive-age women.  If effective, BV treatment may present anopportunity for commercial viability of Ushercell in advance of the completionof the much lengthier required testing for its use as an antiviral contraceptivegel.

 

***Chemdex, Vet Labs and the JointVenture Business***

 

During February 2004, the Company also engaged in thefinished product veterinary pharmaceutical business through its United Statessubsidiary Chemdex, which, in turn, conducted its operations through itssubsidiary, Vet Labs.  On December 1, 1992, Vet Labs and SparhawkLaboratories Inc. entered into a Joint Venture for the purpose of manufacturingand selling veterinary pharmaceutical products.

 

On January 13, 2004, the Company, Chemdex and Vet Labsentered into an Asset Purchase Agreement with Sparhawk pursuant to which theCompany agreed to sell its finished product veterinary pharmaceutical business,including substantially all of the assets of Vet Labs and its ownershipinterest in the Joint Venture, to Sparhawk for $5,500,000 in cash.  Thesale was completed on March 4, 2004.  Simultaneously with

 

13

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the closing, Chemdex advanced $350,000 to Sparhawk inexchange for an unsecured subordinated promissory note bearing interest at 13%per annum and a warrant to purchase 4% of the equity of Sparhawk.  Thepromissory note is payable in full on March 4, 2009.  Interest is payableannually, but can be deferred and added to the principal balance of thepromissory note each year at Sparhawk’s discretion.  The warrant becomesexercisable on March 5, 2009 and expires at the earlier of payment in full ofthe promissory note or March 4, 2014.  Chemdex also entered into a supplyagreement with Sparhawk to supply ferric hydroxide and hydrogenated dextransolution to Sparhawk on an exclusive basis in the United States for 10years.  In connection with the sale, the litigation involving the JointVenture, *Sparhawk Laboratories, Inc. v. VeterinaryLaboratories, Inc., et al*, Case No. 02CV07426, County of Johnson,State of Kansas, was settled, and a Motion of Approval of Settlement andStipulation of Dismissal with Prejudice was filed with the Court on March 4,2004.

 

**Resultsof Operations**

 

***Three months ended July 31, 2004compared to three months ended July 31, 2003***

 
| ** **                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Net income (loss)         |       | $        | 12,759     |     | $          | (236,805 | ) |
|                      |       |     |       |     |       |
| Earnings (loss) per share |       | 0.00     |       | (0.08    | )          |
|                           |            |          |            |          |            |  |  |

 

The large increase in net income for the secondquarter of fiscal year 2005 ended July 31, 2004, as compared to the secondquarter in fiscal year 2004 is attributable to the increase in net income atChemdex.  In addition, there was an increase in the foreign exchange gainin the second quarter of fiscal year 2005 as compared to the second quarter offiscal year 2004.  In the second quarterof fiscal year 2004, there was a rise in the value of the Canadian dollarrelative to the United States

 

14

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dollar.  DextranProducts had a very large exposure to the United States dollar during fiscalyear 2004, which resulted in a foreign exchange loss.  Dextran Products’ exposure to the U.S. dollarhas decreased significantly in fiscal year 2005 with the repayment ofintercompany receivables by Chemdex.

 
| **Income  (loss) before income taxes** | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Consolidated                           |       | $        | 64,707     |     | $          | (180,749     | )          | 136 | % |
| Dextran Products                       |       | 145,832  |       | 115,935  |       | 26           | %          |
| Chemdex                                |       | 9,890    |       | (89,437  | )          | 111          | %          |
|                                        |            |          |            |          |            |              |            |  |  |

 

The increase in operating results in the secondquarter of fiscal year 2005 is primarily attributable to the increase in incomeat Chemdex.

 

*Dextran Products*.  The increase in operating results at DextranProducts is due to increased gross margin and an increase in the foreignexchange gain in the second quarter of fiscal year 2005.  This foreign exchange gain is due to theincrease in the United States dollar relative to the Canadian dollar. During the second quarter of fiscal year 2004, there was a decline in theUnited States dollar relative to the Canadian dollar, which resulted in aforeign exchange loss.  Dextran Productshad a significant net asset exposure to the United States dollar, in fiscalyear 2004, because the majority of its accounts receivable balance andintercompany receivables were denominated in United States dollars, while themajority of its liabilities and expenses were denominated in Canadiandollars.  Therefore, if the value of the Canadian dollar increased inrelation to the United States dollar, margins decreased.  This exposure tothe United States dollar has decreased significantly due to the repayment ofintercompany receivables by Chemdex.

 

*Chemdex*.  During the second quarter of fiscal year 2004,the Joint Venture incurred an operating loss and Chemdex incurred significantlegal and receiver costs due to the winding-up of the Joint Venture andresulting litigation with its joint venture

 

15

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partner.  On March 4, 2004, the Company sold itsfinished product veterinary pharmaceutical business to Sparhawk.  The saleincluded substantially all of the assets of Vet Labs and its ownership interestin the Joint Venture, and settled all outstanding litigation among theparties.  The Company did not incur legal or receiver costs in connectionwith Vet Labs or the Joint Venture following the date of sale.  Chemdex operations are now limited to thesupply of materials to Sparhawk under the terms of the supply agreement betweenthe parties.

 
| **Sales**                   | ** ** | **2004**  | ** ** | **2003**  | ** ** | **Variance** | ** ** |
|-----------------------------|------------|-----------|------------|-----------|------------|--------------|------------|
| Consolidated                |       | $         | 1,338,409  |      | $          | 3,058,369    |       | (56 | )% |
| Dextran Products            |       | 1,232,131 |       | 1,241,185 |       | (1           | )%         |
| Percentage of Company sales |       | 92        | %          | 41        | %          |         |       |
| Chemdex                     |       | $         | 106,278    |      | $          | 1,817,184    |       | (94 | )% |
| Percentage of Company sales |       | 8         | %          | 59        | %          |         |       |

 

The majority of the second quarter sales decrease infiscal year 2005 was attributable to the Chemdex operating segment due to thesale of the finished goods veterinary pharmaceutical business in the firstquarter of fiscal year 2005.

 

*Dextran Products*.  Sales of dextran and related products in thesecond quarter of fiscal year 2005 were consistent with sales levels achievedduring the second quarter of fiscal year 2004.

 

*Chemdex*.  The sale of the Joint Venture operations onMarch 4, 2004 results in a discontinuance of sales of finished veterinaryproduct.  Sales for Chemdex for theremainder of the fiscal year will be limited to sales of ferric hydroxide andhydrogenated dextran solution to Sparhawk, therefore Chemdex sales willcontinue to be significantly less than in fiscal year 2004.

 

16

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| **Gross  profit**   | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|---------------------|------------|----------|------------|----------|------------|--------------|------------|
| Consolidated        |       | $        | 473,860    |     | $          | 685,005      |       | (31 | )% |
| Percentage of sales |       | 35       | %          | 22       | %          |         |       |
| Dextran Products    |       | $        | 437,440    |     | $          | 412,082      |       | 6 | % |
| Percentage of sales |       | 35       | %          | 33       | %          |         |       |
| Chemdex             |       | $        | 11,909     |     | $          | 252,691      |       | (95 | )% |
| Percentage of sales |       | 11       | %          | 14       | %          |         |       |

 

The second quarter fiscal year 2005 decrease inconsolidated gross profit is a result of the sale of the Joint Ventureoperations during the first quarter of fiscal year 2005.  The increase ingross profit percentage is primarily due to the cessation of lower-marginveterinary product sales subsequent to the sale of the Joint Ventureoperations.  Since the sale of the JointVenture operations in March, 2004, sales by Dextran Products comprise themajority of the consolidated sales of the Company.  The Company realizes significantly highergross margins on Dextran Products’ sales than it did on sales of products fromthe Joint Venture operations.

 

*Dextran Products*.  Increased gross margin percentages wereachieved at the Dextran Products operating segment, which resulted in increasedgross profit at that operating segment.

 

*Chemdex*.  The Joint Venture operations ceased on March4, 2004 due to the sale of that business. The decrease in gross profit is due to this loss of sales.

 
| ** **                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Selling, promotion, general and  administrative expenditures |       | $        | 301,840    |     | $          | 577,064      |       | (48 | )% |
|                                                              |            |          |            |          |            |              |            |  |  |

 

The second quarter fiscal year 2005 decrease inselling, promotion, general and administrative expenses is primarily due to thesale of the Joint Venture operations on

 

17

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March 4, 2004.  The majority of the selling,general and administrative expenses for the Chemdex operating segment have beeneliminated because of the sale of these operations.

 
| **Research  and development**         | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Research and development expenditures |       | $        | 16,636     |     | $          | 12,333       |       | 35 | % |
|                                       |            |          |            |          |            |              |            |  |  |

 

Due to continued direct funding of research anddevelopment expenses by third party public and/or private sector groups, theCompany’s research and development expense continued at low levels in thesecond quarter of fiscal year 2005.

 

Funding for the Company’s primary development productsis provided directly by third party public and/or private sector groups to theentities carrying out such research.  The Company does not take possessionor control over these funds.  The Company benefits from the results ofresearch projects through the ownership of patents and/or licenses with respectto the products involved.  The Company has no commitments to repay thefunding or to purchase the results of the research.

 

Significant funding from research and developmentpartners for the current phase of the cellulose sulphate project is expected tocontinue at necessary levels for the foreseeable future.  The Company’sresearch and development expenditures are expected to increase in fiscal year2005 over fiscal year 2004 due to additional product development activities theCompany expects to perform and fund outside of its partnership relationships.

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Depreciation and amortization expense |       | $        | 119,315    |     | $          | 154,246      |       | (23 | )% |
|                                       |            |          |            |          |            |              |            |  |  |

 

18

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The decrease in depreciation and amortization expensein the second quarter of fiscal year 2005 is primarily attributable to the saleof substantially all of the assets of Vet Labs on March 4, 2004.

 
| ** **       | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|------------------|------------|----------|------------|----------|------------|--------------|------------|
| Interest expense |       | $        | 19,608     |     | $          | 34,204       |       | (43 | )% |
|                  |            |          |            |          |            |              |            |  |  |

 

The decrease in interest expense in the second quarterof fiscal year 2005 is primarily attributable to a decrease in long-term debt,as well as the associated decrease in imputed interest due to the continuingrepayment of non-interest bearing long-term debt.  The share valueguarantee payable was paid in full on March 4, 2004 when the Joint Ventureoperations were sold.

 
| ** **                   | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Foreign exchange gain (loss) |       | $        | 26,493     |     | $          | (32,206      | )          | 182 | % |
|                              |            |          |            |          |            |              |            |  |  |

 

The increase in foreign exchange gain at DextranProducts in the second quarter of fiscal year 2005 was due to the significantdecline in Dextran Products’ net exposure to the United States dollar. DextranProducts continues to have a net exposure to the United States dollar becausethe majority of its accounts receivable balance is denominated in United Statesdollars.  In the second quarter of fiscalyear 2004, Dextran Products also had large intercompany receivables denominatedin United States dollars.  There was aforeign exchange loss in the second quarter of fiscal year 2004 because thevalue of the Canadian dollar increased relative to the United Statesdollar.  A large portion of theseintercompany receivables were repaid in March 2004 when the Joint Ventureoperations were sold.  Management does not expect that the Company willincur significant foreign exchange losses in fiscal year 2005.

 
| ** **             | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Other income (expense) |       | $        | 21,753     |     | $          | (55,701      | )          | 139 | % |
|                        |            |          |            |          |            |              |            |  |  |

 

19

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In the second quarter of fiscal year 2005 other incomerelates to interest income earned at Dextran Products.  The proceeds from the sale of the JointVenture operations have been invested in short and mid-term interest earningsecurities.  During the second quarter offiscal year 2004, other expenses consisted almost entirely of legal andreceiver costs associated with the winding-up of the Joint Venture, and theresulting litigation.  This litigation was settled with the closing of thesale of the Joint Venture on March 4, 2004. Management expects no similar costs for the remainder of fiscal 2005.

 
| **Provision  for income taxes** | ** ** | **2004** | ** ** | **2003** | ** ** | **Variance** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|--------------|------------|
| Consolidated                    |       | $        | 51,948     |     | $          | 56,056       |       | (7 | )% |
| Dextran Products                |       | 47,448   |       | 56,056   |       | (15          | )%         |
| Chemdex                         |       | 4,500    |       | —   |       | —       |       |
|                                 |            |          |            |          |            |              |            |  |  |

 

The decrease in tax provision at Dextran Products forthe second quarter of fiscal year 2005 is a result of a decrease intaxable income.  During the secondquarter of fiscal year 2004, Dextran Products incurred a foreign exchange lossthat was not fully tax deductible.  The Canadian operations continue tohave significant research and development tax pools to offset current taxespayable.

 

**Liquidityand Capital Resources**

 

As of July 31, 2004, the Company had cash and cashequivalents of $3,584,014, compared to cash and cash equivalents of $371,528,including amounts classified as assets subject to sale agreement of $312,073,at January 31, 2004.  In the second quarter of fiscal year 2005 theCompany generated cash of $126,956 in its operating activities, compared to$267,209 for the second quarter of fiscal year 2004.  There was a largeincrease in the net income in the second quarter of fiscal year 2005, which

 

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generated the majority of the cash fromoperations.  In the second quarter offiscal year 2004, there were large collections of receivables, which generatedsignificant cash from operations. Depreciation and amortization continues to be a large non-cash expenseof the Company.

 

The Company maintained $4,494,361 of working capitaland a current ratio of 4.1 to 1 as of July 31, 2004, compared to $2,058,161 and1.8 to 1 as of January 31, 2004.

 

Management expects the primary source of its futurecapital needs to be a combination of company earnings and borrowings.  TheCompany, at present, does not have any material commitments for capitalexpenditures, although Management intends to continue the plant refurbishmentprocess at Dextran Products in Toronto.

 

The Company believes that based upon the currentlevels of revenues and spending, its existing working capital resources will besufficient to support continuing operations for the foreseeable future.

 

At July 31, 2004, the Company had accounts receivableof $698,866 and inventory of $1,351,927, compared to $503,864 and $1,226,439 atJanuary 31, 2004 and $941,720 and $1,214,117 at April 30, 2004.  The decreasein accounts receivable at Dextran Products during the second quarter ended July31, 2004 is due to decreased sales towards the end of the quarter.  Dextran Products performs its annualmaintenance shutdown at the end of July each year.  This typically results in a reduction insales and an increase of inventory for the month of July.

 

At July 31, 2004, the Company had accounts payable of$368,554, compared to $515,092 at January 31, 2004 and $486,841 at April 30,2004.  The decrease in accounts payable was due to timing of supplierpayments.

 

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During the second quarter of fiscal year 2005, capitalexpenditures totaled $15,536, as compared to $69,213 in the second quarter offiscal year 2004.  All of the capital expenditures during the secondquarter of fiscal year 2005 were for production equipment at the DextranProducts plant in Toronto.  The secondquarter of fiscal year 2004 included capital expenditures of $26,229 for theJoint Venture operations in Kansas.  Management intends to continue itsplant refurbishment and expansion plan during the remainder of fiscal year2005, and expects capital expenditures to increase in that period.

 

The change in accumulated other comprehensive loss ofthe Company is entirely attributable to the currency translation adjustment ofDextran Products.  Dextran Products’ functional currency is the Canadiandollar.  This currency translation adjustment arises from the translationof Dextran Products’ financial statements to U.S. dollars.

 

Dextran Products has a Cdn. $1,250,000 (U.S. $940,000)line of credit, of which Cdn. $180,000 (U.S. $135,000) was utilized at July 31,2004.  At January 31, 2004, Cdn. $150,000 (U.S. $113,000) of this line ofcredit was utilized.  This line of credit bears interest at the Canadianbanks’ prime lending rate plus 0.75% (July 31, 2004 – 4.5%; January 31, 2004 –5%).  This indebtedness is collateralized by a general security agreementover the Company’s assets and a collateral mortgage of Cdn. $500,000 on theDextran Products building in Toronto. This line of credit is used periodically by the Company to covertemporary short-term Canadian dollar cash needs.  For these short-term cash needs, the interestexpense on the credit line is typically less than the transaction costsincurred in selling short-term investments.

 

Chemdex entered into a long-term debt obligationrelating to the redemption of the 10% minority interest in Chemdex in fiscalyear 2004.  The redemption amount was$146,500, which is to be paid in 25 equal monthly installments of $5,860.  The Company has timely made 11 paymentsthrough July 31, 2004.  Since thisinstallment contract is non-interest bearing, it has been discounted using adiscount rate of 9%.  The present valueof this installment contract is $77,882 which has been recorded as long-termdebt.

 

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The significant decrease in long-term debt fromJanuary 31, 2004 is due to continuing payments by the Company, and the fullrepayment of the share value guarantee.  All long-term debt is due in thenext two years.

 

The Company did not enter into any new capital leaseobligations during the second quarter of fiscal year 2005.  Capital leaseobligations are due over the next three years.

 

Changes in the relative values of the Canadian dollarand the United States dollar occur from time to time and may, in certaininstances, materially affect the Company’s results of operations.

 

The Company does not believe that the impact of inflationand changing prices has had a material effect on its operations or financialresults at any time in the last three years.

 

**RelatedParty Transactions**

 

In August 1997, the Company loaned Thomas C. Usher,its Vice-Chairman, Director of Research and Development, a member of its Boardof Directors and the beneficial owner of greater than 5% of the outstandingcommon shares of the Company, $691,500 at an interest rate equal to the primerate of Toronto Dominion Bank plus 1.50% (the “Loan”).  The Loan was usedto partially fund a $1,000,000 payment to the State of Florida in order toallow Thomas C. Usher to regain possession of 430,000 Common Shares of theCompany then held by the State as collateral security relating to theliquidation of insurance companies formerly owned by Thomas C. Usher. Repayment of the Loan is accomplished by monthly payments and through offsetsby the Company against royalty payments due Thomas C. Usher pursuant tointellectual property license agreements and bonus payments, if any, grantedThomas C. Usher as

 

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an employee of the Company.  The amountoutstanding under the Loan as of July 31, 2004 was $390,731, as compared to$417,467 at January 31, 2004, including accrued interest.  The Company hastaken a cumulative provision of $253,401 against accrued interest on this loanat July 31, 2004, compared to a cumulative provision of $242,677 at January 31,2004.

 

In August 1999, Thomas C. Usher personally assumed allof the assets and liabilities of Novadex Corp., including the balance ofreceivables (the “Receivables”) due to the Company from Novadex Corp.  TheReceivables have no specific repayment terms.  The total outstandingamount of the Receivables as of July 31, 2004 and January 31, 2004 was$366,216.  Thomas C. Usher also owes $250,000 to a subsidiary of theCompany, Novadex International Limited, as of July 31, 2004, pursuant to anon-interest bearing loan with no specific repayment terms.  Theoutstanding amount of this loan has not changed from January 31, 2004.

 

Thomas C. Usher has pledged 328,051 common shares ofthe Company as security for these amounts owing to the Company.  Thesecommon shares have a market value of $2,289,800 at July 31, 2004, based on theclosing price of the Company’s common shares on the Nasdaq SmallCap market.

 

The Company also has an outstanding loan payable toRuth Usher, a member of the Board of Directors until her retirement on October31, 2003, the beneficial owner of greater than 5% of the outstanding commonshares of the Company, and the spouse of Thomas C. Usher.  The amount duefrom the Company pursuant to this loan decreased to $683,011 at July 31, 2004from $683,234 at January 31, 2004 due to monthly payments by the Company less interestcharges.

 

**Off-BalanceSheet Arrangements**

 

TheCompany has no off-balance sheet arrangements.

 

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**TabularDisclosure of Contractual Obligations**

 

As of July 31, 2004, future minimum cash payments dueunder contractual obligations, including, among others, the Dextran Productsline of credit, the loan payable to Ruth Usher, the long-term debt obligationin connection with the Chemdex redemption, and capital lease agreements, are asfollows:

 
| ** **                      | ** ** | **Payment due by period** | ** ** | ** **             | ** ** |
|---------------------------------|------------|---------------------------|------------|------------------------|------------|
| **Contractual  Obligations**    | ** ** | **Total**                 | ** ** | **Less  than  1 year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **More  than  5 years** | ** ** |
|                            |       |                      |       |                   |       |   |   |   |   |   |   |
| Long-term debt obligations (1)  |       | $                         | 765,051    |                   | $          | 82,320 |   | $ | 35,720 |   | $ | 24,000 |   | $ | 623,011 |   |
| Capital lease obligations (2)   |       | 395,228                   |       | 176,628                |       | 218,600 |   | — |   | — |   |
| Operating lease obligations (3) |       | 5,831                     |       | 3,727                  |       | 2,104 |   | — |   | — |   |
| Purchase obligations            |       | —                    |       | —                 |       | — |   | — |   | — |   |
| Revolving loans (4)             |       | 135,420                   |       | 135,420                |       | — |   | — |   | — |   |
| Total                           |       | $                         | 1,301,530  |                   | $          | 398,095 |   | $ | 256,424 |   | $ | 24,000 |   | $ | 623,011 |   |

 

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(1).          Consists of:

 

(a)           Note payable in monthly payments of$5,860 maturing September 19, 2005; and

 

(b)           Amounts due to shareholder which bear interest at theCanadian banks’ prime lending rate plus 1.5%, with required minimum monthlypayments, including interest, of $1,000.

 

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(2).          Consists of capital lease obligations for:

 

(a)           Production equipment of Cdn. $38,734 (US $29,203)repayable in monthly installments, bearing interest at 6.65% and maturing December2004;

 

(b)           Production equipment of Cdn. $103,170 (US $77,783)repayable in monthly installments, bearing interest at 7.59% and maturingNovember 2006; and

 

(c)           Production equipment of Cdn. $449,937 (US $339,217)repayable in monthly installments, bearing interest at 9% and maturing November2006.

 

(3).          Consists of operating lease obligations for:

 

(a)           Office equipment requiring semi-annual payments ofCdn. $2,180 (US $1,644) terminating November 2005; and

 

(b)           Office equipment requiring quarterly payments of Cdn.$161 (US $121) terminating June 2006.

 

(4).          Consists of Canadian operating line of credit bearinginterest at the Canadian banks’ prime lending rate plus 0.75%, repayable upondemand.

 

**RiskFactors**

 

The risks, uncertainties and other factors describedbelow could materially and adversely affect the Company’s business, financialcondition, operating results and prospects.

 

***The Company’s product developmentefforts may be reduced or discontinued due to difficulties or delays inclinical trials.***

 

To achieve sustained profitability, the Company must,alone or with corporate partners and collaborators, successfully research,develop and commercialize identified technologies or product candidates. Current developmental product candidates are in

 

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various stages of clinical and pre-clinicaldevelopment and will require significant further funding, research,development, preclinical and/or clinical testing, regulatory approval andcommercialization testing, and are subject to the risks of failure inherent inthe development of products based on innovative or novel technologies. These products are also rigorously regulated by the U.S. federal government,particularly the FDA, and by comparable agencies in state and localjurisdictions and in foreign countries.  Specifically, each of thefollowing results is possible with respect to any one of the Company’sdevelopmental product candidates:

 

•                  that the Company will not be able tomaintain its current research and development schedules;

 

•                  that the Company will not be able toenter into human clinical trials because of scientific, governmental orfinancial reasons, or that it will encounter problems in clinical trials thatwill cause a delay or suspension of the development of the product candidate;

 

•                  that the developmental product will befound to be ineffective or unsafe;

 

•                  that government regulations will delay orprevent the product’s marketing for a considerable period of time and imposecostly procedures upon the Company’s activities;

 

•                  that the FDA or other regulatory agencieswill not approve the product or the process by which the product ismanufactured, or will not do so on a timely basis; and/or

 

•                  that the FDA’s policies may change andadditional government regulations and policies may be instituted, which couldprevent or delay regulatory approval of the product.

 

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If any of the risks set forth above occurs, theCompany may not be able to successfully develop its identified developmentalproduct candidates.

 

***The Company’s developmentalproduct commercialization efforts may not be successful.***

 

It is possible that, for reasons including, but notlimited to those set forth below, the Company may be unable to commercialize orreceive royalties from the sale of any given developmental product, even if itis shown to be effective, if:

 

•                  the product is uneconomical or if themarket for the product does not develop or diminishes;

 

•                  the Company is not able to enter intoarrangements or collaborations to commercialize and/or market the product;

 

•                  the product is not eligible forthird-party reimbursement from government or private insurers;

 

•                  others hold proprietary rights thatpreclude the Company from commercializing the product;

 

•                  others have brought to market similar orsuperior products;

 

•                  others have superior resources to marketsimilar products or technologies;

 

•                  government regulation imposes limitationson the indicated uses of the product, or later discovery of previously unknownproblems with the product results in

 

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added restrictions on the product or results in theproduct being withdrawn from the market; and/or

 

•                  the product has undesirable or unintendedside effects that prevent or limit its commercial use.

 

***The Company depends onpartnerships with third parties for the development and commercialization ofits products.***

 

The Company’s strategy for development andcommercialization of its products is to rely on licensing agreements with thirdparty partners.  As a result, the ability of the Company to commercializefuture products is dependent upon the success of third parties in performingclinical trials, obtaining regulatory approvals, manufacturing and successfullymarketing its products.  There can be no assurance that such third partycollaborations will be successful.  Should any of the Company’s currentresearch and development partnerships be discontinued, it may not be able to findothers to develop and commercialize its current product candidates.

 

***The Company does not currentlyhave agreements with third parties to market its developmental products.***

 

The commercialization of any of the Company’sdevelopmental products that receive FDA approval will depend upon the Company’sability to enter into agreements with companies that have sales and marketingcapabilities.  The Company currently intends to sell its products in theUnited States and internationally in collaboration with one or more marketingpartners.  The Company may not be able to enter into any suchcollaboration to market its developmental products in a timely manner or oncommercially reasonable terms, if at all.

 

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***The Company may be unable tocommercialize its products if it is unable to protect its proprietary rights,and may be liable for significant costs and damages if it faces a claim ofintellectual property infringement by a third party.***

 

The Company’s success depends in part on its abilityto obtain and maintain patents, protect trade secrets and operate withoutinfringing upon the proprietary rights of others.  In the absence ofpatent and trade secret protection, competitors may adversely affect the Company’sbusiness by independently developing and marketing substantially equivalent orsuperior products, possibly at lower prices.  The Company could also incursubstantial costs in litigation and suffer diversion of attention of technicaland management personnel if it is required to defend intellectual propertyinfringement suits brought by third parties, with or without merit, or ifrequired to initiate litigation against others to protect or assertintellectual property rights.  Moreover, any such litigation may not beresolved in favor of the Company.

 

The Company has received various patents covering theuses of its developmental products.  However, the patent position ofcompanies in the pharmaceutical industry generally involves complex legal andfactual questions, and recently has been the subject of much litigation. Any patents the Company has obtained, or may obtain in the future, may bechallenged, invalidated or circumvented.  To date, no consistent policyhas been developed by the United States Patent and Trademark Office regardingthe breadth of claims allowed in biotechnology patents.

 

In addition, because patent applications in the UnitedStates are maintained in secrecy until patents issue, and because publicationof discoveries in scientific or patent literature often lags behind actualdiscoveries, the Company cannot be certain that it and its licensors are thefirst creators of inventions covered by any licensed patent applications orpatents or that the Company or such licensors are the first to file.  TheUnited States Patent and Trademark Office may commence interference proceedingsinvolving patents or patent applications, in which the question of firstinventorship is

 

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contested.  Accordingly, the patents owned by orlicensed to the Company may not be valid or may not afford the Companyprotection against competitors with similar intellectual property.

 

It is also possible that the Company’s patents mayinfringe on patents or other rights owned by others, licenses to which may notbe available to the Company.  The Company may have to alter its productsor processes, pay licensing fees or cease certain activities altogether becauseof patent rights of third parties.

 

In addition to the products for which the Company haspatents or have filed patent applications, the Company relies upon unpatentedproprietary technology and may not be able to meaningfully protect its rightswith regard to that unpatented proprietary technology.

 

**CriticalAccounting Policies**

 

The Company’s consolidated financial statements areprepared in accordance with accounting principles generally accepted in theUnited States, applied on a consistent basis.  The critical accountingpolicies include the use of estimates of allowance for doubtful accounts, theuseful lives of assets and the realizability of deferred tax assets.  TheCompany’s accounting policies with respect to the Joint Venture and itsdisposition are also discussed below.

 

Management is required to make estimates andassumptions, in preparing the consolidated financial statements, that affectthe reported amounts of assets and liabilities, the disclosure of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of revenue and expenses during the periods.  Theactual results could differ from these estimates.  Significant estimatesmade by management include the calculation of reserves for uncollectible

 

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accounts, inventory allowances, useful lives oflong-lived assets and the realizability of deferred tax assets.

 

***Revenue Recognition***

 

All revenue is from sales of bulk and finished dosagemanufactured products and is recognized when title and risk of ownership ofproducts pass to the customer.  Title and risk of ownership pass to thecustomer pursuant to the applicable sales contract, either upon shipment ofproduct or upon receipt by the customer.  Since returns are rare andgenerally not accepted, management has not made provision for returns.  Inaddition, product sold in bulk quantities is tested, prior to release forshipment, to ensure that it meets customer specifications, and in many cases,customers receive samples for their own testing.  Approval is obtainedfrom the customer prior to shipping.

 

***Allowance for Doubtful Accounts***

 

Accounts receivable is stated net of allowances fordoubtful accounts.  Allowances for doubtful accounts are determined byeach reporting unit on a specific item basis.  Management reviews thecredit worthiness of individual customers and past payment history to determinethe allowance for doubtful accounts.  Since the majority of sales atDextran Products are export, Dextran Products maintains credit insurance througha crown corporation for the majority of its customers receivables.

 

***Long-Lived Assets***

 

Long-lived assets are stated at cost, less accumulateddepreciation or amortization computed using the straight-line method based ontheir estimated useful lives ranging from three to fifteen years.  Usefullife is the period over which the asset is expected to contribute to theCompany’s cash flows.  A significant change in estimated useful livescould have a material impact on the results of operations.  The Company

 

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reviews the recoverability of its long-lived assets,including buildings, equipment and other intangible assets, when events orchanges in circumstances occur that indicate that the carrying value of theasset may not be recoverable.  The assessment of possible impairment isbased on the Company’s ability to recover****the carryingvalue of the asset from the expected future pre-tax cash flows (undiscountedand****without interest charges) of therelated operations.  If these cash flows are less than the****carrying value of such asset, an impairment loss isrecognized for the difference between****estimated fairvalue and carrying value.  The measurement of impairment requiresmanagement to****make estimates of these cash flowsrelated to long-lived assets as well as other fair value****determinations.

 

***Deferred Tax Assets***

 

The Company has recorded a valuation allowance ondeferred tax assets where there is uncertainty as to the ultimate realizationof the future tax deduction.  Dextran Products has incurred capitallosses, which are only deductible against capital gains.  It is notcertain that Dextran Products will realize capital gains in the future to usethese Canadian capital loss deductions.

 

***The Joint Venture***

 

In 1992, Vet Labs and Sparhawk entered into the JointVenture for the manufacture and sale of veterinary pharmaceuticalproducts.  Vet Labs and Sparhawk each owned 50% of the Joint Ventureduring its operation. The Joint Venture was governed by the Agreement for the Operationof Veterinary Laboratories, Inc.’s Lenexa Facility and Sparhawk Lab of KC as aJoint Venture, dated December 1, 1992, by and among Sparhawk, Chemdex and VetLabs (the “Joint Venture Agreement”).

 

Pursuant to the Joint Venture Agreement, the Joint VenturePolicy Committee was responsible for the overall management of the JointVenture, including the direction

 

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and control of the persons designated with the dailymanagement responsibilities of the Joint Venture, and the general supervisionof the management and conduct of the affairs of the Joint Venture.  ThePolicy Committee consisted of five members, three of which were selected by VetLabs and two of which were selected by Sparhawk.  Decisions of the PolicyCommittee required a simple majority vote.

 

Because the Company controlled the operating,financing and investing decisions of the Joint Venture through Vet Labs’control of the Policy Committee, it consolidated the Joint Venture’s assets,liabilities, revenue and expenses in the Company’s financial statements. The Company has funded the Joint Venture’s cumulative losses since 1992 and,accordingly, has recorded 100% of these losses in the consolidated financialstatements.

 

On January 13, 2004, the Company, Chemdex and Vet Labsentered into an Asset Purchase Agreement with Sparhawk.  Pursuant to theAsset Purchase Agreement, the Company agreed to sell substantially all of theassets of Vet Labs, including its interest in the Joint Venture, to Sparhawkfor $5,500,000 in cash.  Effective March 4, 2004, this sale was completedand a gain of $1,859,471 was recognized.  Simultaneously with the closing,Chemdex advanced $350,000 to Sparhawk in exchange for an unsecured subordinatedpromissory note bearing interest at 13% per annum and a warrant to purchase 4%of the equity of Sparhawk.  The promissory note is payable in full onMarch 4, 2009.  Interest is payable annually, but can be deferred andadded to the principal balance of the****promissorynote each year at Sparhawk’s discretion.  The warrant becomes exercisableon March 5, 2009 and expires at the earlier of payment in full of thepromissory note or March 4, 2014.  Chemdex also entered into a supplyagreement with Sparhawk to supply ferric hydroxide and hydrogenated dextransolution to Sparhawk on an exclusive basis in the United States for 10years.  In connection with the sale, the litigation involving the JointVenture, *Sparhawk Laboratories, Inc. v. VeterinaryLaboratories, Inc., et al*, Case No. 02CV07426, County of Johnson,State of Kansas, was settled, and a Motion of

 

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Approval of Settlement and Stipulation of Dismissalwith Prejudice was filed with the Court on March 4, 2004.

 

Since Sparhawk is thinly capitalized and highlyleveraged, the Company has deferred $350,000 of the gain relating to thepromissory note receivable from Sparhawk. The Company will monitor the financial position of Sparhawk and willrecognize this deferred gain at such time as Sparhawk’s cash flows fromoperations are sufficient to fund debt service on a full accrual basis.

 

There will be significant changes in the Company’sresults of operations due to the sale of the Vet Labs assets and its ownershipinterest in the Joint Venture.  Sales of the Joint Venture accounted for66% of the Company’s total sales in fiscal year 2004.  Income beforeincome taxes from Vet Labs and the Joint Venture amounted to $408,667 in fiscalyear 2004.  Management expects that gross profit as a percentage of salesfor the Company will increase because the Joint Venture’s margins weregenerally lower than those of Dextran Products.

 

**Changesin Accounting Policies**

 

No changes in accounting principles or theirapplication have been implemented in the reporting period that would have amaterial effect on reported income.

 

**RecentAccounting Pronouncements**

 

In December 2003, the FASB issued FASB Interpretation[“FIN”] No. 46R, “Consolidation of Variable Interest Entities an interpretationof ARB No. 51” [the “Interpretation”], which is a revision of FIN No. 46originally issued in January 2003.  TheInterpretation introduces a new consolidation model - the variable interestsmodel - which determines control [and consolidation] based on potential variabilityin gains and losses of the entity being evaluated for consolidation. It alsorequires application in

 

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financial statements of public entities for periodsended after December 15, 2003 to special purpose entities, and in financialstatements for periods ending after March 15, 2004 to other types of variableinterest entities.  The Company does nothave any interests in special purpose entities, and will account for anyvariable interest entities in accordance with the Interpretation. The adoptionof this Interpretation had no impact on the Company’s consolidated financialstatements.

 

**Forward-lookingStatements**

 

This Form 10-Q, including the Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, contains various“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities ExchangeAct of 1934, as amended, which represent the Company’s expectations or beliefsconcerning future events, including, but not limited to statements regardingmanagement’s expectations of regulatory approval and the commencement ofsales.  In addition, statementscontaining expressions such as “believes”, “anticipates”, “plans” or “expects”used in this Form 10-Q, the Company’s Annual Report, and the Company’s periodicreports on Forms 10-K and 10-Q previously filed with the Securities andExchange Commission are intended to identify forward-looking statements.  The Company cautions that various risks anduncertainties and other factors could cause actual results to differ materiallyfrom those expressed in or implied by the forward-looking statements.  These factors include, without limitation,changing market conditions, the progress of clinical trials, and the resultsobtained, the establishment of new corporate alliances, the impact ofcompetitive products and pricing, the timely development, FDA approval andmarket acceptance of the Company’s products, and the other risks discussedabove, none of which can be assured.

 

The forward-looking statements contained in this quarterly report speakonly as to the date of this report. Except as otherwise required by federal securities laws, we undertake noobligation to publicly update or revise any forward-looking statements or therisk factors described in this quarterly report, whether as a result of newinformation, future events, changed circumstances or any other reason after thedate of this report.

 

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with United States generally acceptedaccounting principles for interim financial information and the instructions toForm 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.  In the opinion ofmanagement, all adjustments (consisting of normally recurring accruals)considered necessary for a fair presentation have been included.

 

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**Item3****  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

**Exchange Rate Sensitivity**

 

TheCompany’s operations consist of manufacturing activities in the United Statesand Canada.  The Company’s products aresold in North America, Europe and the Pacific Rim.

 

While the majority of the sales of Dextran Products,the Company’s Canadian operation, are denominated in United States dollars, themajority of its expenses are incurred in Canadian dollars.  The majority of the assets and liabilities ofDextran Products are denominated in Canadian dollars prior to the currencytranslation adjustment necessary for preparation of the interim consolidatedfinancial statements of the Company contained in this report.  Therefore, Dextran Products has a net assetexposure to the United States dollar. When the Canadian dollar rises in value relative to the United Statesdollar, the carrying value of the assets and liabilities of Dextran Products asstated in United States dollars increases. A rise in the Canadian dollar relative to the United States dollar alsoresults in a decrease in gross margins and net income of Dextran Products. Dextran Products also experiences a foreign exchange loss when the Canadiandollar rises in relation to the United States dollar due to this net assetexposure.  Similarly, a decline in theCanadian dollar relative to the United States dollar results in a foreignexchange gain and increased gross margins and net income at Dextran Products.

 

Managementmonitors currency fluctuations to ensure that an acceptable margin level atDextran Products is maintained. Management has the ability, to some extent, to adjust sales prices tomaintain an acceptable margin level.

 

Thefollowing table presents information about the Company’s financial instrumentsother than accounts receivable that are sensitive to changes in foreigncurrency exchange rates.  All financialinstruments are held for other than trading purposes.  The table presents principal cash flows andrelated weighted average interest rates by expected maturity dates.

 
| ** **              | ** ** | **Expected Maturity Date** | ** ** | ** **  | ** ** | **Fair**    | ** ** |
|-------------------------|------------|----------------------------|------------|-------------|------------|-------------|------------|
| ** **              | ** ** | **1/31/05**                | ** ** | **1/31/06** | ** ** | **1/31/07** | ** ** | **1/31/08** | ** ** | **1/31/09** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Value** | ** ** |
| ** **              | ** ** | **(US$ Equivalent)**  | ** ** |
| **Assets:**             |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Short-term investments: |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Fixed rate ($Cdn.)      |       | 3,246,314                  |       | —      |       | —      |       | — |   | — |   | — |   | 3,246,314 |   | 3,260,157 |   |
| Average interest rate   |       | 2.00                       | %          | 2.00        | %          | 2.00        | %          | 2.00 | % | 2.00 | % | 2.00 | % | 2.00 | % |   |   |
| Marketable securities:  |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Fixed rate ($Cdn.)      |       | —                     |       | —      |       | 1,192,362   |       | — |   | — |   | — |   | 1,192,362 |   | 1,127,239 |   |
| Average interest rate   |       | 4.00                       | %          | 4.00        | %          | 4.00        | %          | — |   | — |   | — |   | 4.00 | % |   |   |
|                    |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities:**        |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Long-term debt:         |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Fixed rate ($Cdn.)      |       | 158,434                    |       | 141,530     |       | 138,437     |       | — |   | — |   | — |   | 438,401 |   | 439,484 |   |
| Average interest rate   |       | 8.35                       | %          | 8.73        | %          | 8.75        | %          | — |   | — |   | — |   | 8.61 | % |   |   |

 

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**Interest Rate Sensitivity**

 

TheCompany has interest earning assets consisting of investment grade or highershort-term commercial paper.  Asignificant portion of the Company’s debt is at fixed rates.  The variable rate debt represents theshareholder loan payable, which is approximately offset with the shareholderloan receivable.  Both of these financialinstruments carry the same interest rate.  As such, the Company has nosignificant risk exposure to changes in interest rates.

 

Thefollowing table presents information about the Company’s financial instrumentsthat are sensitive to changes in interest rates.  All financial instruments are held for otherthan trading purposes.  The tablepresents principal cash flows and related weighted average interest rates byexpected maturity dates.

 
| ** **              | ** ** | **Expected Maturity Date** | ** ** | ** **  | ** ** | **Fair**    | ** ** |
|-------------------------|------------|----------------------------|------------|-------------|------------|-------------|------------|
| ** **              | ** ** | **1/31/05**                | ** ** | **1/31/06** | ** ** | **1/31/07** | ** ** | **1/31/08** | ** ** | **1/31/09** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Value** | ** ** |
| ** **              | ** ** | **(US$ Equivalent)**  | ** ** |
| **Assets:**             |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Short-term investments: |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Fixed rate ($Cdn.)      |       | 3,246,314                  |       | —      |       | —      |       | — |   | — |   | — |   | 3,246,314 |   | 3,260,157 |   |
| Average interest rate   |       | 2.00                       | %          | 2.00        | %          | 2.00        | %          | 2.00 | % | 2.00 | % | 2.00 | % | 2.00 | % |   |   |
| Marketable securities:  |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Fixed rate ($Cdn.)      |       | —                     |       | —      |       | 1,192,362   |       | — |   | — |   | — |   | 1,192,362 |   | 1,127,239 |   |
| Average interest rate   |       | 4.00                       | %          | 4.00        | %          | 4.00        | %          | — |   | — |   | — |   | 4.00 | % |   |   |
| Notes receivable:       |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Variable rate ($US)     |       | 54,861                     |       | 58,153      |       | 61,642      |       | 65,340 |   | 69,261 |   | 108,209 |   | 417,466 |   | 417,466 |   |
| Average interest rate   |       | 6.00                       | %          | 6.00        | %          | 6.00        | %          | 6.00 | % | 6.00 | % | 6.00 | % | 6.00 | % |   |   |
|                    |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities:**        |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Long-term debt:         |       |                       |       |        |       |        |       |   |   |   |   |   |   |   |   |   |   |
| Fixed rate ($Cdn.)      |       | 158,434                    |       | 141,530     |       | 138,437     |       | — |   | — |   | — |   | 438,401 |   | 439,484 |   |
| Average interest rate   |       | 8.35                       | %          | 8.73        | %          | 8.75        | %          | — |   | — |   | — |   | 8.61 | % |   |   |
| Variable rate ($US)     |       | 1,007                      |       | 1,068       |       | 1,132       |       | 1,200 |   | 1,272 |   | 677,535 |   | 683,214 |   | 683,214 |   |
| Average interest rate   |       | 6.00                       | %          | 6.00        | %          | 6.00        | %          | 6.00 | % | 6.00 | % | 6.00 | % | 6.00 | % |   |   |

 

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**Item 4****.  Controls and Procedures.**

 

The Company completed an evaluation as of the end ofthe period covered by this report under the supervision and with theparticipation of management, including its Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design and operation of itsdisclosure controls and procedures pursuant to Rule 13a-14 of the SecuritiesExchange Act of 1934.  Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures are effective in alertingthem on a timely basis of material information relating to the Company(including its consolidated subsidiaries) required to be included in itsperiodic Securities and Exchange Commission filings.

 

There have been no changes in the Company’s internalcontrol over financial reporting identified in connection with the evaluationdiscussed above that occurred in the Company’s last fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

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**PART II**

**OTHER INFORMATION**

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders.**

 

(a)                                  The 2004 AnnualGeneral Meeting of the Members was held on July 9, 2004.

 

(c)                                  No matters were votedupon at the 2004 Annual Meeting of the Members other than the election of Mr.Joseph Buchman and Mr. John L.E. Seidler as directors of the Company to holdoffice for a three-year term expiring at the Annual General Meeting of theMembers held in 2007 or until successors are duly elected and qualified.  The tabulation of votes in person or by proxyat the Annual Meeting with respect to Mr. Joseph Buchman’s and Mr. John L.E.Seidler’s election are as follows:

 
| ** **        | ** ** | **Class**                 | ** ** | **Votes For**   | ** ** | **Votes Withheld** | ** ** | **Abstentions and  Non-Votes** | ** ** |
|-------------------|------------|---------------------------|------------|-----------------|------------|--------------------|------------|--------------------------------|------------|
| Joseph Buchman    |       | Common  Shares            |       | 2,609,001  |       | 5,936              |       | 1,050                          |       |
|              |       | Class B  Preferred Shares |       | 1,798,800       | (1)        |               |       |                           |       |
|              |       |                      |       |            |       |               |       |                           |       |
| John L.E. Seidler |       | Common  Shares            |       | 2,610,051  |       | 4,886              |       |                           |       |
|              |       | Class B  Preferred Shares |       | 1,798,800       | (1)        |               |       |                           |       |

 

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(1)           Class B PreferredShares are entitled to two (2) votes per share.

 

(d)                                 Not applicable.

 

40

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**Item 6****.  Exhibits and Reports on Form8-K.**

 

(a)           Exhibits

 

3.1           Memorandum of Association of PolydexPharmaceuticals Limited, as amended to date (filed as Exhibit 3.1 to the AnnualReport on Form 10-K filed April 30, 1997, and incorporated herein by reference)

 

3.2           Articles of Association of PolydexPharmaceuticals Limited, as amended to date (filed as Exhibit 3.2 to theQuarterly Report on Form 10-Q filed September 13, 1999, and incorporated hereinby reference)

 

31.1         Certification of Chief Executive Officerpursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

 

31.2         Certification of Chief Financial Officerpursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

 

32.1         Certification of Chief Executive Officerpursuant to 19 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

32.2         Certification of Chief Financial Officerpursuant to 19 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

(b)           Reports on Form 8-K

 

None.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
| Date:     September 14, 2004 |                            |
|-------------------------------------------------------|---------------------------------|
|                                                  |                            |
|                                                  | POLYDEX PHARMACEUTICALS LIMITED |
|                                                  | (Registrant)                    |
|                                                  |                            |
|                                                  | By                              | /s/ George G. Usher |   |
|                                                  |                            | George G. Usher, Chairman, President and Chief |
|                                                  |                            | Executive Officer |
|                                                  |                            | (Principal Executive Officer) |
|                                                  |                            |
|                                                  | By                              | /s/ Sharon L. Wardlaw |   |
|                                                  |                            | Sharon L. Wardlaw, Treasurer, Secretary and  Chief Financial and Accounting Officer |
|                                                  |                            | (Principal Financial Officer) |

 

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**Exhibit Index**

 

31.1         Certification of Chief Executive Officerpursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

 

31.2         Certification of Chief Financial Officerpursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

 

32.1         Certification of Chief Executive Officerpursuant to 19 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

32.2         Certification of Chief Financial Officerpursuant to 19 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

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