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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2004

or

For the transition period from              to             

Commission File Number 1-15445

DRUGMAX, INC.

(Exact name of registrant as specified in its charter)

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

(Address of principal executive offices)

(727) 533-0431

(Registrant’s telephone number, including area code)

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

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

As of November 8, 2004 there were 8,201,886 shares of common stock, par value $0.001 per share, outstanding.

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DRUGMAX, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE THREE AND SIX MONTHS ENDED SEPTEMBER 30, 2004

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DRUGMAX, INC. AND SUBSIDIARIES

PART I – FINANCIAL INFORMATION

Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DRUGMAX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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DRUGMAX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

See accompanying notes to condensed consolidated financial statements.

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DRUGMAX, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(concluded)

See accompanying notes to condensed consolidated financial statements.

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DRUGMAX, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

For the Three and Six Months Ended September 30, 2004 and 2003.

NOTE A-BASIS OF PRESENTATION

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

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

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

NOTE B – STOCK BASED COMPENSATION

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

For purposes of the above disclosure, the determination of the fair value of stock options granted in the three and six months ended September 30, 2004 and 2003, was based on the following: (i) a risk free interest rate of 3.94% (ii) expected option lives of 5—10 years; and (iii) expected volatility in the market price of the Company’s common stock of 156%

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

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NOTE C - ACQUISITIONS

VetMall, Inc.

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

Avery Pharmaceuticals, Inc.

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

Pursuant to the Avery Agreement, the Company acquired accounts receivable, inventory, equipment, furniture, the trade name and a patent pending for the process of the manufacture of vials for the respiratory therapy industry, totaling approximately $789,000. The liabilities assumed, which were comprised principally of trade payables, amounted to approximately $647,000, in addition to the forgiveness of debt owed to the Company of approximately $53,000. In addition, the Company executed a promissory note in the amount of $318,000 to the predecessor company’s 50% shareholder (“Sankary”) (the “Sankary Note”), as additional consideration. The Sankary Note includes a right of off set for accounts payable in excess of an agreed upon amount assumed at closing. The original Sankary Note may not be reduced below $90,000 after set off. Management believes the adjusted Sankary note amount will be $90,000 after the set off for accounts payables honored by the Company since the acquisition; therefore, the Company recorded the Sankary Note in the amount of $90,000. The Company and Avery specifically contemplated that the Company might have to pay certain unknown liabilities in connection with the acquisition in excess of the amount of assumed liabilities. Accordingly, the Sankary Note and the Avery Agreement permit the Company to “set off” payments due under the Sankary Note against payments made in excess of the assumed liabilities. The Company believes that it has paid Avery’s obligations well in excess of the assumed liabilities. Therefore, all other payments under the Sankary Note are offset such that nothing more is due and payable there under.

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

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

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

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

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

NOTE D - GOODWILL AND OTHER INTANGIBLE ASSETS

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

The carrying value of other intangible assets is as follows:

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NOTE E - DEBT

On April 15, 2003, the Company obtained from Congress Financial Corporation (“Congress”) a $40 million revolving line of credit and a $400,000 term loan. The Congress credit facility along with the Mellon Bank N.A. (“Mellon”) restricted cash account of $2 million were used to satisfy the outstanding line of credit and term loan with Standard Federal Bank National Association (“Standard”), formerly Michigan National Bank as successor in interest to Mellon. The Congress revolving line of credit enables the Company to borrow a maximum of $40 million, with borrowings limited to 85% of eligible accounts receivable and 65% of eligible inventory. The revolving line of credit and the term note currently bear interest at the rate of 0.50% per annum in excess of the Prime Rate. The Congress credit facility is collateralized by all of the Company’s assets. The line of credit is for a term of 36 months, and the term note is payable over the same 36-month period. The Congress credit facility imposes certain restrictive covenants on Tangible Net Worth and EBITDA. The Company currently is not in compliance with either the Tangible Net Worth or EBITDA covenants. Additionally, the actions taken by AmeriSource Bergen in connection with the amount owed to AmeriSource Bergen by the Company and its subsidiaries may also constitute a default under the Congress credit facility. (See Management’s Discussion and Analysis –Liquidity). However, on October 22, 2004, Congress and the Company entered into a Forbearance Agreement and Fifth Amendment to Loan and Security Agreement (“Forbearance Agreement”), pursuant to which Congress agrees, subject to the terms and conditions of that agreement, to forebear from exercising its rights and remedies under the credit facility, applicable law or otherwise, to the effect that the rights and benefits otherwise available to the Company under the credit facility in the absence of the existing defaults shall continue until November 19, 2004. On November 12, 2004 the Company and Congress executed the Sixth Amendment to Loan and Security Agreement and Consent by and Between Congress Financial Corporation (Florida) and DrugMax, Inc., Together with its Subsidiaries, Valley Drug Company, Valley Drug Company South, and Discount Rx, Inc. (the “Sixth Amendment”). The Sixth Amendment amends the Forbearance Agreement by extending the termination date to December 10, 2004, subject to terms and conditions of the agreement. The Company intends to refinance the Congress credit facility in connection with its merger with Familymeds Group, Inc. (“FMG”) See Note H—Pending Merger and Management’s Discussion and Analysis. If the Congress credit facility is not refinanced prior to the expiration of the forbearance period or if the existing defaults are not cured prior to such time, Congress’ Forbearance Agreement will expire and Congress may then exercise its rights and remedies against the Company. The Forbearance Agreement, as amended, also applies a one percent reduction each week in the inventory valuation used for the availability calculation during the term of the Forbearance Agreement, as amended. All costs associated with the Congress credit facility will be amortized as interest expense over the term of the loan. The outstanding balance on the revolving line of credit and term loan were approximately $11,980,000 and $211,000, respectively, at September 30, 2004. At September 30, 2004, the interest rate on the revolving line of credit and term loan was 5.0%.

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

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

NOTE F- SEGMENT INFORMATION

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

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

The Company distributes product both within and outside the United States. Revenues from distribution within the United States represented approximately 99.4% for both the three months ended September 30, 2004 and 2003, and approximately 99.6% and 99.3% for the six months ended September 30, 2004 and 2003, respectively, of gross revenues. Foreign revenues were generated from distribution to customers in Puerto Rico.

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NOTE G – CONTINGENCIES

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

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

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

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

On November 12, 2003, Phil & Kathy’s, Inc. d/b/a Alliance Wholesale Distributors (“Alliance”) served a complaint against the Company seeking to recover the non-payment of open invoices approximating $2,000,535, based upon an alleged breach of contract for the sale of pharmaceuticals. On December 18, 2003, the Company filed an answer and counterclaim. The counterclaim seeks to recover lost profits and other damages relating to the purchase of twenty bottles of Lipitor from Alliance, which the Company later sold to QK. The Company intends to vigorously defend Alliance’s breach of contract action and prosecute the counterclaim. Valley also filed a separate action against Alliance for breach of an indemnification agreement related to the sale of the twenty bottles of Lipitor that precipitated the lawsuit against Valley by QK in New York. At March 31, 2004, the amount that the Company recorded as a trade payable balance due Alliance on the above was approximately $1.5 million. Under the Company’s indemnification agreement with Alliance, pursuant to which Alliance is required to indemnify the Company for all losses, expenses and damages sustained by the Company as a result of product sold to the Company by Alliance, and the Company’s right to offset its losses, expenses and damages against any amounts due to Alliance, the Company has reduced the payable to Alliance by the cost of the faulty Lipitor sold by Alliance to the Company plus the settlement and litigation expenses incurred by the Company directly as a result of the Lipitor.

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While the Company has recorded the foregoing trade payable, it continues to assess the extent of its full damages and cannot at this time reasonably estimate the total future possible loss that it will sustain as a result of the Alliance complaint or the possible recovery through the Company’s counterclaim or Valley’s consolidated action.

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

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

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

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

NOTE H – PENDING MERGER

On March 19, 2004, the Company entered into an Agreement and Plan of Merger with Familymeds Group, Inc., a Connecticut Company as amended on July 1, 2004 and October 11, 2004, pursuant to which FMG will be merged with and into the Company, with the Company being the surviving company. FMG is a pharmacy chain with a strategy of locating pharmacies at or near a patient’s point of medical care. FMG operates more than 76 pharmacies in 14 states. Many of these pharmacies are located at or near the point of care between physicians and patients, many times inside or near medical office buildings. Across these distribution channels, FMG annually services over 400,000 acute and chronically ill patients, many with complex specialty and medical product needs. The principal executive offices of FMG are located at 312 Farmington Avenue, Farmington, CT 06032. The Company’s annual meeting of it shareholders where the shareholders will be asked to vote on the merger, is scheduled for November 12, 2004. Management expects that the merger will be consummated promptly after the shareholders’ meeting, assuming the merger is approved by the shareholders. However, the closing of the merger is also subject to the satisfaction or waiver of other closing conditions, including obtaining a new credit facility of at least $60 million to refinance the existing credit facilities of FMG and the Company. A commitment for a new credit facility upon consummation of the merger has been executed by and between FMG and a creditworthy financial institution. Also, as discussed under Management’s Discussion and Analysis of Financial Condition and Results of Operations, AmeriSource Bergen has filed a lien against the assets of Valley South. While management is attempting to negotiate with AmeriSource Bergen to structure an agreement, there can be no assurances that a mutually acceptable agreement will be reached.

If the merger is consummated, the Company expects that the current Company stockholders will, as a group, own approximately 40%, and FMG stockholders, employees and directors will, as a group, own approximately 60%, of the issued and outstanding shares of the Company immediately after the merger, assuming the vesting of all restricted shares and the exercise of all stock options. In addition, at the closing of the merger, the Company will issue warrants to the FMG stockholders and certain FMG warrant holders and note holders entitling them to purchase certain additional shares of the Company common stock.

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

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

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

Important factors that could cause the actual results to differ materially from those in the forward-looking statements include, among other items, (i) changes in the regulatory and general economic environment related to the health care and pharmaceutical industries, including possible changes in reimbursement for healthcare products and in manufacturers’ pricing or distribution policies; (ii) conditions in the capital markets, including the interest rate environment and the availability of capital; (iii) changes in the competitive marketplace that could affect the Company’s revenue and/or cost bases, such as increased competition, lack of qualified marketing, management or other personnel, and increased labor and inventory costs; (iv) changes in technology or customer requirements; (v) changes regarding the availability and pricing of the products which the Company distributes, as well as the loss of one or more key suppliers for which alternative sources may not be available, (vi) the Company’s ability to integrate recently acquired businesses; and (vii) the Company’s ability to consummate its proposed merger. Further information relating to factors that could cause actual results to differ from those anticipated is included but not limited to information under the headings “Business,” particularly under the subheading, “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Form 10-K for the year ended March 31, 2004, as well as information contained in this Form 10-Q. The Company disclaims any intention or obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

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

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

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On March 19, 2004, the Company entered into an Agreement and Plan of Merger with FMG, as amended on July 1, 2004 and October 11, 2004, pursuant to which FMG will be merged with and into the Company, with the Company being the surviving company. FMG is a pharmacy chain with a strategy of locating pharmacies at or near a patient’s point of medical care. FMG operates more than 76 pharmacies in 14 states. Many of these pharmacies are located at or near the point of care between physicians and patients, many times inside or near medical office buildings. Across these distribution channels, FMG annually services over 400,000 acute and chronically ill patients, many with complex specialty and medical product needs. The principal executive offices of FMG are located at 312 Farmington Avenue, Farmington, CT 06032. The Company’s annual meeting of its shareholders where the shareholders will vote on the merger, has been scheduled for November 12, 2004. Management expects that the merger will be consummated promptly after the shareholders’ meeting, assuming the merger is approved by the shareholders. However, the closing of the merger is also subject to the satisfaction or waiver of other closing conditions, including obtaining a new credit facility of at least $60 million to refinance the existing credit facilities of FMG and the Company. A commitment for a new credit facility upon consummation of the merger has been executed by and between FMG and a creditworthy financial institution. As discussed under Management’s Discussion and Analysis of Financial Condition and Results of Operations, AmeriSource Bergen has filed a lien against the assets of Valley South. While management is attempting to negotiate with AmeriSouce Bergen to structure an agreement, there can be no assurances that a mutually acceptable agreement will be reached.

If the merger is consummated, the Company expects that the current Company stockholders will, as a group, own approximately 40%, and FMG stockholders, employees and directors will, as a group, own approximately 60%, of the issued and outstanding shares of the Company immediately after the merger, assuming the vesting of all restricted shares and the exercise of all stock options In addition, at the closing of the merger, the Company will issue warrants to the FMG stockholders and certain FMG warrant holders and note holders entitling them to purchase certain additional shares of the Company common stock.

On September 30, 2004, the Company combined the operations of the Pittsburgh distribution center with the Valley and Valley South operations, whereby the customers of the Pittsburgh distribution center are being serviced through the Valley and Valley South locations. Inventory of the Pittsburgh distribution center was transferred to Valley and Valley South.

The Company’s Chief Executive Officer and Chief Financial Officer concluded that as of March 31, 2004, the Company’s disclosure controls and procedures needed improvement and were not adequately effective. See, “Item 4. Controls and Procedures.”

Critical Accounting Policies and Estimates

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

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

Allowance for Doubtful Accounts

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

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Inventory Valuation

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

Goodwill and Intangible Assets

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

Impairment of Long-Lived Assets

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

Allowance for Deferred Income Tax Asset

The Company had a deferred income tax asset and valuation allowance at March 31, 2001, which primarily represented the potential future tax benefit associated with its operating losses through the fiscal year ended March 31, 2001. In assessing the realizability of deferred income tax assets, management considered whether it is more likely than not that some portion or all of the deferred income tax assets would not be realized. The ultimate realization of deferred income tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management evaluated the scheduled reversal of deferred income tax liability, the Company’s profitability for the year ended March 31, 2002, reviewed the Company’s business model, and future earnings projections, and believed the evidence indicated that the Company will be able to generate sufficient taxable income to utilize the deferred income tax asset. Based upon the evaluations made, management concluded that realization of the deferred income tax asset was more likely than not; therefore, the valuation allowance was reversed in fiscal 2002. During the fiscal year ended March 31, 2003, the Company recorded a deferred income tax benefit of approximately $.3 million related to losses reported for the fiscal year, and recorded a valuation allowance of $.6 million for a portion of deferred tax assets which management concluded that their realization was not more likely than not. Based upon management’s analysis and discussion in fiscal 2004, the Company reserved the net deferred tax asset at March 31, 2004, as it appears to be more likely than not that the Company will not be able to utilize the deferred income tax asset of approximately $1.4 million. Therefore, the Company recorded the $1.4 million as a charge to income tax expense in the fourth quarter of fiscal 2004.

Revenue Recognition

The Company recognizes revenue when goods are shipped and title or risk of loss resides with unaffiliated customers, and at which time the appropriate provisions are recorded for estimated contractual chargeback credits from the manufacturers based on the Company’s contract with the manufacturer. Rebates and allowances are recorded as a component of cost of sales in the

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period they are received from the vendor or manufacturer unless such rebates and allowances are reasonably estimable at the end of a reporting period. The Company records chargeback credits due from its vendors in the period when the sale is made to the customer which is eligible for contract pricing from the manufacturer. Detailed accounting, internal auditing and reconciliations are necessary for the Company to maintain accurate records for the rebates, allowances and chargebacks. The Company’s failure to properly record, audit and submit timely reports to vendors could result in the loss of revenue related to the rebates, allowances and chargebacks.

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

Results of Operations

For the Three and Six Months Ended September 30, 2004 and 2003.

Revenues. The Company generated revenues of approximately $42.9 million and $60.2 million for the three months ended September 30, 2004 and 2003, respectively, and approximately $82.8 million and $120.8 million for the six months ended September 30, 2004 and 2003, respectively.

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

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The net decrease in revenues were the result of several factors:

1. General. As stated previously, the Company’s products function within the structure of the healthcare financing and reimbursement system of the United States. As a result of a wide variety of political, economic and regulatory influences, this system is currently under intense scrutiny and subject to fundamental changes. In recent years, the system has changed significantly in an effort to reduce costs. These changes include increased use of managed care, cuts in Medicare, consolidation of pharmaceutical and medical-surgical supply distributors, and the development of large and sophisticated purchasing groups. As a result, the Company’s revenues and profit margins have been negatively impacted, particularly with regard to branded drugs. In the three months ended September 30, 2004, the Company’s revenues and profit margins were also negatively impacted by:

An alternate source customer is a licensed distributor that is not designated as an authorized distributor of a manufacturer. DrugMax generally is an authorized distributor for many of its manufacturer/suppliers, but many of the Company’s wholesale customers are not. Buying opportunities occur when manufacturers announce that wholesalers with whom they conduct business may purchase inventory at favorable prices if they are willing to purchase more than their usual inventory of product. Forward buying is a speculative purchasing strategy employed in the industry to purchase inventory in advance of expected price increases.

In 2003, QK, who had previously been a large wholesale (i.e., non-core) customer of the Company, sued the Company in connection with the sale by the Company of twenty bottles of allegedly counterfeit Lipitor (which the Company had acquired from another wholesaler), and subsequently, in May 2003, ceased doing business with the Company. This lawsuit has now been settled. Pursuant to the settlement agreement between QK and the Company, QK has committed to purchasing $30 million of product from DrugMax for one year starting in July 2004, and the Company has agreed to provide QK with discounted prices during this one-year period. Accordingly during the quarter ended September 30, 2004, QK purchased approximately $2.1 million of product from the Company. The Company expects this trend to continue, but the actual amount purchased by QK in any period will depend on demand and availability. After the one-year settlement period, the Company anticipates that its business with QK will continue in line with its historical relationship, which has approximated an average of $30 million annually in sales to QK since 2000, and thus, while there can be no assurances, the Company does not currently expect any continuing negative impact from its dispute with QK. See “Legal Proceedings.”

2. Branded Drugs. Sales of branded drugs were particularly hard hit by the market forces discussed above. Branded drug sales declined by approximately $17.1 million and $36.8 million for the three and six months ended September 30, 2004, respectively, as compared to the three and six month periods ended September 30, 2003. Although it is not possible for the Company to quantify in detail the negative impact that each of the market forces had on sales of branded drugs during the three and six month periods ended September 30, 2004, the Company estimates that of the total decline in sales in branded drugs the following items had the following impact on the Company:

3. Generics. As a result of the continuing pressures on the sale of branded drugs and the resulting decreasing profit margins on the sale of branded drugs, the Company has implemented a business strategy aimed at increasing its margins while reducing costs by focusing on higher-margin products. In general, branded drug products experience smaller margins than generic, over-the-counter and other products. The Company is implementing this strategy by focusing on its core business of servicing independent pharmacies, hospitals and small chain stores, and de-emphasizing sales to warehouse customers, which generate high-volume revenue, but nominal gross profit.

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However, despite the implementation of this strategy, the Company’s sale of generic drugs decreased by approximately $.9 million during the three months ended September 30, 2004 as compared to the three months ended September 30 2003, and decreased by approximately $2.2 million during the six months ended September 30, 2004 as compared to the six months ended September 30, 2003. This decrease was almost entirely caused by credit and collection problems related to various customers of the Company. The Company ceased making sales to these customers, as it was unwilling to continue to extend credit to the customers, and, in three and six months ended September 30, 2004, the replacement of sales to new customers were not sufficient to cover the loss of these customers. The Company’s sale of generic products was also negatively impacted to a much smaller degree by the restructuring of the Company’s telemarketing department focused on generic drugs, which was relocated from the Clearwater headquarters to the Valley facility in fiscal 2005. The process required the hiring and training of new personnel. Finally, the Company also witnessed continuing price pressure on certain generic drugs in fiscal 2004 caused by the entry into the market of multiple generic drug manufacturers.

4. Over the Counter and Respiratory Products. During the three months ended September 30, 2004, total over the counter and respiratory sales amounted to approximately $1.6 million, as compared to approximately $.9 million for the same three months ended September 30, 2003, and during the six months ended September 30, 2004, total over the counter and respiratory sales amounted to approximately $3.0 million as compare to approximately $1.9 million for the same six month period ended September 30, 2003. The increase was primarily due to the revenues generated by the respiratory products sold as a result of the Company’s acquisition of Avery in May 2003, and other healthcare related products.

5. Sales Strategy. Going forward, management remains committed to its strategy of focusing on its higher margin products and its core customers (i.e., independent pharmacies, hospitals and small chain stores). To increase its sales, particularly of its higher-margin products, the Company intends to:

While there can be no assurances, the Company also believes that its proposed merger with FMG will result in higher revenues and margins and result in various purchasing benefits and costs savings to the Company.

Gross Profit. The Company achieved gross profit of approximately $1.4 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively, and approximately $2.6 million and $4.1 million for the six months ended September 30, 2004 and 2003, respectively. The Company’s margin, as a percentage of revenue, was 3.2% and 3.5% for the three months ended September 30, 2004 and 2003, respectively, and approximately 3.1% and 3.4% for the six months ended September 30, 2004 and 2003, respectively. The decrease in gross margin percentage was primarily as a result of the (a) decline in volume of higher-profit generic sales, (b) the loss of “buy-in” opportunities and incentives from manufacturers, which increased the cost of purchased goods for the Company, and (c) loss of several of the Company’s core business customers as a result of customer credit issues, including bankruptcy filings. The loss of “buy-in” opportunities primarily resulted from the reduced purchasing levels caused by the loss of the QK business. The gross profit earned on sales to the Company’s core business customers ranges from 1% to 3%, and represented more than 96% of the total gross profit earned by the Company for fiscal 2004, 2003 and 2002. Gross profit and gross profit margin was also negatively impacted by brand name drug manufacturers continuing pressures on drug wholesalers to reduce or eliminate forward buying.

Operating Expenses and Other Income and Expenses. The Company incurred operating expenses of approximately $2.1 million and $1.9 million for the three months ended September 30, 2004 and 2003, respectively, and approximately $3.9 million and $3.7 million for the six months ended September 30, 2004 and 2003, respectively. The following schedule details the major components of operating expenses:

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Administrative, sales, marketing and other direct operating expenses were approximately 4.9% and 3.1% of gross revenues for the three months ended September 30, 2004 and 2003, respectively, and approximately 4.8% and 3.0% of gross revenues for the six months ended September 30, 2004 and 2003, respectively. Administrative, sales, marketing and other direct operating expenses increased approximately $.2 million for the three months ended September 30, 2004 over the three months ended September 30, 2003, and increased approximately $.3 million for the six months ended September 30, 2004 over the six months ended September 30, 2003. During the six months ended September 30, 2004, the Company incurred approximately $.2 million in expenses related directly to the proposed merger with FMG.

The Company acquired the business of Avery in May 2003. Based upon the initial projections management received from Avery personnel, it was anticipated that the Avery operations would impact the Company positively, primarily as a result of the Company’s acquisition of a patent on the manufacture of respiratory products. For the three and six months ended September 30, 2004, the Avery operations combined with the Valley South operations incurred a net loss of approximately $426,000 and $733,000, respectively. The Company has completed the testing of the patented product and began production in July 2004.

Other income and expense. The Company realized approximately $4,000 and $22,000 in other income for the three months ended September 30, 2004 and 2003, respectively and approximately $7,000 and $457,000 for the six months ended September 30, 2004 and 2003, respectively. For the three and six months ended September 30, 2004, other income and expense primarily represented interest and finance charge income. In April 2003, the Company recorded approximately $73,000 in costs associated with the termination of the Standard credit facility, which were charged as other expense, and recorded as other income the reversal of a long-term liability due to Butler of approximately $502,000 in connection with the agreement between the Company and Butler whereby Butler assigned its 30% ownership in VetMall to the Company. (See Acquisitions.)

For the three and six months ended September 30, 2004, the Company recorded a loss of approximately $20 and $100, respectively, as equity loss from unconsolidated subsidiary. The joint venture with MorepenMax has nominal operations. The equity loss from unconsolidated subsidiary recorded represents 49% of the joint venture’s operations.

Interest expense. Interest expense was approximately $274,000 and $255,000, for the three months ended September 30, 2004 and 2003, respectively, and approximately $531,000 and $928,000 for the six months ended September 30, 2004 and 2003, respectively. Included in interest expense is the amortization of loan financing costs, which were approximately $60,000 and $46,000 for the three months ended September 30, 2004 and 2003, respectively, and approximately $110,000 and $143,000 for the six months ended September 30, 2004 and 2003, respectively. Included in interest expense for the six months ended September 30, 2003 is an early termination fee of $350,934 and the 90-day notice waiver fee of $30,000 charged by Standard for the early termination of that credit facility in April 2003.

Net income (loss) per share. EPS is calculated by dividing the net income (loss) by the weighted average number of shares of common stock outstanding for the period. Diluted EPS is calculated by dividing net income by the weighted average number of shares of common stock outstanding for the period, adjusted for the dilutive effect of options and warrants, using the treasury stock method. The net loss per basic share for the six months ended September 30, 2004 was $.23 as compared to net income of $0 per basic and diluted share for the six months ended September 30, 2003. The Company had issued and outstanding 1,355,837 and 1,593,629 options, respectively, to purchase shares of the Company’s common stock, in addition to warrants to purchase 150,000 shares of the Company’s common stock, which were anti-dilutive and not included in the computation of diluted EPS for the six months ended September 30, 2004 and 2003. These anti-dilutive shares could potentially dilute the basic EPS in the future. Shares of common stock used in the calculation of the basic net loss per share for the six months ended September 30, 2004 were 8,193,277, and shares of common stock used in the calculation of the basic and diluted shares calculation for the six months ended September 30, 2003 were 7,153,208 and 7,223,164, respectively.

Income Taxes. SFAS No. 109 requires a valuation allowance to reduce the deferred income tax assets reported, if based on the weight of the evidence, it is more likely than not that a portion or all of the deferred income tax assets will not be realized. The

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

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

Financial Condition, Liquidity and Capital Resources

The Company has a working capital deficit and cash and cash equivalents of approximately ($3.6) million and $.3 million, respectively, at September 30, 2004.

In April 2003, the Company obtained a $40 million revolving line of credit and a $400,000 term note from Congress to satisfy the outstanding line of credit and term loan with Standard, and to provide working capital for possible future acquisitions. The Congress credit facility is collateralized by all assets of the Company. The revolving line of credit enables the Company to borrow a maximum of $40 million, with borrowings limited to 85% of eligible accounts receivable and 65% of eligible inventory and is available until April 2006. At September 30, 2004, availability on the Congress credit facility was approximately $2.2 million. The revolving line of credit and the term note currently bear interest at the rate of 0.50% per annum in excess of the Prime Rate. The term note and revolving line of credit are payable over a 36-month period. The Congress credit facility imposes certain restrictive covenants on tangible net worth and EBIDTA. The Company currently is not in compliance with either the Tangible Net Worth or EBITDA covenants. Additionally, the actions taken by AmeriSource Bergen in connection with the amount owed to AmeriSource Bergen by the Company and its subsidiaries may also constitute a default under the Congress credit facility. These actions are discussed in more detail in the next paragraph. However, on October 22, 2004, Congress and the Company entered into a Forbearance Agreement, pursuant to which Congress agrees, subject to the terms and conditions of that agreement, to forebear from exercising its rights and remedies under the credit facility, applicable law or otherwise, to the effect that the rights and benefits otherwise available to the Company under the credit facility in the absence of the existing defaults shall continue until November 19, 2004. On November 12, 2004 the Company and Congress executed the Sixth Amendment to Loan and Security Agreement and Consent by and Between Congress Financial Corporation (Florida) and DrugMax, Inc., together with its Subsidiaries, Valley Drug Company, Valley Drug Company South, and Discount Rx, Inc. (the “Sixth Amendment”). The Sixth Amendment amends the Forbearance Agreement by extending the termination date to read December 10, 2004, subject to terms and conditions of the agreement. As discussed in greater detail below, the Company intends to refinance the Congress credit facility in connection with its merger with Familymeds Group, Inc. If the Congress credit facility is not refinanced prior to the expiration of the forbearance period as amended or if the existing defaults are not cured prior to such time, Congress’ forbearance agreement will expire and Congress may then exercise its rights and remedies against the Company. The forbearance agreement as amended applies a one percent reduction each week in the inventory valuation used for the availability calculation during the term of the Forbearance Agreement.

In September 2004, AmeriSource Bergen, one of the Company’s largest suppliers, ceased supplying product on credit to the Company and its subsidiaries. Since that date, the Company has purchased a limited amount of supplies from AmeriSource Bergen on COD terms. As of October 20, 2004, the Company owed to AmeriSource Bergen $6,625,939 and Valley Drug Company South, one of the Company’s subsidiaries, owed AmeriSource Bergen an additional $4,095,403. On October 22, 2004, AmeriSource Bergen filed a lien in Louisiana against Valley Drug Company South’s assets based upon an Application for Credit and Purchase Agreement dated July 3, 2002 that AmeriSource Bergen argues provides it with the right to file such a lien. The Company believes that any amounts due to AmeriSource Bergen directly by the Company or any of its subsidiaries (other than Valley Drug Company South) are unsecured. In a letter dated October 21, 2004, AmeriSource Bergen demanded that, because the Company is in default under the AmeriSource agreement, the Company turnover of all collateral securing the obligations to AmeriSource Bergen, including but not limited to inventory, equipment, deposit accounts, proceeds of general intangibles, etc. The Company has not authorized the turnover of such assets. The Company’s primary lender, Congress Financial, has a first lien on all of the Company’s assets. In connection with the Company’s merger with FMG, the Company is

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seeking to refinance the Congress credit facility and to reach an agreement that will allow the merger and the refinancing to be consummated and that will provide a repayment schedule for AmeriSource Bergen that is acceptable to all of the parties. While management is negotiating the terms of such agreement currently, there can be no assurances that such an agreement will be reached.

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

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

Further, if the merger is consummated, the combined company will inherit the debt and obligations of FMG. FMG has incurred significant losses and negative cash flow in the past. Further, unless restructured in connection with the merger, FMG’s senior collateralized revolving credit facility with General Electric Capital Corporation (“General Electric”), and its debt under that facility will mature on November 12, 2004. As of September 25,, 2004, the amount outstanding under the General Electric facility was approximately $27.8 million. These facts raise doubt about FMG’s ability to continue as a going concern. FMG’s auditor has issued a going concern opinion, in part as a result of its credit facility having a maturity date of less than one year. While management believes that the merger offers the combined company a greater opportunity than either company individually would have to improve its financial position, for the reasons discussed under the heading “Risk Factors” in the Company’s Form 10-K for the year ended March 31, 2004, there can be no assurance that management will be able to integrate the two companies or that the anticipated benefits of the merger will be realized. If the Company and FMG fail to integrate the companies, achieve its business plan, realize some or all of the anticipated revenue opportunities or cost savings and other benefits of the merger, or if the costs of the merger or the integration of the companies exceeds what is anticipated, its working capital and financial condition will be materially negatively impacted.

As discussed above, to complete the merger, the merger agreement requires that the Company obtain a new credit facility for at least $60 million. A commitment for a new credit facility upon consummation of the merger has been executed by and between FMG and a creditworthy financial institution.

Further, while management presently believes that the new credit facility, for which FMG has a commitment letter, will be sufficient to allow the surviving company to integrate the businesses of FMG and the Company and to fund its business plan for the next 12 months, it may be insufficient to fund the Company’s credit needs. The Company is currently considering the need to seek alternate or additional financing.

In the event the merger with FMG is not consummated, management believes the Company has sufficient capital resources from its current credit facility with Congress, which expires in April 2006, and capital injected into the Company during the fourth quarter 2004, to fund the Company’s operations for the next twelve months in spite of the negative $3.6 million working capital position reported at September 30, 2004. Management’s long-range viewpoint believes that the growth and capital needs of the Company will be met through primarily achieving positive results from its business model, utilization of available debt financing from its Congress bank facility and continually looking to the equity markets for new capital. However, management also realized that depending upon the outcome of the demand action filed by Amerisource, and until the merger with FMG is consummated, the Company’s precarious financial position raises doubts of its ability to continue as a going concern.

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Net cash provided by operating activities was approximately $3.3 million for the six months ended September 30, 2004. Cash was provided primarily by decreases in inventory and notes receivable and an increase in accounts payable, offset by increases in accounts receivable, prepaid and other current assets, deposits and a decrease in accrued expenses and other current liabilities. The increase in accounts receivable and the decrease in inventory was caused by an increase in sales to small chains and mail order pharmacies, which generally receive a longer payment term, and inventory reduction initiated by management to increase inventory turns while maintaining service levels resulting from decreased sales. The increase in accounts payable to trade vendors and the related decrease in the Company’s line of credit was caused principally by the due dates of the payments to vendors and the availability of the line of credit to fund disbursements. Net cash used in operating activities was $3.9 million for the six months ended September 30, 2003. Cash was used primarily by increases in accounts receivables, prepaid and other current assets, and decreases in accrued expenses and other current liabilities; offset by decreases in inventory, due from affiliates, other assets and notes receivable and an increase in accounts payable.

Net cash used in investing activities was approximately $.3 million for the six months ended September 30, 2004, which represented cash invested in property and equipment.

Net cash used in financing activities was approximately $5.5 million for the six months ended September 30, 2004, primarily representing a decrease in the Company’s line of credit of approximately $5.3 million, an increase in deferred financing costs associated with the Congress credit facility, and payments of long-term debt, capital leases. The decrease in the line of credit balance was principally caused by the payment cycles due to vendors. Fluctuations between accounts payable and the line of credit balances are normal depending upon the payment cycles.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company is subject to market risk from exposure to changes in interest rates based on its financing and cash management activities, which could affect its results of operations and financial condition. At September 30, 2004, the Company’s outstanding debt with Congress was approximately $12.0 million on the line of credit and $.2 million on the term loan. The interest rates charged on the line of credit and term loan currently bear interest at the rate of 0.5% per annum in excess of the Prime Rate. The Company is at risk of increased interest rates, due to fluctuations in the Prime Rate, contingent upon economic conditions. At September 30, 2004, the interest rate charged on the line of credit and term loan was 5.0%. At September 30, 2004, based on the amount of debt outstanding as of such date, (i.e., $12.0 million), a 1% change in interest rates up or down would affect the Company’s income statement on an annual basis by approximately $120,000. The company manages its risk by choosing the most advantageous interest option offered by its lender. See “Managements Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition, Liquidity and Capital Resources”. The Company holds several notes receivable from its customers which do not carry variable interest rates. The Company does not currently utilize derivative financial instruments to address market risk.

Item 4. CONTROLS AND PROCEDURES.

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

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

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

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

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

2. The Company has reorganized its credit and collection functions and previously hired a Vice President of Asset Management to assist in the granting of credit to customers or potential customers. Recently, more independent pharmacies, which are a significant part of the Company’s core business, have incurred financial difficulties, as indicated by the number of recent bankruptcies by such pharmacies. As a result, the Company’s credit policy is being reviewed and restructured.

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

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

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

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PART II - OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

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

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

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

On November 12, 2003, Phil & Kathy’s, Inc. d/b/a Alliance Wholesale Distributors (“Alliance”) served a complaint against the Company seeking to recover the non-payment of open invoices approximating $2,000,535, based upon an alleged breach of contract for the sale of pharmaceuticals. On December 18, 2003, the Company filed an answer and counterclaim. The counterclaim seeks to recover lost profits and other damages relating to the purchase of twenty bottles of Lipitor from Alliance, which the Company later sold to QK. The Company intends to vigorously defend Alliance’s breach of contract action and prosecute the counterclaim. Valley also filed a separate action against Alliance for breach of an indemnification agreement related to the sale of the twenty bottles of Lipitor that precipitated the lawsuit against Valley by QK in New York. At March 31, 2004, the amount that the Company recorded as a trade payable balance due Alliance on the above was approximately $1.5 million. Under the Company’s indemnification agreement with Alliance, pursuant to which Alliance is required to indemnify the Company for all losses, expenses and damages sustained by the Company as a result of product sold to the Company by Alliance, and the Company’s right to offset its losses, expenses and damages against any amounts due to Alliance, the Company has reduced the payable to Alliance by the cost of the faulty Lipitor sold by Alliance to the Company plus the settlement and litigation expenses incurred by the Company directly as a result of the Lipitor.

While the Company has recorded the foregoing trade payable, it continues to assess the extent of its full damages and cannot at this time reasonably estimate the total future possible loss that it will sustain as a result of the Alliance complaint or the possible recovery through the Company’s counterclaim or Valley’s consolidated action.

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

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

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

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

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

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

None.

Item 6. EXHIBITS

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SIGNATURES

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

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