**`UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-Q**







(Mark
      One)


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





**For
      the quarterly period ended December 31, 2006**





OR





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





For
      the
      transition period from_______ to ______





**Commission
      File Number 1-15345**





**GALAXY
      NUTRITIONAL FOODS, INC.**


(Exact
      name of registrant as specified in its charter)





**Delaware**
            **25-1391475**(State
                or other jurisdiction of
            (I.R.S.
                Employerincorporation
                or organization)
            Identification
                No.)**5955
                T. G. Lee Blvd Suite 201****Orlando,
                Florida**
            **32822**(Address
                of principal executive offices)
            (Zip
                Code)





**(407)
      855-5500**


(Registrant's
      telephone number, including area code)





2441
      Viscount Row


Orlando,
      Florida 32809


(Former
      address, if changed since last report)





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.  YES x  NO
o





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


Large
      accelerated filer oAccelerated
      filer oNon-accelerated
      filer o





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).  YES oNO
x





On
      February 9, 2007, there were 17,109,910 shares of common stock, $.01 par value
      per share, outstanding.


1





**GALAXY** **NUTRITIONAL FOODS, INC.**





**Index
      to Form 10-Q**


**For
      the Quarter Ended December 31, 2006**








**PAGE
                NO.****PART
                I. FINANCIAL INFORMATION****Item
                1. Financial Statements**Balance
                Sheets
            3Statements
                of Operations
            4Statement
                of Stockholders’ Deficit
            5Statements
                of Cash Flows
            6Notes
                to Financial Statements
            7**Item
                2. Management's Discussion and Analysis of Financial Condition and
                Results
                of Operations**
            19**Item
                3. Quantitative and Qualitative Disclosures About Market
                Risk**
            31**Item
                4. Controls and Procedures**
            31**PART
                II. OTHER INFORMATION****Item
                1A. Risk Factors**
            32**Item
                6. Exhibits**
            34**SIGNATURES**
            38


2


**PART
      I. FINANCIAL INFORMATION**


**GALAXY
      NUTRITIONAL FOODS, INC.**


**Balance
      Sheets**


**DECEMBER
                  31,**
              
              **MARCH
                  31,****Notes**
              
              **2006**
              
              **2006****(unaudited)****ASSETS****CURRENT
                  ASSETS:**Cash
              
              
              
              
              $
              321,432
              
              $
              435,880Trade
                  receivables, net
              
              
              
              
              
              2,915,411
              
              
              4,018,806Inventories
              
              
              
              
              
              340,474
              
              
              273,528Prepaid
                  expenses and other
              
              
              
              
              
              282,115
              
              
              70,717Total
                  current assets
              
              
              
              
              
              3,859,432
              
              
              4,798,931**PROPERTY
                  AND EQUIPMENT, NET**
              
              
              
              
              
              96,404
              
              
              226,349**ASSETS
                  HELD FOR SALE**
              
              
              
              
              
              --
              
              
              61,950**OTHER
                  ASSETS**
              
              
              
              
              
              113,880
              
              
              162,840**TOTAL**
              
              
              
              
              $
              4,069,716
              
              $
              5,250,070**LIABILITIES
                  AND STOCKHOLDERS’ DEFICIT****CURRENT
                  LIABILITIES:**Secured
                  borrowings
              
              
              **3**
              
              $
              1,173,777
              
              $
              1,919,002Accounts
                  payable
              
              
              
              
              
              1,338,427
              
              
              2,665,963Accrued
                  disposal costs
              
              
              **4**
              
              
              49,733
              
              
              480,404Accrued
                  and other current liabilities
              
              
              
              
              
              352,078
              
              
              542,811Related
                  party notes payable
              
              
              **3**
              
              
              2,673,544
              
              
              2,273,021Current
                  portion of accrued employment contracts
              
              
              **5**
              
              
              366,305
              
              
              434,114Current
                  portion of obligations under capital leases
              
              
              
              
              
              --
              
              
              20,231Total
                  current liabilities
              
              
              
              
              
              5,953,864
              
              
              8,335,546**ACCRUED
                  EMPLOYMENT CONTRACTS,**less
                  current portion
              
              
              **5**
              
              
              288,585
              
              
              559,677**OBLIGATIONS
                  UNDER CAPITAL LEASES,**less
                  current portion
              
              
              
              
              
              --
              
              
              37,507Total
                  liabilities
              
              
              
              
              
              6,242,449
              
              
              8,932,730**COMMITMENTS
                  AND CONTINGENCIES**
              
              
              **6**
              
              
              --
              
              
              --**STOCKHOLDERS’
                  DEFICIT:**Common
                  stock
              
              
              
              
              
              171,099
              
              
              200,546Additional
                  paid-in capital
              
              
              
              
              
              70,167,150
              
              
              71,345,556Accumulated
                  deficit
              
              
              
              
              
              (72,510,982
              )
              
              (72,456,301
              )(2,172,733
              )
              
              (910,199
              )Less:
                  Notes receivable arising from the exercise of stock
                  options
              
              
              **5**
              
              
              --
              
              
              (2,652,000
              )Treasury
                  stock
              
              
              **5**
              
              
              --
              
              
              (120,461
              )Total
                  stockholders’ deficit
              
              
              
              
              
              (2,172,733
              )
              
              (3,682,660
              )**TOTAL**
              
              
              
              
              $
              4,069,716
              
              $
              5,250,070






See
      accompanying notes to financial statements


3


**GALAXY
      NUTRITIONAL FOODS, INC.**


**Statements
      of Operations**


**(UNAUDITED)**








**THREE
                MONTHS ENDED**
            
            **NINE
                MONTHS ENDED****DECEMBER
                31,**
            
            **DECEMBER
                31,****Notes**
            
            **2006**
            
            **2005**
            
            **2006**
            
            **2005****NET
                SALES**
            
            
            
            
            $
            6,110,619
            
            $
            9,072,097
            
            $
            20,670,958
            
            $
            29,361,475**COST
                OF GOODS SOLD**
            
            
            
            
            
            3,417,232
            
            
            7,182,502
            
            
            12,450,194
            
            
            22,582,708**Gross
                margin**
            
            
            
            
            
            2,693,387
            
            
            1,889,595
            
            
            8,220,764
            
            
            6,778,767**OPERATING
                EXPENSES:**Selling
            
            
            
            
            
            775,043
            
            
            1,161,751
            
            
            2,621,845
            
            
            3,655,543Delivery
            
            
            
            
            
            217,431
            
            
            544,665
            
            
            643,714
            
            
            1,886,214General
                and administrative, including $10,000, $52,676, $108,160 and $923,513
                non-cash compensation related to stock based transactions
            
            
            **7**
            
            
            639,030
            
            
            1,394,599
            
            
            2,496,658
            
            
            3,999,362Research
                and development
            
            
            
            
            
            47,345
            
            
            75,961
            
            
            134,128
            
            
            256,055Reserve
                on stockholder note receivable
            
            
            **5**
            
            
            --
            
            
            9,129,343
            
            
            1,428,000
            
            
            9,129,343Cost
                of disposal activities
            
            
            **4**
            
            
            134,744
            
            
            668,936
            
            
            283,547
            
            
            1,342,204Impairment
                of equipment
            
            
            
            
            
            --
            
            
            --
            
            
            --
            
            
            7,896,554Loss
                on disposal of assets
            
            
            
            
            
            19,775
            
            
            65,360
            
            
            44,280
            
            
            70,966**Total
                operating expenses**
            
            
            
            
            
            1,833,368
            
            
            13,040,615
            
            
            7,652,172
            
            
            28,236,241**INCOME
                (LOSS) FROM OPERATIONS**
            
            
            
            
            
            860,019
            
            
            (11,151,020
            )
            
            568,592
            
            
            (21,457,474
            )**OTHER
                INCOME (EXPENSE):**Interest
                expense
            
            
            
            
            
            (133,835
            )
            
            (595,692
            )
            
            (623,273
            )
            
            (1,246,490
            )Gain
                (loss) on fair value of warrants
            
            
            
            
            
            --
            
            
            (8,269
            )
            
            --
            
            
            388,731Total
                other income (expense)
            
            
            
            
            
            (133,835
            )
            
            (603,961
            )
            
            (623,273
            )
            
            (857,759
            )**NET
                INCOME (LOSS)**
            
            
            
            
            $
            726,184
            
            $
            (11,754,981
            )
            $
            (54,681
            )
            $
            (22,315,233
            )**BASIC
                NET INCOME (LOSS) PER COMMON SHARE**
            
            
            **8**
            
            $
            0.04
            
            $
            (0.59
            )
            $
            0.00
            
            $
            (1.14
            )**DILUTED
                NET INCOME (LOSS) PER COMMON SHARE**
            
            
            **8**
            
            $
            0.03
            
            $
            (0.59
            )
            $
            0.00
            
            $
            (1.14
            )








See
      accompanying notes to financial statements.


4


**GALAXY
      NUTRITIONAL FOODS, INC.**


**Statement
      of Stockholders’ Deficit**


**Nine
      months Ended December 31, 2006**


**(UNAUDITED)**





Common
                Stock
            
            
            
            
            
            NotesShares
            
            Par
                Value
            
            Additional
              Paid-In
                Capital
            
            Accumulated
                Deficit
            
            Receivable
                for Common Stock
            
            Treasury
                Stock
            
            TotalBalance
                at March 31, 2006
            
            
            20,054,623
            
            $
            200,546
            
            $
            71,345,556
            
            $
            (72,456,301
            )
            $
            (2,652,000
            )
            $
            (120,461
            )
            $
            (3,682,660
            )Fair
                value of stock-based transactions
            
            
            --
            
            
            --
            
            
            126,160
            
            
            --
            
            
            --
            
            
            --
            
            
            126,160Reserve
                on stockholder note receivable
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            1,428,000
            
            
            --
            
            
            1,428,000Refund
                of costs on issuance of common stock
            
            
            --
            
            
            --
            
            
            10,448
            
            
            --
            
            
            --
            
            
            --
            
            
            10,448Rounding
                shares
            
            
            16
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --Value
                of returned shares transferred to treasury stock
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            1,224,000
            
            
            (1,224,000
            )
            
            --Cancellation
                of treasury stock
            
            
            (2,944,729
            )
            
            (29,447
            )
            
            (1,315,014
            )
            
            --
            
            
            --
            
            
            1,344,461
            
            
            --Net
                loss
            
            
            --
            
            
            --
            
            
            --
            
            
            (54,681
            )
            
            --
            
            
            --
            
            
            (54,681
            )Balance
                at December 31, 2006
            
            
            17,109,910
            
            $
            171,099
            
            $
            70,167,150
            
            $
            (72,510,982
            )
            $
            --
            
            $
            --
            
            $
            (2,172,733
            )








See
      accompanying notes to financial statements.


5


**GALAXY
      NUTRITIONAL FOODS, INC.**


**Statements
      of Cash Flows**


**(UNAUDITED)**





**Nine
                months Ended December 31,**
            
            **Notes**
            
            **2006**
            
            **2005****CASH
                FLOWS FROM OPERATING ACTIVITIES:**Net
                Loss
            
            
            
            
            $
            (54,681
            )
            $
            (22,315,233
            )Adjustments
                to reconcile net loss to net cash from (used in) operating
                activities:Depreciation
                and amortization
            
            
            
            
            
            130,102
            
            
            1,463,036Amortization
                of debt discount and financing costs
            
            
            
            
            
            256,546
            
            
            424,016Provision
                for promotional deductions and losses on trade receivables
            
            
            
            
            
            (253,150
            )
            
            1,543,025Provision
                for loss on stockholder note receivable
            
            
            **5**
            
            
            1,428,000
            
            
            9,129,343Loss
                on disposal and impairment of assets
            
            
            
            
            
            44,280
            
            
            7,967,520Gain
                on fair value of warrants
            
            
            
            
            
            --
            
            
            (388,731
            )Non-cash
                compensation related to stock-based transactions
            
            
            **7**
            
            
            108,160
            
            
            923,513(Increase)
                decrease in:Trade
                receivables
            
            
            
            
            
            1,356,545
            
            
            (2,331,397
            )Inventories
            
            
            
            
            
            (66,946
            )
            
            3,245,797Prepaid
                expenses and other
            
            
            
            
            
            (176,477
            )
            
            (415,264
            )Increase
                (decrease) in:Accounts
                payable
            
            
            
            
            
            (1,317,088
            )
            
            487,749Accrued
                and other liabilities
            
            
            
            
            
            (675,201
            )
            
            (520,555
            )**NET
                CASH FROM (USED IN) OPERATING ACTIVITIES**
            
            
            
            
            
            780,090
            
            
            (787,181
            )**CASH
                FLOWS FROM INVESTING ACTIVITIES:**
            
            
            **9**Purchase
                of property and equipment
            
            
            
            
            
            (22,854
            )
            
            (304,353
            )Proceeds
                from sale of equipment
            
            
            
            
            
            45,455
            
            
            8,747,075Decrease
                in other assets
            
            
            
            
            
            34,923
            
            
            --**NET
                CASH FROM (USED IN) INVESTING ACTIVITIES**
            
            
            
            
            
            57,524
            
            
            8,442,722**CASH
                FLOWS FROM FINANCING ACTIVITIES:**Net
                borrowings (payments) on secured borrowings
            
            
            
            
            
            (745,225
            )
            
            (3,219,757
            )Borrowings
                on term notes payable
            
            
            
            
            
            1,200,000
            
            
            2,400,000Repayments
                on term notes payable
            
            
            
            
            
            (1,200,000
            )
            
            (8,241,985
            )Principal
                payments on capital lease obligations
            
            
            
            
            
            (62,826
            )
            
            (194,428
            )Financing
                costs for long term debt
            
            
            
            
            
            (144,011
            )
            
            (288,697
            )Proceeds
                from issuance of common stock under employee stock purchase
                plan
            
            
            
            
            
            --
            
            
            11,861Proceeds
                from exercise of common stock options
            
            
            
            
            
            --
            
            
            2,879Proceeds
                from exercise of common stock warrants, net of costs
            
            
            
            
            
            --
            
            
            1,691,758**NET
                CASH FROM (USED IN) FINANCING ACTIVITIES**
            
            
            
            
            
            (952,062
            )
            
            (7,838,369
            )**NET
                INCREASE (DECREASE) IN CASH**
            
            
            
            
            
            (114,448
            )
            
            (182,828
            )**CASH,
                BEGINNING OF PERIOD**
            
            
            
            
            
            435,880
            
            
            561,782**CASH,
                END OF PERIOD**
            
            
            
            
            $
            321,432
            
            $
            378,954








See
      accompanying notes to financial statements.


6


**GALAXY
      NUTRITIONAL FOODS, INC.**


**Notes
      To Financial Statements**


**(UNAUDITED)**





**(1)** **Basis
      of Presentation**


The
      unaudited financial statements have been prepared by Galaxy Nutritional Foods,
      Inc. (the “Company”), in accordance with accounting principles generally
      accepted in the United States of America (“GAAP”) for interim financial
      information and applicable rules and regulations of the Securities and Exchange
      Commission. The accompanying financial statements contain all normal recurring
      adjustments which are, in the opinion of management, necessary for the fair
      presentation of such financial statements. Certain information and disclosures
      normally included in the financial statements prepared in accordance with GAAP
      have been omitted under such rules and regulations although the Company believes
      that the disclosures are adequate to make the information presented not
      misleading. The March 31, 2006 balance sheet data was derived from the audited
      financial statements, but does not include all disclosures required by GAAP.
      These unaudited financial statements should be read in conjunction with the
      financial statements and notes included on Form 10-K for the fiscal year ended
      March 31, 2006. Interim results of operations for the nine-month period ended
      December 31, 2006 may not necessarily be indicative of the results to be
      expected for the full year.





During
      fiscal 2006, the Company transitioned its manufacturing and distribution
      operations to an outside supplier. In November 2005, Schreiber Foods, Inc.,
      a
      Wisconsin corporation (“Schreiber”), began manufacturing and distributing
      substantially all of the Company’s products in accordance with a Supply
      Agreement that was signed on June 30, 2005. The prices for such products are
      based on cost plus a processing fee as determined by the parties from time
      to
      time. Additionally, in December 2005, the Company sold substantially all of
      its
      manufacturing and production equipment to Schreiber for $8,700,000 in cash
      pursuant to an Asset Purchase Agreement dated June 30, 2005.




The
      Company incurred substantial losses in recent years and, as a result, has a
      stockholders deficit of $2,172,733 as of December 31, 2006. Losses for the
      years
      ended March 31, 2006, 2005 and 2004 were $24,148,553, $3,859,783 and $3,299,277,
      respectively. Additionally, the Company received a report from its independent
      accountants relating to its audited financial statements as of March 31, 2006
      containing a paragraph stating that because it was then in
      default of its notes payable, had suffered recurring losses from operations
      and
      at March 31, 2006 had deficiencies in working capital and equity ,
      there
      was substantial doubt as to its ability to continue as a going concern. The
      Company's ability to continue as a going concern depended upon successfully
      obtaining sufficient cash resources to refinance its $2.4 million of unsecured
      related party notes payable that matured on June 15, 2006 and obtaining positive
      cash flow from operations to sustain normal business operations.





The
      Company’s fiscal 2007 business plan eliminated certain low margin private label
      and Galaxy imitation business from its sales mix. The elimination of these
      low
      margin items and the elimination of excess overhead that was part of the
      Company’s former manufacturing operations has resulted in higher gross margins
      and produced positive cash flows from operations in the nine months ended
      December 31, 2006.




As a result
      of the successful refinancing of the $2.4 million short-term notes and line
      of
      credit for the Company’s receivables financing (See
      Note
      3) and the
      positive cash flow that the Company is currently experiencing from operations,
      management believes that the Company has sufficient cash resources to meet
      its
      current liquidity needs for general operations excluding the related party
      note
      payable.   Therefore,
      the Company’s financial statements have been prepared in accordance with
      accounting principles generally accepted in the United States of America
      assuming that it will continue on a going concern basis. This assumes the
      realization of assets and the satisfaction of liabilities in the normal course
      of business.





It
      is
      unlikely at this time that the Company will have enough cash from operations
      to
      repay the $2,685,104 related party note payable that matures in October 2007
      (See Note 3), if the Note Holder chooses not to convert the note into common
      shares or refinance or renew this loan. If the Note Holder demands a cash
      repayment of the related party note payable and the Company cannot generate
      enough cash from operations or alternative financing, it will be unable to
      satisfy the note by its maturity date. In such an event, the Note Holder could
      exercise his rights under the loan documents, which could include, among other
      things, declaring a default under the loan which would then trigger interest
      to
      accrue at 17.5% per annum. Additionally, a default to the Note Holder would
      trigger a default under the Systran Agreement. In such an event, Systran could
      exercise its rights under its loan documents, which could include, among other
      things, declaring a default and pursuing foreclosure on the Company’s assets
      that are pledged as collateral for the advances on its accounts receivable
      invoices. If these events occurred, it would be substantially more difficult
      for
      the Company to effectively continue the operation of its business, and it
      is
      unlikely that it would be able to continue as a going concern .
      Management has commenced discussions with the Note Holder regarding possible
      conversion, extension or other alternatives related to the note.





7


Use
      of
      Estimates


The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and reported amounts of revenues and expense during
      the
      reporting period. The Company’s significant estimates include the allowance for
      doubtful accounts receivable, which is made up of reserves for promotions,
      discounts and bad debts, valuation of deferred taxes, valuation of compensation
      expense on options and warrants, and accruals for disposal costs. Actual results
      could differ from those estimates.




Reclassifications


Certain
      items in the financial statements of the prior period have been reclassified
      to
      conform to current period presentation.





**(2)** **Summary
      of Significant Accounting Policies**


Revenue
      Recognition


Sales
      are
      recognized upon shipment of products to customers. The Company offers a right
      of
      return policy on certain products sold to certain retail customers in the
      conventional grocery stores and mass merchandising industry. If the product
      is
      not sold during its shelf life, the Company will allow a credit for the unsold
      merchandise. Since the shelf life of the Company’s products range from 6 months
      to one year, the Company historically averages less than 2% in credits for
      unsold product. The Company’s reserve on accounts receivable takes these
      potential future credits into consideration. Certain expenses such as returns,
      slotting fees, rebates, coupons and other discounts are accounted for as a
      reduction to Revenues.





Disposal
      Costs


The
      Company has recorded accruals in connection with the asset sale and outsourcing
      arrangements with Schreiber. Prior to December 31, 2006, these accruals included
      estimates pertaining to employee termination costs and abandonment of excess
      equipment and facilities and other potential costs. Given the significance
      and
      complexity of these activities, and the timing of the execution of such
      activities, the accrual process involved periodic reassessments of estimates
      made at the time the original decisions were made, including evaluating
      estimated employment terms, contract cancellation charges and real estate market
      conditions for sub-lease rents. As of December 31, 2006, there are no further
      costs that require estimates and any future disposal costs will be recorded
      as
      incurred in accordance with SFAS No. 146, *“Accounting
      for Costs Associated with Exit or Disposal Activities.”*





Stock
      Based Compensation


On
      September 29, 2006, the shareholders approved the 2006 Stock Incentive Plan.
      This 2006 Stock Incentive Plan has up to 1,000,000 shares available for stock
      awards to employees and directors and expires on January 20, 2016.





Effective
      April 1, 2006, the Company adopted SFAS
      No.
      123 (revised 2004), “ *Share-Based
      Payment* ”
(“SFAS
      No. 123R”). SFAS
      No.
      123R requires companies to measure the cost of employee services received in
      exchange for an award of equity instruments, including stock options, based
      on
      the grant-date fair value of the award and to recognize it as compensation
      expense over the period the employee is required to provide service in exchange
      for the award, usually the vesting period.





SFAS
      No.
      123R applies to new awards and to awards modified, repurchased, or cancelled
      after the effective date, as well as to the unvested portion of awards
      outstanding as of the effective date. The Company uses the Black-Scholes model
      to value its new stock option grants under SFAS No. 123R, applying the “modified
      prospective method” for existing grants which requires the Company to value
      stock options prior to its adoption of SFAS No. 123R under the fair value method
      and expense the value over the requisite service period. SFAS No. 123R also
      requires the Company to estimate forfeitures in calculating the expense related
      to stock-based compensation. In addition, SFAS No. 123R requires the Company
      to
      reflect cash flows resulting from the tax benefits related to tax deductions
      in
      excess of the compensation cost recognized for those options to be classified
      as
      a cash inflow from financing activities and a cash outflow from operating
      activities.





8


From
      April 1, 2003 through March 31, 2006, the
      Company accounted for stock awards granted to employees under the fair value
      recognition provisions of SFAS No. 123, “ *Accounting
      for Stock-Based Compensation,* ”
and
      applied SFAS No. 148, *“Accounting
      for Stock-Based Compensation - Transition and Disclosure,* ”
      prospectively to all employee awards granted on or after April 1, 2003. Prior
      to
      April 1, 2003, the
      Company accounted for stock awards granted to employees under the recognition
      and measurement principles of Accounting Principles Board Opinion No.
      25, *“Accounting
      for Stock Issued to Employees, and related Interpretations* .”
As
      a
      result, no compensation expense was recognized for stock options granted to
      employees prior to April 1, 2003 other than as related to option grants to
      employees and directors below the fair market value of the underlying stock
      at
      the date of grant or as related to subsequent modifications to options granted
      to employees and directors.





The
      Black-Scholes model requires subjective assumptions, including future stock
      price volatility and expected time to exercise, which greatly affect the
      calculated values. The risk-free rate is based on the U.S Treasury rates in
      effect during the corresponding period of the grant. Expected volatilities
      are
      based on the historical volatility of the Company’s stock. Prior to April 1,
      2006, the Company input the expected life of options granted based on the
      contractual life of the options granted. For any new awards, the Company will
      input the expected life of options granted based on information derived from
      historical data on employee exercises and post-vesting employment termination
      behavior. There is no expected dividend yield.  These factors could change
      in the future, which may affect the stock-based compensation expense in future
      periods. SFAS No. 123R requires forfeitures to be estimated at the time of
      grant
      and revised, if necessary, in subsequent periods if actual forfeitures differ
      from those estimates.





The
      Company's financial statements for the nine months ended December 31, 2006
      reflect the impact of SFAS No. 123R. In accordance with the modified prospective
      transition method, the Company's financial statements for prior periods have
      not
      been restated to reflect, and do not include, the impact of SFAS No.
      123R.




Stock-based
      compensation expense recognized during the period is based on the value of
      the
      portion of share-based payment awards that is ultimately expected to vest during
      the period. Stock-based compensation expense recognized in the Company's
      Statements of Operations for the three and nine months ended December 31, 2006
      included compensation expense for share-based payment awards granted prior
      to,
      but not yet vested as of March 31, 2006 based on the grant date fair value
      estimated in accordance with the pro forma provisions of SFAS 123 and
      compensation expense for the share-based payment awards granted subsequent
      to
      March 31, 2006 based on the grant date fair value estimated in accordance with
      the provisions of SFAS No. 123R. As stock-based compensation expense recognized
      in the Statement of Operations is based on awards ultimately expected to vest
      and to be exercised, it will be reduced for estimated forfeitures. There was
      no
      forfeiture rate applied to the stock-based compensation expense for the three
      and nine months ended December 31, 2006 as all options were fully vested and
      are
      able to be exercised. In the Company's pro forma information required under
      SFAS
      123 for the periods prior to April 1, 2006, the Company accounted for
      forfeitures as they occurred. The
      Company estimated the fair value of each stock-based award using the
      Black-Scholes pricing model with the following assumptions:




**Three
                Months Ended**
            
            **Nine
                months Ended****December
                31, 2006**
            
            **December
                31, 2006**Risk-free
                interest rate
            
            
            4.52
            %
            
            4.07-4.94
            %Volatility
            
            
            48.7
            %
            
            50.3-51.9
            %Expected
                life (months)
            
            
            120
            
            
            36-120Dividends
            
            
            None
            
            
            None





The
      following table summarizes nonvested plan and non-plan stock options as of
      December 31, 2006, as well as activity for the three and nine months then
      ended.




**Three Months Ended**
              **December
                31, 2006**
            
            **Nine
                months Ended**
              **December
                31, 2006****Shares**
            
            **Weighted**
              **Average**
              **Grant Date**
              **Fair Value**
            
            **Shares**
            
            **Weighted
                Average**
              **Grant
                Date**
              **Fair
                Value**Beginning
                of period
            
            
            -0-
            
            $
            -0-
            
            
            53,000
            
            $
            0.51Granted
            
            
            40,000
            
            
            0.25
            
            
            540,000
            
            
            0.19Vested
            
            
            (40,000
            )
            
            0.25
            
            
            (593,000
            )
            
            0.22Forfeited
            
            
            —
            
            
            —
            
            
            —
            
            
            —End
                of period
            
            
            -0-
            
            $
            -0-
            
            
            -0-
            
            $
            -0-




9


Compensation
      cost arising from nonvested stock granted to employees and from non-employee
      stock awards is recognized as expense using the graded vesting attribution
      method over the vesting period. As of December 31, 2006, there was no remaining
      unrecognized compensation cost related to nonvested stock. For the three and
      nine months ended December 31, 2006, the Company’s total stock-based
      compensation expense was $10,000 and $108,160, respectively.





The
      following table summarizes plan
      and
      non-plan stock
      options outstanding as of December 31, 2006 as well as activity during the
      nine
      months then ended:




**Nine
                  Months Ended****December
                  31,2006****Shares**
              
              **Weighted-
                  Average Exercise Price**
              
              **Weighted-
                  Average Remaining Contractual Term**
              
              **Aggregate
                  Intrinsic Value**Outstanding
                  at beginning of period
              
              
              4,846,406
              
              $
              3.12Granted
              
              
              540,000
              
              
              0.44Exercised
              
              
              —
              
              
              —Forfeited
              
              
              (48,656
              )
              
              2.56Outstanding
                  at end of period
              
              
              5,337,750
              
              $
              2.86
              
              
              2.8Years
              
              $
              -0-Exercisable
                  at end of period
              
              
              5,337,750
              
              $
              2.86
              
              
              2.8Years
              
              $
              -0-




At
      December 31, 2006, the aggregate intrinsic value of options outstanding and
      options exercisable was zero, because the market value of the underlying stock
      was below the average exercise price of all options. The closing price of the
      Company’s common stock on December 31, 2006 as quoted on the OTC Bulletin Board
      was $0.52 per share. The weighted-average fair value computed on options granted
      during the three and nine months ended December 31, 2006 was $0.25 and $0.19,
      respectively. The weighted-average fair value computed on options granted during
      the three and nine months ended December 31, 2005 was $1.07.





***Pro
      Forma Information for Periods Prior to April 1, 2006***


T he
      Company estimated the fair value of each stock-based award during the nine
      months ended December 31, 2005 as if compensation cost for all the Company's
      employee and director stock-based awards had been determined in accordance
      with
      the fair value method prescribed in SFAS No. 123. The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option-pricing model. The risk-free rate is based on the U.S
      Treasury rates in effect during the corresponding period of grant. Expected
      volatilities are based on the historical volatility of the Company’s stock.
      Expected life of options granted is computed using the contractual life of
      the
      options granted. There is no expected dividend yield. The
      Company estimated the fair value of each stock-based award using the
      Black-Scholes pricing model with the following assumptions:




**Nine
                months Ended****December
                31, 2005**Risk-free
                interest rate
            
            
            3.35-4.30
            %Volatility
            
            
            24.9-46.0
            %Expected
                life (months)
            
            
            1-120Dividends
            
            
            None





10


The
      following table illustrates the effect on net loss and net loss per share for
      the three and nine months ended December 31, 2005 as if the Company’s
      stock-based compensation had been determined based on the fair value at the
      grant dates for awards made prior to April 1, 2006, under those plans and
      consistent with SFAS 123:




**Three
                  Months Ended**
              
              **Nine
                  months****Ended****December
                  31, 2005**
              
              **December
                  31, 2005**Net
                  loss as reported
              
              $
              (11,754,981
              )
              $
              (22,315,233
              )Add:
                  Stock-based compensation included in reported net loss
              
              
              52,676
              
              
              923,513Deduct:
                  Stock-based compensation under fair-value based method for all
                  awards
              
              
              (62,568
              )
              
              (953,814
              )Pro
                  forma net loss
              
              $
              (11,764,873
              )
              $
              (22,345,534
              )Pro
                  forma basic and diluted net loss per common share:Pro
                  forma net loss per common share - basic and diluted
              
              $
              (0.59
              )
              $
              (1.14
              )Reported
                  net loss per common share - basic and diluted
              
              $
              (0.59
              )
              $
              (1.14
              )


Segment
      Information


The
      Company does not identify separate operating segments for management reporting
      purposes. The results of operations are the basis on which management evaluates
      operations and makes business decisions. The Company sells to customers
      throughout the United States and 14 other countries.





Recent
      Accounting Pronouncements


In
      July
      2006, the FASB issued Interpretation No. 48, *“Accounting
      for Uncertainty in Income Taxes - An Interpretation of FASB Statement No.
      109”* (“FIN
      48”). ** FIN
      48
      provides guidance on the financial statement recognition and measurement of
      a
      tax position taken or expected to be taken in a tax return. FIN 48 also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods, disclosures, and transition. FIN 48 is effective for fiscal
      years beginning after December 15, 2006. The
      Company is currently evaluating the impact of this standard on its financial
      statements.





In
      September 2006, the FASB issued SFAS 157, "Fair Value Measurements." SFAS 157
      simplifies and codifies guidance on fair value measurements under generally
      accepted accounting principles. This standard defines fair value, establishes
      a
      framework for measuring fair value and prescribes expanded disclosures about
      fair value measurements. SFAS 157 is effective for financial statements issued
      for fiscal years beginning after November 15, 2007, and interim periods within
      those fiscal years, with early adoption permitted. The Company is currently
      evaluating the effect, if any, the adoption of SFAS 157 will have on its
      financial condition, results of operations and cash flows.





In
      September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108,
“Considering the Effects of Prior Year Misstatements when quantifying
      Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108
      requires companies to evaluate the materiality of identified unadjusted errors
      on each financial statement and related financial statement disclosure using
      both the rollover approach and the iron curtain approach. The rollover approach
      quantifies misstatements based on the amount of the error in the current year
      financial statements whereas the iron curtain approach quantifies misstatements
      based on the effects of correcting the misstatement existing in the balance
      sheet at the end of the current year, irrespective of the misstatement’s year(s)
      origin. Financial statements would require adjustment when either approach
      results in quantifying a misstatement that is material. Correcting prior year
      financial statements for immediate errors would not require previously filed
      reports to be amended. SAB 108 is effective for the first fiscal year ending
      after November 15, 2006. The Company does not expect the impact of SAB 108
      on
      its financial condition, results of operations and cash flows to be
      material.








**(3)**
            **Secured
                Borrowings and Related Party Notes Payable**


Secured
      Borrowings


On
      June
      23, 2006, the
      Company entered into a Receivables Purchase Agreement with Systran
      Financial Services Corporation, a subsidiary of Textron Financial Corporation
      (“Systran”), whereby Systran will provide financing to the Company through
      advances against certain trade receivable invoices due to the Company (the
      “Systran Agreement”). The Systran Agreement is secured by the Company’s accounts
      receivable and all other assets. Generally, subject to a maximum principal
      amount of $3,500,000 which can be borrowed under the Systran Agreement, the
      amount available for borrowing is equal to 85%
      of
      the Company’s eligible accounts receivable invoices less a dilution reserve and
      any required fixed dollar reserves . The
      dilution and fixed dollar reserves have been initially set at 7% and $100,000,
      respectively. Advances
      under the Systran Agreement bear interest at a variable
      rate equal to the prime rate plus 1.5% per annum (9.75% on December 31, 2006).
      The Company paid a one-time closing fee of $35,000 and is also obligated to
      pay
      a $1,500 monthly service fee. The
      initial term of the Systran Agreement ends on June 23, 2009 and may renew
      automatically for consecutive twelve-month terms unless terminated sooner.





11


In
      accordance with SFAS No. 140, *“Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Debt,”* the
      Company accounts for the Systran Agreement as a liability since it is a
      full-recourse agreement and the Company maintains effective control over the
      accounts receivable.





On
      June
      23, 2006, Systran advanced $2,379,262 under the Systran Agreement of which

      $1,839,086 was used to pay in full and terminate the Company’s obligations under
      its line of credit with Textron Financial Corporation which was to terminate
      on
      June 27, 2006 pursuant to a Sixth Amendment to the Textron Loan Agreement that
      was executed on May 26, 2006. The Sixth Amendment provided for an extension
      of
      the Textron Loan from May 26, 2006 until June 27, 2006 and reduced the maximum
      principal amount which could be borrowed under the Textron Loan to $3,000,000.
      In exchange for the amendment and extension, the Company paid a fee of $10,000.
      As of December 31, 2006, advances under the Systran Agreement totaled
      $1,173,777.





Related
      Party Notes Payable


Pursuant
      to a Note and Warrant Purchase Agreement dated September 12, 2005, the Company
      received $1,200,000 as a loan from Mr. Frederick A. DeLuca, a greater than
      10%
      shareholder. In October 2005, pursuant to several Note and Warrant Purchase
      Agreements dated September 28, 2005, the Company received a $600,000 loan from
      Conversion Capital Master, Ltd., a $485,200 loan from SRB Greenway Capital
      (Q.P.), L.P., a $69,600 loan from SRB Greenway Capital, L.P. and a $45,200
      loan
      from SRB Greenway Offshore Operating Fund, L.P. The combined total of these
      loans was $2,400,000. The loans were evidenced by unsecured promissory notes
      (the “Notes”) held by the above referenced parties (the “Note Holders”). The
      Notes required monthly interest-only payments at 3% above the bank prime rate
      of
      interest per the Federal Reserve Bank and matured on June 15, 2006.





The
      Company did not
      have the short-term liquidity to pay its related party Note Holders on the
      $2.4
      million Notes that matured on June 15, 2006 in accordance with their original
      terms. The Company received a letter on June 20, 2006 from all of the Note
      Holders, other than Mr. DeLuca, notifying the Company that its failure to pay
      the amounts due and owing on the maturity date constituted a default on $1.2
      million of the Notes held by those Note Holders. Pursuant to the terms of the
      Notes, since the Company did not cure the default within 10 days after receipt
      of the notice of default, it was obligated to pay interest at the default rate
      of 8% above the Prime Rate beginning July 1, 2006.





Pursuant
      to a Note Purchase Agreement dated July 19, 2006, the Company issued a new
      unsecured convertible note for $2,685,104 (the “Convertible Note”) to Mr.
      DeLuca. The proceeds from the Convertible Note were used to repay or refinance
      the above mentioned $2.4 million Notes that matured on June 15, 2006 and a
      $285,104 registration rights penalty owed to Mr. DeLuca. The Convertible Note
      accrues interest at 12.5% per annum. No interest or principal payments are
      required under the Convertible Note until its maturity on October 19, 2007.
      Principal, together with any accrued and unpaid interest, on the Convertible
      Note is convertible at any time prior to payment into shares of the Company’s
      common stock at a conversion price of $0.35 per share. The market price of
      the
      Company’s common stock as quoted on the OTC Bulletin Board on July 19, 2006 was
      $0.28. As additional consideration for making the loan, the Company issued
      Mr.
      DeLuca a warrant (the “Warrant”) to purchase up to 200,000 shares of the
      Company’s common stock at an exercise price equal to $0.35 per share. The
      Warrant is fully vested and can be exercised on or before the expiration date
      of
      July 19, 2009. In July 2006, the Company recorded the $18,000 fair value of
      the
      Warrant as a discount to debt that is being amortized from July 2006 through
      October 2007.





The
      Company amortized $3,600 and $133,419 related to debt discounts in the three
      and
      nine months ended December 31, 2006, respectively. The Company amortized
      $152,376 and $165,376 related to debt discounts in the three and nine months
      ended December 31, 2005, respectively. Additionally, the Company recorded
      interest expense related to the above Notes of $85,774 and $237,335 in the
      three
      and nine months ended December 31, 2006, respectively, and $60,452 and $66,561
      in the three and nine months ended December 31, 2005, respectively. As of
      December 31, 2006, the outstanding principal balance of $2,685,104 on the
      Convertible Note less the remaining debt discount of $11,560 is
      $2,673,544.





12


**(4)** **Disposal
      Activities**


On
      December 8, 2005, the Company completed the sale of substantially all of its
      manufacturing and production equipment to Schreiber Foods, Inc., a Wisconsin
      corporation (“Schreiber”), for $8,700,000 in cash pursuant to an Asset Purchase
      Agreement dated June 30, 2005. In connection with the Asset Purchase Agreement,
      the Company also entered into a Supply Agreement with Schreiber (the “Supply
      Agreement”) on June 30, 2005 pursuant to which, Schreiber became the Company’s
      sole source of supply and distribution for substantially all of its products
      in
      November 2005.





The
      Company accounted for the costs associated with these transactions in accordance
      with SFAS No. 146, “ *Accounting
      for Costs Associated with an Exit or Disposal Activity,”* because
      the above arrangements were planned and controlled by management and materially
      change the manner in which the Company’s business will be conducted. In
      accordance with SFAS No. 146, costs associated with disposal activities should
      be reported as a reduction of income from operations. The above transactions
      were communicated to the Company’s employees on July 6, 2005. During the fiscal
      year ended March 31, 2006, all 104 employee positions related to the
      manufacturing and distribution of the Company’s products were eliminated. The
      majority of these employee termination costs were paid during fiscal 2006 with
      the remaining employee termination costs expected to be paid in fiscal 2007.
      In
      December 2005, the Company abandoned its distribution facility and the
      production portion of its administrative facility and accrued $396,197 related
      to abandonment of these facilities. This amount was calculated as the present
      value of the remaining lease rentals, reduced by the estimated market value
      of
      sublease rentals. The actual expense exceeded this estimate for the time that
      the Company did not sublease these facilities. Other exit costs consist
      primarily of legal and professional fees related to the disposal activities
      and
      maintenance costs on the abandoned facilities.





As
      of
      December 31, 2006, the Company has accrued the following costs associated with
      the above transactions:




**Employee
                Termination Costs**
            
            **Excess
                Facilities**
            
            **Other
                Exit Costs**
            
            **Total**Accrued
                Balance March 31, 2005
            
            $
            --
            
            $
            --
            
            $
            --
            
            $
            --Charges
            
            
            --
            
            
            --
            
            
            189,069
            
            
            189,069Payments
            
            
            --
            
            
            --
            
            
            (189,069
            )
            
            (189,069
            )Accrued
                Balance, June 30, 2005
            
            
            --
            
            
            --
            
            
            --
            
            
            --Charges
            
            
            359,774
            
            
            --
            
            
            124,425
            
            
            484,199Payments
            
            
            --
            
            
            --
            
            
            (124,425
            )
            
            (124,425
            )Accrued
                Balance, September 30, 2005
            
            
            359,774
            
            
            --
            
            
            --
            
            
            359,774Charges
            
            
            51,638
            
            
            396,197
            
            
            221,101
            
            
            668,936Payments
            
            
            (204,847
            )
            
            --
            
            
            (221,101
            )
            
            (425,948
            )Accrued
                Balance, December 31, 2005
            
            
            206,565
            
            $
            396,197
            
            $
            --
            
            $
            602,762Charges
            
            
            39,590
            
            
            122,282
            
            
            142,414
            
            
            304,286Payments
            
            
            (220,277
            )
            
            (168,530
            )
            
            (37,837
            )
            
            (426,644
            )Accrued
                Balance, March 31, 2006
            
            $
            25,878
            
            $
            349,949
            
            $
            104,577
            
            $
            480,404Charges
            
            
            --
            
            
            88,955
            
            
            12,789
            
            
            101,744Payments
            
            
            (7,257
            )
            
            (136,260
            )
            
            (18,427
            )
            
            (161,944
            )Accrued
                Balance, June 30, 2006
            
            
            18,621
            
            
            302,644
            
            
            98,939
            
            
            420,204Charges
            
            
            --
            
            
            23,905
            
            
            23,154
            
            
            47,059Payments
            
            
            --
            
            
            (280,420
            )
            
            (72,624
            )
            
            (353,044
            )Accrued
                Balance, September 30, 2006
            
            
            18,621
            
            
            46,129
            
            
            49,469
            
            
            114,219Charges
            
            
            --
            
            
            4,612
            
            
            130,132
            
            
            134,744Payments
            
            
            --
            
            
            (19,629
            )
            
            (179,601
            )
            
            (199,230
            )Accrued
                Balance, December 31, 2006
            
            $
            18,621
            
            $
            31,112
            
            $
            --
            
            $
            49,733





13


The
      Company reports its disposal costs for the period as Costs of Disposal
      Activities in the Statement of Operations. A summary of the nine months and
      total disposal costs incurred is as follows:





**Employee
                Termination Costs**
            
            **Excess
                Facilities**
            
            **Other
                Exit Costs**
            
            **Total**Nine
                months Ended December 31, 2005
            
            $
            411,412
            
            $
            396,197
            
            $
            534,595
            
            $
            1,342,204Nine
                months Ended December 31, 2006
            
            
            --
            
            
            117,472
            
            
            166,075
            
            
            283,547Total
                Costs Incurred from inception through December 31, 2006
            
            $
            451,002
            
            $
            635,951
            
            $
            843,084
            
            $
            1,930,037





The
      Company anticipates that in future periods, there may be additional disposal
      costs related to professional fees and leasehold repair charges that are in
      dispute between the Company and the landlord on its former leasehold
      manufacturing facility. The Company exited this facility and the lease expired
      in November 2006.





From
      April 15, 2006 through November 12, 2006, the Company received approximately
      $89,064 in rental income under a sublease agreement for a portion of its unused
      manufacturing facility and parking spaces. This rental income offset the
      Company’s lease payment obligations recorded in Cost of Disposal Activities
      during fiscal 2007.





Effective
      July 31, 2006, the Company entered into a lease termination agreement with
      its
      landlord, CLP Industrial Properties, regarding its unused leased distribution
      facilities whereby the landlord released the Company from $1,068,869 in future
      payment obligations from August 1, 2006 through July 31, 2009 under the terms
      of
      its operating lease, in exchange for a termination fee of $228,859 that was
      paid
      as follows: $128,859 upon the effective date, followed by payments of $75,000
      and $25,000 thirty and forty-five days thereafter, respectively.








**(5)** **Related
      Party Transactions**


Angelo
      S. Morini


In
      a
      Second Amended and Restated Employment Agreement effective October 13, 2003,
      Angelo S. Morini the Company’s Founder, Vice-Chairman and President resigned
      from his positions with the Company as Vice Chairman and President and he is
      no
      longer involved in the daily operations of the Company. He retains the title
      of
      Founder and has been named Chairman Emeritus. Mr. Morini continues to be a
      stockholder and a member of the Company’s Board of Directors. Additionally, he
      may carry out special assignments designated to him by the Chairman of the
      Board. The agreement is for a five-year period beginning October 13, 2003 and
      provides for an annual base salary of $300,000, plus standard health insurance
      benefits, club dues and an auto allowance.





Because
      Mr. Morini is no longer performing ongoing services for the Company, the Company
      accrued and expensed the five-year cost of this agreement in October 2003.
      The
      total estimated costs expensed under this agreement were $1,830,329 of which
      $654,890 remained unpaid but accrued ($366,305 as short-term liabilities and
      $288,585 as long-term liabilities) as of December 31, 2006. The obligation
      is
      being paid out in nearly equal monthly installments ending in October
      2008.





In
      June
      1999, in connection with an amended and restated employment agreement for Angelo
      S. Morini, the Company consolidated two full-recourse notes receivable
      ($1,200,000 from November 1994 and $11,572,200 from October 1995) related to
      his
      purchase of 2,914,286 shares of the Company’s common stock into a single
      stockholder note receivable in the amount of $12,772,200 that was due on June
      15, 2006. This stockholder note receivable was non-interest bearing and
      non-recourse and was secured by the 2,914,286 shares of the Company’s common
      stock (the “Shares”).





On
      June
      16, 2006, Mr. Morini failed to repay the non-recourse note obligation to the
      Company. The 2,914,286 shares being held as collateral were deemed to be no
      longer outstanding and thus considered as treasury stock. On June 20, 2006,
      the
      Company delivered notice to Mr. Morini that it intended to exercise its rights
      to the Shares and retain all the Shares in full satisfaction of his obligations
      under the stockholder note receivable. On July 6, 2006, Mr. Morini consented
      to the Company’s acceptance of the Shares in full satisfaction of his
      obligations under the stockholder note receivable .
      Based
      upon the $0.42 closing price of the Company’s common stock as quoted on the OTC
      Bulletin Board on June 16, 2006, the Shares had an approximate value of
      $1,224,000 on such date. Accordingly, the Company recorded an additional expense
      of $1,428,000 in the nine months ended December 31, 2006 in order to record
      the
      additional decline in the value of the Shares from its $2,652,000 value as
      of
      March 31, 2006. In July 2006, the Company cancelled the Shares along with its
      other 30,443 treasury shares.





14


Although
      this expense resulted in a material loss to the Company’s operations, it did not
      have any affect on the balance sheet since the stockholder note receivable
      was
      already shown as a reduction to Stockholders’ Deficit.





Christopher
      J. New


On
      July
      8, 2004, Christopher J. New resigned from his position as Chief Executive
      Officer in order to pursue other opportunities. In accordance with the
      Separation and Settlement Agreement between the Company and Mr. New, the Company
      recorded $444,883 related to the employment contract expense in July 2004.
      This
      settlement was paid out in nearly equal installments over two years payable
      on
      the Company’s regular payroll dates until July 2006, when the balance was paid
      in full.





Board
      of Directors


On
      August
      7, 2006, the Board of Directors the Company appointed two new directors, Mr.
      Peter J. Jungsberger and Mr. Robert S. Mohel. As a result of these appointments,
      all then vacancies on the Company’s Board of Directors were filled. The current
      Board consists of two independent directors (including Messrs. Jungsberger
      and
      Mohel) and three non-independent directors. Upon their appointment, the Board
      of
      Directors issued to each Mr. Jungsberger and Mr. Mohel an option to purchase
      up
      to 100,000 shares of the Company’s common stock with an exercise price of $0.45
      (110% of the $.041 market price as quoted on the OTC Bulletin Board on August
      7,
      2006). The options were granted outside of any stock option plan, were
      immediately vested and expire on August 7, 2011. In accordance with the
      accounting provisions of SFAS No. 123R, the Company recorded a fair value
      expense of $38,000 upon the issuance of these options.





On
      August
      17, 2006, the Board of Directors approved the grant of options to acquire
      100,000 shares of the Company’s common stock to each of David Lipka, Michael
      Broll and Angelo Morini, each a director of the Company. Each of these options
      has an exercise price of $0.44 (110% of the $.40 market price as quoted on
      the
      OTC Bulletin Board on August 17, 2006). The options were granted outside of
      any
      stock option plan, were immediately vested and expire on August 17, 2011. In
      accordance with the accounting provisions of SFAS No. 123R, the Company recorded
      a fair value expense of $54,000 upon the issuance of these options.





On
      August
      17, 2006, in recognition of David Lipka’s substantial efforts on behalf of the
      Company, the Board voted to increase his compensation in his capacity as
      Chairman of the Board of Directors of the Company, from $60,000 per year to
      $120,000 per year. As a result of this increase, Mr. Lipka is no longer
      considered an “independent” director within the meaning of applicable securities
      regulations. In addition, the Board resolved that the entire Board should act
      as
      the audit committee of the Board and appointed Robert Mohel, an independent
      director, to serve as Chairman of the meetings of the audit
      committee.








**(6)**
            **Commitments
                and Contingencies**


Supply
      Agreement


In
      November 2005, Schreiber began manufacturing and distributing substantially
      all
      of the Company’s products in accordance with a Supply Agreement that was signed
      on June 30, 2005. The prices for such products are based on cost plus a
      processing fee as determined by the parties from time to time. Other material
      terms of the Supply Agreement are as follows:


·  The
      initial term of the Supply Agreement is for a period of five years from the
      effective date of September 1, 2005 and is renewable at the Company’s option for
      up to two additional five-year periods (for a total term of up to fifteen
      years). If the Company does not exercise its first option to extend the term,
      then the Company will be obligated to pay Schreiber $1,500,000. If the Company
      exercises its first option to extend the term, but does not exercise its second
      option to extend the term, then the Company will be obligated to pay Schreiber
      $750,000.


·  The
      Supply Agreement originally provided for a contingent short-fall payment
      obligation up to $8,700,000 by the Company if a specified production level
      was
      not met during the one-year period from September 1, 2006 to August 31, 2007.
      If
      a contingent short-fall payment was accrued after such one-year period, it
      may
      be reduced by the amount by which production levels in the one-year period
      from
      September 1, 2007 to August 31, 2008 exceeded the specified target level of
      production, if any. The
      short-fall payment is based on a formula that calculates the payment as follows:
      ((required pounds shipped - actual pounds shipped) / required pounds shipped)
      *
      $8,700,000. In November 2006, the Supply Agreement was amended so that the
      short-fall payment obligation would not be measured until the one year period
      from September 1, 2009 to August 31, 2010 ,
      and the
      target level of production was reduced by approximately 22% .





15


Operating
      Leases


On
      October 3, 2006, the Company entered into a sublease agreement with Oracle
      Corporation whereby the Company moved its corporate headquarters from its
      Viscount location to 5955 T.G. Lee Boulevard Suite 201 in Orlando, Florida.
      The
      sublease agreement requires monthly base rental payments of $12,333.33 through
      November 14, 2007, $12,706.67 from November 15, 2007 through November 14, 2008,
      and $13,086.67 from November 15, 2008 through January 31, 2009.





Litigation


The
      Company is currently a party to certain legal proceedings, claims, disputes
      and
      litigation arising in the ordinary course of business, including the dispute
      mentioned in Note 4. The Company currently believes that the ultimate outcome
      of
      these proceedings, individually and in the aggregate, will not have a material
      adverse affect on the Company's financial position, results of operations or
      cash flows. However, because of the nature and inherent uncertainties of
      litigation, should the outcome of these actions be unfavorable, the Company's
      business, financial condition, results of operations and cash flows could be
      materially and adversely affected.








**(7)**
            **Non-Cash
                Compensation Related to Stock-Based
                Transactions**


Effective
      April 1, 2006, SFAS No. 123R applies to new awards and to awards modified,
      repurchased, or cancelled after the effective date, as well as to the unvested
      portion of awards outstanding as of the effective date. The Company uses the
      Black-Scholes model to value its new stock option grants under SFAS No. 123R,
      applying the “modified prospective method” for existing grants which requires
      the Company to value stock options prior to its adoption of SFAS No. 123R under
      the fair value method and expense the value over the requisite service period.
      For the three and nine months ended December 31, 2006, the Company’s total
      stock-based compensation expense was $10,000 and $108,160, respectively.





From
      April 1, 2003 through March 31, 2006, the
      Company accounted for stock awards granted to employees under the fair value
      recognition provisions of SFAS No. 123, “ *Accounting
      for Stock-Based Compensation,* ”
and
      applied SFAS No. 148, *“Accounting
      for Stock-Based Compensation - Transition and Disclosure,* ”
      prospectively to all employee awards granted on or after April 1, 2003. Prior
      to
      April 1, 2003, the
      Company accounted for stock awards granted to employees under the recognition
      and measurement principles of Accounting Principles Board Opinion No.
      25, *“Accounting
      for Stock Issued to Employees, and related Interpretations* ”
(“APB
      No. 25”). As a result, no compensation expense was recognized for stock options
      granted to employees prior to April 1, 2003 other than as related to option
      grants to employees and directors below the fair market value of the underlying
      stock at the date of grant or as related to subsequent modifications to options
      granted to employees and directors. For
      the
      three and nine months ended December 31, 2005, the Company’s total stock-based
      compensation expense was $52,676 and $923,513 including an expense of $1,116,069
      for awards valued pursuant to SFAS No. 123 and income of $192,556 for
      modification of awards valued pursuant to APB No. 25.








**(8)** **Earnings
      Per Share**


The
      following is a reconciliation of basic net income (loss) per share to diluted
      net income (loss) per share:





**THREE
                MONTHS ENDED**
              **DECEMBER
                31,**
            
            **NINE
                MONTHS ENDED**
              **DECEMBER
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                income (loss) - basic
            
            $
            726,184
            
            $
            (11,754,981
            )
            $
            (54,681
            )
            $
            (22,315,233
            )Plus
                interest on convertible related party note payable
            
            
            85,774
            
            
            --
            
            
            152,902
            
            
            --Net
                income (loss) - diluted
            
            $
            811,958
            
            $
            (11,754,981
            )
            $
            98,221
            
            $
            (22,315,233
            )


16




**THREE
                MONTHS ENDED**
              **DECEMBER
                31,**
            
            **NINE
                MONTHS ENDED**
              **DECEMBER
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Weighted
                average shares outstanding - basic
            
            
            17,109,910
            
            
            20,051,278
            
            
            17,926,015
            
            
            19,590,263Potential
                shares issued upon conversion of related party note
                payable
            
            
            7,863,519
            
            
            --
            
            
            7,671,726
            
            
            --Potential
                shares “in-the-money” under stock option and warrant
                agreements
            
            
            723,043
            
            
            --
            
            
            277,891
            
            
            --Less:
                Shares assumed repurchased under the treasury stock method
            
            
            (652,400
            )
            
            --
            
            
            (251,005
            )
            
            --Weighted
                average shares outstanding -diluted
            
            
            25,044,072
            
            
            20,051,278
            
            
            25,624,627
            
            
            19,590,263Basic
                net income (loss) per common share
            
            $
            0.04
            
            $
            (0.59
            )
            $
            0.00
            
            $
            (1.14
            )Diluted
                net income (loss) per common share
            
            $
            0.03
            
            $
            (0.59
            )
            $
            0.00
            
            $
            (1.14
            )





Options
      for 4,797,975 and 4,920,837 shares and warrants for 1,123,142 and 1,127,469
      shares have not been included in the computation of diluted net income (loss)
      per common share for the three and nine months ended December 31, 2006,
      respectively, as their effect would be antidilutive. Options for 5,057,775
      shares and warrants for 1,166,713 shares have not been included in the
      computation of diluted net income (loss) per common share for the three and
      nine
      months ended December 31, 2005, as their effect would be antidilutive.








**(9)** **Supplemental
      Cash Flow Information**


For
      purposes of the statement of cash flows, all highly liquid investments with
      a
      maturity date of three months or less are considered to be cash equivalents.





Nine
                months ended December 31,
            
            2006
            
            2005**Non-cash
                financing and investing activities:**Purchase
                of equipment through a capital lease
            
            $
            5,088
            
            $
            --Payment
                of note payable through issuance of revised note payable
            
            
            1,200,000
            
            
            --Payment
                of accrued liability through issuance of note payable
            
            
            285,104
            
            
            --Cash
                paid for:Interest
            
            
            225,091
            
            
            852,267








**(10)** **Economic
      Dependence and Segment Information**


The
      Company has one operating segment and sells to customers throughout the United
      States and 14 other countries. For the three months ended December 31, 2006
      and
      2005, the Company’s gross sales before discounts, returns and allowances were
      $6,641,303 and $9,885,719, respectively. For the nine months ended December
      31,
      2006 and 2005, the Company’s gross sales before discounts, returns and
      allowances were $22,799,140 and $31,992,005, respectively. Gross sales derived
      from foreign countries were approximately $953,000 and $1,162,693 representing
      14% and 12% of gross sales for the three months ended December 31, 2006 and
      2005, respectively. Gross sales derived from foreign countries were
      approximately $3,164,000 and $3,878,000 representing 14% and 12% of gross sales
      for the nine months ended December 31, 2006 and 2005, respectively. Gross sales
      are attributed to individual countries based on the customer’s shipping address.
      The Company has no long-term assets located outside of the United States.





The
      following table sets forth the percentage of foreign gross sales to each
      country, which accounted for 10% or more of the Company’s foreign gross sales
      for the three and nine months ended December 31, 2006 and 2005:


17





**Three
                months ended**
              **December
                31,**
            
            **Nine
                months ended**
              **December
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Canada
            
            
            70.0
            %
            
            58.1
            %
            
            67.3
            %
            
            58.2
            %Puerto
                Rico
            
            
            16.7
            %
            
            25.9
            %
            
            15.4
            %
            
            24.2
            %





The
      Company had one customer that accounted for approximately 14% and 13% of gross
      sales for the three and nine months December 31, 2006, respectively. There
      were
      no customers whose balance outstanding was greater than 10% of accounts
      receivable as of December 31, 2006. The Company had no customers that accounted
      for more than 10% of gross sales for the three and nine months ended December
      31, 2005 nor more than 10% of accounts receivable as of December 31, 2005.





For
      the
      three and nine months ended December 31, 2006, the Company purchased
      approximately 100% and 96%, respectively, of its inventory for sale to customers
      from Schreiber. For the three and nine months ended December 31, 2005, the
      Company did not have any supplier that comprised more than 10% of total raw
      material purchases.





18


**GALAXY
      NUTRITIONAL FOODS, INC.**





**Item
      2. Management's Discussion and Analysis of Financial Condition and Results
      of
      Operations**





Information
      in this Management’s Discussion and Analysis of Financial Condition and Results
      of Operations (“MD&A”) is intended to enhance a reader’s understanding of
      the financial condition, changes in financial condition and results of
      operations of our company. This MD&A is a supplement to and should be read
      in conjunction with our financial statements and notes thereto appearing
      elsewhere in this report. This Form 10-Q & MD&A contain forward-looking
      statements within the meaning of the federal securities laws that relate to
      future events or our future financial performance. These forward-looking
      statements are based on our current expectations, estimates and projections
      about our industry, management’s beliefs and certain assumptions made by our
      company. Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,”
“seek,” “project,” “estimate,” “may,” “will,” “could,” “should,” “potential,” or
“continue” or the negative or variations of these words or similar expressions
      are intended to identify forward-looking statements. Additionally, these
      forward-looking statements include, but are not limited to statements
      regarding:





·
            Improving
                cash flows from operations;




·
            Marketing
                our existing products and those under
                development;




·
            Our
                estimates of future revenue and
                profitability;




·
            Our
                expectations regarding future expenses, including cost of goods sold,
                delivery, selling, general and administrative, research and development
                expenses, and disposal costs;




·
            Our
                estimates regarding capital requirements and our needs for additional
                financing; and




·
            Competition
                in our market.




Although
      we believe that these forward-looking statements are reasonable at the time
      they
      are made, these statements are not guarantees of future performance and are
      subject to certain risks, uncertainties and assumptions that are difficult
      to
      predict. Therefore, actual results may differ materially from our historical
      results and those expressed or forecasted in any forward-looking statements
      as a
      result of a variety of factors, including those set forth under “Risk Factors”
and elsewhere in, or incorporated by reference into, this Form 10-Q. We are
      not
      required and undertake no obligation to publicly update or revise any
      forward-looking statements for any reason, even if new information becomes
      available or other events occur in the future.





Terms
      such as “fiscal 2007” or “fiscal 2006” refer to our fiscal years ending March
      31, 2007 and 2006, respectively. Terms such as “first quarter,” “second
      quarter,” “third quarter,” or “fourth quarter” refer to the fiscal quarters
      ending June 30, September 30, December 31, or March 31,
      respectively.





This
      MD&A contains the following sections:


·
            Business
                Environment


·
            Basis
                of Presentation


·
            Critical
                Accounting Policies


·
            Results
                of Operations


·
            Liquidity
                and Capital Resources


·
            Recent
                Accounting Pronouncements








**Business
      Environment**





***General***


Galaxy
      Nutritional Foods, Inc. (our “Company”) is principally engaged in developing and
      globally marketing plant-based cheese and dairy alternatives, as well as
      processed organic cheese and cheese food to grocery and natural foods retailers,
      mass merchandisers and foodservice accounts. Veggie, the leading brand in the
      grocery cheese alternative category and our  Company’s
      top selling product group, is primarily merchandised in the produce section
      and
      provides calcium and protein without cholesterol, saturated fat or trans-fat.
      Other popular brands include: Rice, Veggy, Vegan, and Wholesome Valley. We
      are
      dedicated to developing nutritious products to meet the taste and dietary needs
      of today’s increasingly health conscious consumers. Our Company headquarters are
      located in Orlando, Florida.





19


In
      fiscal
      2006, we determined that our manufacturing capacity was significantly in excess
      of our requirements and that it would be advantageous to outsource manufacturing
      and distribution operations. On June 30, 2005, Galaxy Nutritional Foods, Inc.
      and Schreiber Foods, Inc., a Wisconsin corporation (“Schreiber”), entered into a
      Supply Agreement, whereby we agreed that Schreiber would become our sole source
      of supply for substantially all of our products. In November 2005, Schreiber
      began to deliver such products directly to our customers.




On
      December 8, 2005, we completed the sale of substantially all of our
      manufacturing and production equipment to Schreiber for $8,700,000 in cash
      pursuant to an Asset Purchase Agreement dated June 30, 2005. Our Company has
      now
      converted from a manufacturing company into a branded marketing company that
      will continue to develop, market and sell our products.




***Cheese
      Alternative Category***


We
      are
      the market leader within our cheese alternative category niche, but in being
      so,
      the category increases or decreases partly as a result of our marketing and
      pricing efforts. We believe that the greatest source of future growth in the
      cheese alternative category will come through consumers shifting to cheese
      alternatives from natural cheese. Our strategy is to broaden the consumer base
      to include younger, less price sensitive consumers seeking products with overall
      health and nutrition attributes. Historically, our products and marketing
      efforts appealed to older consumers purchasing cheese alternatives for specific
      dietary concerns.





***Marketing***


We
      use
      several internal and external reports to monitor sales by brand, segment, form
      and channel of sale to determine the outside factors affecting the sales levels.
      These reports provide management information on which brand, segments, forms
      and/or channel sales are increasing or decreasing both in units sold and price
      per unit. By reviewing these reports along with industry data from publications,
      syndicated retail consumption reports, and conversations with major retailers,
      other manufacturers in the food and beverage industry, and ingredient and
      service suppliers, we make decisions on which brands to promote and analyze
      trends in the consumer marketplace.





In
      fiscal
      2006, we launched a regional consumer marketing campaign to educate conventional
      cheese users on the benefits and location of Galaxy branded products. The
      campaign drivers included traditional consumer advertising on television, price
      based promotions through newspaper coupons, secondary placement and event
      marketing sponsorships.





We
      are
      using the results from the fiscal 2006 marketing campaigns to target our fiscal
      2007 marketing campaign, as we focus our efforts on growth as a branded sales
      and marketing company. To this end, we have continued many of our fiscal 2006
      initiatives. We have worked to optimize our price based promotions by focusing
      on deeper, less frequent in-store discounts. Additionally, we have
      continued event marketing with a second consecutive year of sponsoring the
      Komen
      Race for the Cure in New York and by sponsoring the Runner’s Classic, SeaWorld
      in Orlando.





For the
      second half of fiscal 2007, we also shifted our focus to a print advertising
      campaign with publications like Weight Watchers and Shape to reach health
      conscious consumers. Product attributes and location were incorporated into
      a
      unified marketing message to increase consumer education and awareness of cheese
      alternatives. Similar advertising is expected to continue and grow in the fourth
      quarter of fiscal 2007 and into fiscal 2008.





As
      we
      grow our marketing initiatives, valuable insights on campaign efficacy are
      gained and used to continually fine-tune our efforts. Such information is then
      used to maximize the return on marketing spend by focusing on those efforts
      that
      best increase brand and product awareness, increase consumer education and
      ultimately broaden the consumer base within the cheese alternative category.








***Recent
      Material Developments***


Debt
      Refinancing


On
      June
      23, 2006, we
      entered into a Receivables Purchase Agreement with Systran
      Financial Services Corporation, a subsidiary of Textron Financial Corporation
      (“Systran”), whereby Systran will provide financing to our Company through
      advances against certain trade receivable invoices due to our Company (the
      “Systran Agreement”). On June 23, 2006, Systran advanced $2,379,262 under the
      Systran Agreement of which $1,839,086 was used to pay in full and terminate
      our
      obligations under our line of credit with Textron Financial Corporation which
      was to terminate on June 27, 2006.





Pursuant
      to a Note Purchase Agreement dated July 19, 2006, we issued a new unsecured
      convertible note for $2,685,104 (the “Convertible Note”) to Frederick A. DeLuca,
      a greater than 10% shareholder. The proceeds from the Convertible Note were
      used
      to repay or refinance $2,400,000 in unsecured promissory notes that matured
      on
      June 15, 2006 (including one such note in the principal amount of $1,200,000
      owned by Mr. DeLuca) and a $285,104 registration rights penalty owed to Mr.
      DeLuca.





20


See *Debt
      Financing* under
      Liquidity and Capital Resources for additional information on the above
      refinancing.





Outsourcing
      Effect


We
      believe that the long-term benefits in the transition from a manufacturing
      company to a branded marketing company will substantially outweigh the
      short-term costs of the transition. Without the cash-flow burden of carrying
      inventory and managing manufacturing overhead and production issues, we believe
      that we can focus a greater amount of time and resources on the sale of our
      products. Additionally, we plan to enhance our marketing efforts in order to
      increase our consumer base.





Some
      of
      the effects of the transition are as follows:


·
            We
                are solely a branded marketing company without any manufacturing
                and
                distribution functions.


·
            In
                December 2005, we ceased to use the manufacturing portion of our
                main
                leased facility at 2441 Viscount Row in Orlando, Florida where our
                administrative offices were located, but we continued to stay in
                this
                location through the end of our lease in November 2006. From April
                15,
                2006 through November 12, 2006, we received approximately $89,064
                in
                rental income under a sublease agreement for a portion of our unused
                manufacturing facility and parking spaces. This rental income offset
                our
                lease payment obligations recorded in Cost of Disposal Activities
                during
                fiscal 2007.


·
            On
                October 3, 2006, we entered into a sublease agreement with Oracle
                Corporation whereby we moved our corporate headquarters from our
                Viscount
                location to 5955 T.G. Lee Boulevard Suite 201 in Orlando, Florida.
                The
                sublease agreement requires monthly base rental payments of $12,333.33
                through November 14, 2007, $12,706.67 from November 15, 2007 through
                November 14, 2008, and $13,086.67 from November 15, 2008 through
                January
                31, 2009. This sublease results in savings of over $20,000 per month
                in
                rent when compared to the monthly rent we paid for our Viscount
                location.


·
            In
                December 2005, we abandoned our distribution facility that had a
                lease
                termination date of July 31, 2009. Effective July 31, 2006, we entered
                into a lease termination agreement with our landlord, CLP Industrial
                Properties, regarding our unused leased distribution facilities whereby
                the landlord released us from $1,068,869 in future payment obligations
                from August 1, 2006 through July 31, 2009 under the terms of our
                operating
                lease, in exchange for a termination fee of
                $228,859.


·
            We
                eliminated 104 employee positions related to the manufacturing and
                distribution of our products and created 2 new sales and marketing
                positions. We now maintain 28 full time
                positions.


·
            We
                used the proceeds from the sale of our manufacturing equipment to
                reduce a
                substantial portion of our outstanding debt and liabilities. Repayment
                of
                these liabilities will result in annual interest savings in excess
                of
                $800,000.


·
            We
                no longer have a large carrying value of inventory nor need to use
                asset
                based financing to support the production of inventory. Prior to
                the
                outsourcing, we averaged 50 to 60 days of sales in
                inventory.


·
            We
                have experienced substantial savings on costs of goods sold and improved
                gross margins as a result of reduced overhead and lower material
                costs. In
                the third quarter of fiscal 2007, gross margin was approximately
                44% of
                net sales compared to 21% of net sales in the third quarter of fiscal
                2006.





***Measurements
      of Financial Performance***


We
      focus
      on several items in order to measure our performance. We are working towards
      obtaining and maintaining positive trends in the following areas:


·
            Operating
                cash flow


·
            Gross
                margin in dollars and % of gross
                sales


·
            Operating
                income excluding non-cash compensation and reserves related to stock
                based
                transactions,
                disposal costs and fixed asset impairment
                charges


·
            EBITDA
                excluding non-cash compensation and reserves related to stock based
                transactions, disposal costs and fixed asset impairment
                charges


·
            Volume
                and margin analysis by individual inventory
                items


·
            Key
                financial ratios (such as accounts receivable and accounts payable
                turnover ratios)




21


**Basis
      of Presentation; Going Concern Issues**





We
      incurred substantial losses in recent years and, as a result, have a
      stockholders deficit of $2,172,733 as of December 31, 2006. Losses for the
      years
      ended March 31, 2006, 2005 and 2004 were $24,148,553, $3,859,783 and $3,299,277,
      respectively. Additionally, we received a report from our independent
      accountants relating to our audited financial statements as of March 31, 2006
      containing a paragraph stating that because we were then in
      default of our notes payable, had suffered recurring losses from operations
      and
      at March 31, 2006 had deficiencies in working capital and equity ,
      there
      was substantial doubt as to our ability to continue as a going concern. Our
      ability to continue as a going concern depended upon successfully obtaining
      sufficient cash resources to refinance our $2.4 million of unsecured notes
      payable that matured on June 15, 2006 and obtaining positive cash flow from
      operations to sustain normal business operations.





Our
      fiscal 2007 business plan eliminated certain low margin private label and Galaxy
      imitation business from our sales mix. The elimination of these low margin
      items
      and the elimination of excess overhead that was part of our former manufacturing
      operations has resulted in higher gross margins with lower operating costs
      and
      produced positive cash flows from operations in fiscal 2007.





As a result
      of the successful refinancing of the $2.4 million short-term notes and line
      of
      credit for our receivables financing and the positive cash flow that we are
      currently experiencing from operations, we believe that we have sufficient
      cash
      resources to meet our needs for general operations excluding the related party
      note payable through December 31, 2007. It is unlikely at this time that we
      will
      have enough cash from operations to repay the $2,685,104 related party note
      payable that matures in October 2007 if the Note Holder chooses not to convert
      the note into common shares or refinance or renew this loan. If the Note Holder
      demands a cash repayment of the related party note payable and we cannot
      generate enough cash from operations or alternative financing, we will be unable
      to satisfy the note by its maturity date. In such an event, the Note Holder
      could exercise his rights under the loan documents, which could include, among
      other things, declaring a default under the loan which would then trigger
      interest to accrue at 17.5% per annum. Additionally, a default to our Note
      Holder would trigger a default under our Systran Agreement. In such an event,
      Systran could exercise its rights under its loan documents, which could include,
      among other things, declaring a default and pursuing foreclosure on our assets
      that are pledged as collateral for the advances on our accounts receivable
      invoices. If these events occurred, it would be substantially more difficult
      for
      us to effectively continue the operation of our business, and it
      is
      unlikely that we would be able to continue as a going concern .
      Management has commenced discussions with the Note Holder regarding possible
      conversion, extension or other alternatives related to the note. See *Debt
      Financing* for
      further details.








**Critical
      Accounting Policies**





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and reported amounts of income and expense during
      the
      reporting periods presented. Our significant estimates include the allowance
      for
      doubtful accounts receivable and chargebacks, valuation of deferred taxes,
      valuation of compensation expense on options and warrants, and accruals for
      disposal costs. Although we believe that these estimates are reasonable, actual
      results could differ from those estimates given a change in conditions or
      assumptions that have been consistently applied.





Management
      has discussed the selection of critical accounting policies and estimates with
      our Board of Directors and the Board of Directors has reviewed our disclosure
      relating to critical accounting policies and estimates in this quarterly report
      on Form 10-Q. Our significant accounting policies are described in Note 1 of
      our
      financial statements herein and in Note 1 of our Form 10-K for the fiscal year
      ended March 31, 2006. The critical accounting policies used by management and
      the methodology for its estimates and assumptions are as follows:





***Valuation
      of Accounts Receivable and Chargebacks***


We
      record
      revenue upon shipment of products to our customers and upon reasonable assurance
      of collection on the sale. We generally provide credit terms to customers based
      on net 30-day terms. We perform ongoing credit evaluations of our accounts
      receivable balances and based on historical experience, make reserves for
      anticipated future customer credits for promotions, discounts, spoils, and
      other
      reasons. In addition, we evaluate the accounts for potential uncollectible
      amounts based on a specific identification methodology and record a general
      reserve for all remaining balances.





Based
      on
      the age of the receivable, cash collection history and past dilution in the
      receivables, we make an estimate of our anticipated bad debt, anticipated future
      authorized deductions due to current period activity and anticipated collections
      on non-authorized amounts that customers have currently deducted on past
      invoices. Based on this analysis, we reserved $1,518,000 and $1,673,000 for
      known and anticipated future credits and doubtful accounts at December 31,
      2006
      and 2005, respectively. We believe that this estimate is reasonable, but there
      can be no assurance that our estimate will not change given a change in economic
      conditions or business conditions within the food industry, our individual
      customer base or our Company.





22


***Deferred
      Taxes***


Valuation
      allowances are established when necessary to reduce deferred tax assets to
      the
      amount expected to be realized. We have reserved our net deferred tax assets
      in
      full.





***Valuation
      of Non-Cash Compensation***


Effective
      April 1, 2006, we adopted SFAS
      No.
      123 (revised 2004), “ *Share-Based
      Payment* ”
(“SFAS
      No. 123R”). SFAS
      No.
      123R requires companies to measure the cost of employee services received in
      exchange for an award of equity instruments, including stock options, based
      on
      the grant-date fair value of the award and to recognize it as compensation
      expense over the period the employee is required to provide service in exchange
      for the award, usually the vesting period.





SFAS
      No.
      123R applies to new awards and to awards modified, repurchased, or cancelled
      after the effective date, as well as to the unvested portion of awards
      outstanding as of the effective date. We use the Black-Scholes model to value
      our new stock option grants under SFAS No. 123R, applying the “modified
      prospective method” for existing grants which requires us to value stock options
      prior to our adoption of SFAS No. 123R under the fair value method and expense
      the value over the requisite service period. SFAS No. 123R also requires us
      to
      estimate forfeitures in calculating the expense related to stock-based
      compensation. In addition, SFAS No. 123R requires us to reflect cash flows
      resulting from the tax benefits related to tax deductions in excess of the
      compensation cost recognized for those options to be classified as a cash inflow
      from financing activities and a cash outflow from operating
      activities.





From
      April 1, 2003 through March 31, 2006, we
      accounted for stock awards granted to employees under the fair value recognition
      provisions of SFAS No. 123, “ *Accounting
      for Stock-Based Compensation,* ”
and
      applied SFAS No. 148, *“Accounting
      for Stock-Based Compensation - Transition and Disclosure,* ”
      prospectively to all employee awards granted on or after April 1, 2003. Prior
      to
      April 1, 2003, we
      accounted for stock awards granted to employees under the recognition and
      measurement principles of Accounting Principles Board Opinion No.
      25, *“Accounting
      for Stock Issued to Employees, and related Interpretations* .”
As
      a
      result, no compensation expense was previously recognized for stock options
      granted to employees prior to April 1, 2003 other than as related to option
      grants to employees and directors below the fair market value of the underlying
      stock at the date of grant or as related to subsequent modifications to options
      granted to employees and directors.





The
      Black-Scholes model requires subjective assumptions, including future stock
      price volatility and expected time to exercise, which greatly affect the
      calculated values. The risk-free rate is based on the U.S Treasury rates in
      effect during the corresponding period of the grant. Expected volatilities
      are
      based on the historical volatility of our stock. Prior to April 1, 2006, we
      input the expected life of options granted based on the contractual life of
      the
      options granted. For any new awards, we will input the expected life of options
      granted based on information derived from historical data on employee exercises
      and post-vesting employment termination behavior. There is no expected dividend
      yield.  These factors could change in the future, which may affect the
      stock-based compensation expense in future periods. SFAS No. 123R requires
      forfeitures to be estimated at the time of grant and revised, if necessary,
      in
      subsequent periods if actual forfeitures differ from those
      estimates.





***Disposal
      Costs***


We
      have
      recorded accruals in connection with the asset sale and outsourcing arrangements
      with Schreiber. Prior to December 31, 2006, these accruals included estimates
      pertaining to employee termination costs and abandonment of excess equipment
      and
      facilities and other potential costs. Given the significance and complexity
      of
      these activities, and the timing of the execution of such activities, the
      accrual process involved periodic reassessments of estimates made at the time
      the original decisions were made, including evaluating estimated employment
      terms, contract cancellation charges and real estate market conditions for
      sub-lease rents. As of December 31, 2006, there are no further costs that
      require estimates. Any future disposal costs will be recorded as incurred in
      accordance with SFAS No. 146, *“Accounting
      for Costs Associated with Exit or Disposal Activities.”*




23


**Results
      of Operations**





**3-Months
                Ended December 31,**
            
            
            **9-Months
                Ended December 31,****2006**
            
            **2005**
            
            **$
                Change**
            
            **%
                Change**
            
            
            **2006**
            
            **2005**
            
            **$
                Change**
            
            **%
                Change**Net
                Sales
            
            
            6,110,619
            
            
            9,072,097
            
            
            (2,961,478
            )
            
            -32.6
            %
            
            
            20,670,958
            
            
            29,361,475
            
            
            (8,690,517
            )
            
            -29.6
            %Cost
                of Goods Sold
            
            
            3,417,232
            
            
            7,182,502
            
            
            (3,765,270
            )
            
            -52.4
            %
            
            
            12,450,194
            
            
            22,582,708
            
            
            (10,132,514
            )
            
            -44.9
            %**Gross
                Margin**
            
            
            2,693,387
            
            
            1,889,595
            
            
            803,792
            
            
            42.5
            %
            
            
            8,220,764
            
            
            6,778,767
            
            
            1,441,997
            
            
            21.3
            %**Gross
                Profit %**
            
            
            44.1
            %
            
            20.8
            %
            
            
            
            
            
            
            
            
            39.8
            %
            
            23.1
            %





***Sales***


For
      the
      three months ended December 31, 2006 and 2005, our gross sales before discounts,
      returns and allowances were $6,641,303 and $9,885,719, respectively. For the
      nine months ended December 31, 2006 and 2005, our gross sales before discounts,
      returns and allowances were $22,799,140 and $31,992,005, respectively. The
      following chart sets forth the percentage of gross sales derived from our
      product brands during the three and nine months ended December 31, 2006 and
      2005:





Three
                months ended
              December
                31,
            
            Nine
                months ended
              December
                31,Brand
            
            2006
            
            2005
            
            2006
            
            2005Veggie
            
            
            66.7
            %
            
            55.9
            %
            
            59.7
            %
            
            51.7
            %Private
                Label, Imitation and Other
            
            
            11.5
            %
            
            28.9
            %
            
            19.2
            %
            
            32.5
            %Rice
            
            
            11.0
            %
            
            7.6
            %
            
            10.5
            %
            
            7.4
            %Veggy
            
            
            4.0
            %
            
            3.1
            %
            
            4.2
            %
            
            3.8
            %Wholesome
                Valley Organic
            
            
            3.2
            %
            
            2.6
            %
            
            3.2
            %
            
            2.7
            %Vegan
            
            
            3.6
            %
            
            1.9
            %
            
            3.2
            %
            
            1.9
            %





Net
      sales, after discounts, returns and allowances, in the three and nine months
      ended December 31, 2006 decreased 33% and 30% from net sales in the three and
      nine months ended December 31, 2005, respectively primarily due to the
      elimination of certain private label and Galaxy imitation products as
      demonstrated by the above shift in product mix.





During
      fiscal 2007, we reduced marginally profitable private label and Galaxy imitation
      sales, which led to the improvement in our gross margins. Additionally, we
      plan
      to increase the effectiveness of our price based promotions in fiscal 2007
      to
      generate higher sales on our branded products. We anticipate that our sales
      throughout the remainder of fiscal 2007 will continue to be lower than sales
      in
      fiscal 2006 due to our specific focus to eliminate marginally profitable private
      label and other products.




***Cost
      of Goods Sold***


Cost
      of
      goods sold was approximately 56% and 60% of net sales in the three and nine
      months ended December 31, 2006 compared to 79% and 77% of net sales in the
      three
      and nine months ended December 31, 2005, respectively. This sharp decrease
      in
      cost of goods sold is primarily due to the elimination of production overhead
      through the outsourcing of our manufacturing operations in November 2005 as
      discussed under *Recent
      Material Developments* .
      Our
      production overhead was substantially higher than the current processing fee
      charged for the production of our products due to an 85% underutilization of
      our
      manufacturing equipment and facilities.





We
      anticipate that the cost of goods sold will remain improved over prior year
      levels as a result of the outsourcing arrangement with Schreiber. However,
      actual results could differ from our expectations.





***Gross
      Margin***


Despite
      a
      $8.7 million decline in sales, gross margin dollars in the nine months ended
      December 31, 2006 was approximately $1.4 million higher than in the first nine
      months ended December 31, 2005 due to the elimination of certain low margin
      private label and Galaxy imitation business, the change in our product mix
      and
      the reduction in excess overhead. Our anticipated higher margin sales combined
      with our lower overhead burden should continue to produce higher gross margins
      in dollars and as a percentage of sales throughout the remainder of fiscal
      2007.





24


***EBITDA***


We
      utilize certain GAAP measures such as Operating Income and Net Income and
      certain non-GAAP measures, in order to compute key financial measures that
      are
      reviewed by management, lenders and investors in order to effectively review
      our
      current on-going operations and analyze trends related to our financial
      condition and results of operations. Additionally, these measures are key
      factors upon which we prepare our budgets and forecasts, and calculate bonuses. I n
      our
      calculation of key financial non-GAAP measures for adjusted Operating Income,
      adjusted Net Income and adjusted EBITDA, we exclude items such as non-cash
      compensation and reserves related to stock based transactions, disposal costs
      and fixed asset impairment and disposal charges. These adjusted measures are
      not
      in accordance with, or an alternative for, generally accepted accounting
      principles and may be different from non-GAAP measures reported by other
      companies.





**EBITDA*****(a
                non-GAAP measure):***





**3-Months
                Ended December 31,**
            
            
            **9-Months
                Ended December 31,****2006**
            
            **2005**
            
            **$
                Change**
            
            **%
                Change**
            
            
            **2006**
            
            **2005**
            
            **$
                Change**
            
            **%
                Change****Gross
                Margin**
            
            
            2,693,387
            
            
            1,889,595
            
            
            803,792
            
            
            42.5
            %
            
            
            8,220,764
            
            
            6,778,767
            
            
            1,441,997
            
            
            21.3
            %**Operating
                Expenses:**Selling
            
            
            775,043
            
            
            1,161,751
            
            
            (386,708
            )
            
            -33.3
            %
            
            
            2,621,845
            
            
            3,655,543
            
            
            (1,033,698
            )
            
            -28.3
            %Delivery
            
            
            217,431
            
            
            544,665
            
            
            (327,234
            )
            
            -60.1
            %
            
            
            643,714
            
            
            1,886,214
            
            
            (1,242,500
            )
            
            -65.9
            %General
                and administrative, including $10,000 and $52,676, $108,160 and $923,513
                non-cash stock compensation(1)
            
            
            639,030
            
            
            1,394,599
            
            
            (755,569
            )
            
            -54.2
            %
            
            
            2,496,658
            
            
            3,999,362
            
            
            (1,502,704
            )
            
            -37.6
            %Research
                and development
            
            
            47,345
            
            
            75,961
            
            
            (28,616
            )
            
            -37.7
            %
            
            
            134,128
            
            
            256,055
            
            
            (121,927
            )
            
            -47.6
            %Reserve
                on stockholder note receivable(2)
            
            
            -
            
            
            9,129,343
            
            
            (9,129,343
            )
            
            -100.0
            %
            
            
            1,428,000
            
            
            9,129,343
            
            
            (7,701,343
            )
            
            -84.4
            %Cost
                of disposal activities(2)
            
            
            134,744
            
            
            668,936
            
            
            (534,192
            )
            
            -79.9
            %
            
            
            283,547
            
            
            1,342,204
            
            
            (1,058,657
            )
            
            -78.9
            %Impairment
                of fixed assets(2)
            
            
            -
            
            
            -
            
            
            -
            
            
            0.0
            %
            
            
            -
            
            
            7,896,554
            
            
            (7,896,554
            )
            
            -100.0
            %Loss
                on disposal of assets(2)
            
            
            19,775
            
            
            65,360
            
            
            (45,585
            )
            
            -69.7
            %
            
            
            44,280
            
            
            70,966
            
            
            (26,686
            )
            
            -37.6
            %Total
                operating expenses
            
            
            1,833,368
            
            
            13,040,615
            
            
            (11,207,247
            )
            
            -85.9
            %
            
            
            7,652,172
            
            
            28,236,241
            
            
            (20,584,069
            )
            
            -72.9
            %**Income
                (Loss) from Operations**(3)
            
            
            860,019
            
            
            (11,151,020
            )
            
            12,011,039
            
            
            -107.7
            %
            
            
            568,592
            
            
            (21,457,474
            )
            
            22,026,066
            
            
            -102.6
            %**Other
                Income (Expense), Net**Interest
                expense, net
            
            
            (133,835
            )
            
            (595,692
            )
            
            461,857
            
            
            -77.5
            %
            
            
            (623,273
            )
            
            (1,246,490
            )
            
            623,217
            
            
            -50.0
            %Gain
                (loss) on FV of warrants
            
            
            -
            
            
            (8,269
            )
            
            8,269
            
            
            -100.0
            %
            
            
            -
            
            
            388,731
            
            
            (388,731
            )
            
            -100.0
            %Total
            
            
            (133,835
            )
            
            (603,961
            )
            
            470,126
            
            
            -77.8
            %
            
            
            (623,273
            )
            
            (857,759
            )
            
            234,486
            
            
            -27.3
            %**NET
                INCOME (LOSS)**
            
            
            726,184
            
            
            (11,754,981
            )
            
            12,481,165
            
            
            -106.2
            %
            
            
            (54,681
            )
            
            (22,315,233
            )
            
            22,260,552
            
            
            -99.8
            %Interest
                expense, net
            
            
            133,835
            
            
            595,692
            
            
            (461,857
            )
            
            -77.5
            %
            
            
            623,273
            
            
            1,246,490
            
            
            (623,217
            )
            
            -50.0
            %Depreciation
            
            
            24,005
            
            
            387,184
            
            
            (363,179
            )
            
            -93.8
            %
            
            
            130,102
            
            
            1,463,036
            
            
            (1,332,934
            )
            
            -91.1
            %**EBITDA**(*a
                non-GAAP measure)*
            
            
            884,024
            
            
            (10,772,105
            )
            
            11,656,129
            
            
            -108.2
            %
            
            
            698,694
            
            
            (19,605,707
            )
            
            20,304,401
            
            
            -103.6
            %





(1)
            In
                our calculation of key financial measures, we exclude the non-cash
                compensation related to stock-based transactions because we believe
                that
                this item does not accurately reflect our current on-going operations.
                Many times non-cash compensation is calculated based on fluctuations
                in
                our stock price, which can skew the financial results dramatically
                up and
                down. The market price of our common shares is outside our control
                and
                typically does not reflect our current operations.


(2)
            In
                our calculation of key financial measures, we exclude the reserve
                on
                stockholder note receivable, disposal costs and fixed asset impairment
                charges because we believe that these items do not reflect expenses
                related to our current on-going operations. See below for a detailed
                description of these items.


(3)
            Operating
                Income has increased due to the changes in non-cash compensation
                related
                to stock-based transactions as discussed below under general and
                administrative, and certain non-standard expenses such as the reserve
                on
                stockholder note receivable, disposal costs and fixed asset impairment
                charges related to the Asset Purchase Agreement and the Supply Agreement
                with Schreiber as discussed under*Recent
                Material Developments*.





25


***Selling***


Selling
      expense is partly a function of sales through variable costs such as brokerage
      commissions and promotional costs along with certain fixed costs for employee
      salaries and benefits and marketing campaigns. Our selling expense typically
      averages between 12% and 13% of net sales. Selling expenses for the three and
      nine months ended December 31, 2006 and 2005 were 13%.





We
      expect
      fixed selling expenses for advertising and market research in fiscal 2007 to
      be
      nearly the same level as in fiscal 2006, but with a more focused use of funds.
      We sell our products through our internal sales force and an independent broker
      network.





***Delivery***


Delivery
      expense is primarily a function of sales, and historically ranged from
      approximately 5% to 6% of net sales. In the three and nine months ended December
      31, 2006, delivery expense decreased to 4% and 3%, respectively, of net sales
      due to our Supply Agreement with Schreiber. The Supply Agreement fixed the
      delivery charges based on a per pound rate that was lower than our historical
      delivery cost per pound. However, this rate can be adjusted by the parties
      as
      agreed upon from time to time. In September 2006, the parties adjusted the
      rate
      to reflect current market conditions. As a result, we anticipate delivery
      expense will increase to up to 5% of net sales, but still remain lower than
      our
      delivery expense prior to the outsourcing.





***General
      and administrative***


During
      the nine months ended December 31, 2006, general and administrative expenses
      decreased approximately $1.5 million compared to the nine months ended December
      31, 2005. During the nine months ended December 31, 2006, non-cash compensation
      related to stock-based transactions decreased by approximately $815,000, as
      detailed below, and we did not incur a net $506,000 expense of unusual items
      that were incurred during the nine months ended December 31, 2005. These items
      include: a) $261,000 of additional bad debt costs related to the Del Sunshine
      account; b) $285,000 in liquidated damages accrued in related to a registration
      rights agreement; c) $110,000 in consulting fees related to researching
      strategic alternatives; and d) $150,000 income received pursuant to a
      Termination, Settlement and Release Agreement signed on July 22, 2005 between
      our Company and Fromageries Bel S.A. During the nine months ended December
      31,
      2006, we expensed an additional $212,000 in general overhead costs such as
      corporate insurance, property taxes and depreciation as general and
      administrative expenses. Prior to the outsourcing, these costs were allocated
      to
      cost of goods sold.





Excluding
      the effects of non-cash compensation related to stock-based transactions, which
      cannot be predicted, we anticipate that general and administrative expenses
      will
      remain lower in fiscal 2007 due to the non-recurrence of the highly intensive
      consulting, legal and audit services related to major contracts, review of
      strategic alternatives and additional SEC filings that were required in fiscal
      2006. Additionally, we do not anticipate the occurrence of liquidated damages
      related to stock registration that were incurred in fiscal 2006. However, we
      anticipate that we will begin incurring additional costs related to the
      implementation of Sarbanes Oxley 404 in the fourth quarter of fiscal 2007 and
      throughout fiscal 2008.





The
      reduction of $815,353 in non-cash compensation related to stock-based
      transactions included in general and administrative expenses was a result of
      the
      following:





Effective
      April 1, 2006, SFAS No. 123R applies to new awards and to awards modified,
      repurchased, or cancelled after the effective date, as well as to the unvested
      portion of awards outstanding as of the effective date. We use the Black-Scholes
      model to value our new stock option grants under SFAS No. 123R, applying the
      “modified prospective method” for existing grants which requires us to value
      stock options prior to our adoption of SFAS No. 123R under the fair value method
      and expense the value over the requisite service period. For the three and
      nine
      months ended December 31, 2006, our total stock-based compensation expense
      was
      $10,000 and $108,160, respectively.





26


From
      April 1, 2003 through March 31, 2006, we
      accounted for stock awards granted to employees under the fair value recognition
      provisions of SFAS No. 123, “ *Accounting
      for Stock-Based Compensation,* ”
and
      applied SFAS No. 148, *“Accounting
      for Stock-Based Compensation - Transition and Disclosure,* ”
      prospectively to all employee awards granted on or after April 1, 2003. Prior
      to
      April 1, 2003, we
      accounted for stock awards granted to employees under the recognition and
      measurement principles of Accounting Principles Board Opinion No.
      25, *“Accounting
      for Stock Issued to Employees, and related Interpretations* ”
(“APB
      No. 25”). As a result, no compensation expense was recognized for stock options
      granted to employees prior to April 1, 2003 other than as related to option
      grants to employees and directors below the fair market value of the underlying
      stock at the date of grant or as related to subsequent modifications to options
      granted to employees and directors. For the three and nine months ended December
      31, 2005, our total stock-based compensation expense was $52,676 and $923,513
      including an expense of $1,116,069 for awards valued pursuant to SFAS No. 123
      and income of $192,556 for modification of awards valued pursuant to APB No.
      25.





***Reserve
      on stockholder note receivable***


In
      June
      1999, in connection with an amended and restated employment agreement for Angelo
      S. Morini, our Founder, stockholder and a member of our Board of Directors,
      we
      consolidated two full-recourse notes receivable ($1,200,000 from November 1994
      and $11,572,200 from October 1995) related to his purchase of 2,914,286 shares
      of our common stock into a single stockholder note receivable in the amount
      of
      $12,772,200 that was due on June 15, 2006. This stockholder note receivable
      was
      non-interest bearing and non-recourse and was secured by the 2,914,286 shares
      of
      our common stock (the “Shares”).




On
      June
      16, 2006, Mr. Morini failed to repay the non-recourse note obligation to our
      Company. The 2,914,286 shares being held as collateral were deemed to be no
      longer outstanding and thus considered as treasury stock. On June 20, 2006,
      we
      delivered notice to Mr. Morini that we intended to exercise our rights to the
      Shares and retain all the Shares in full satisfaction of his obligations under
      the stockholder note receivable. On July 6, 2006, Mr. Morini consented to our
      acceptance of the Shares in full satisfaction of his obligations under the
      stockholder note receivable. Based upon the $0.42 closing price of our common
      stock as quoted on the OTC Bulletin Board on June 16, 2006, the Shares had
      an
      approximate value of $1,224,000 on such date. Accordingly, we recorded an
      additional expense of $1,428,000 in the nine months ended December 31, 2006
      in
      order to record the additional decline in the value of the Shares from its
      $2,652,000 value as of March 31, 2006. In July 2006, we cancelled the Shares
      along with our other 30,443 treasury shares.





Although
      this expense resulted in a material loss to our operations, it did not have
      any
      affect on the balance sheet since the stockholder note receivable was already
      shown as a reduction to Stockholders’ Deficit.





***Cost
      of disposal activities***


We
      accounted for the costs associated with the Schreiber transactions in accordance
      with SFAS No. 146, “ *Accounting
      for Costs Associated with an Exit or Disposal Activity,”* because
      the arrangements were planned and controlled by management and materially change
      the manner in which our business will be conducted. In accordance with SFAS
      No.
      146, costs associated with disposal activities should be reported as a reduction
      of income from operations. During the year ended March 31, 2006, all 104
      employee positions related to the manufacturing and distribution of our products
      were eliminated. The remaining employee termination costs are expected to be
      paid in fiscal 2007. In December 2005, we abandoned our distribution facility
      and the production portion of our administrative facility and accrued $396,197
      related to abandonment of these facilities. This amount was calculated as the
      present value of the remaining lease rentals, reduced by the estimated market
      value of sublease rentals. The actual expense exceeded this estimate for the
      time that we do not sublease these facilities. Other exit costs consist
      primarily of legal and professional fees related to the disposal activities
      and
      maintenance costs on the abandoned facilities.





We
      report
      our disposal costs for the period as Costs of Disposal Activities in the
      Statement of Operations. A summary of the nine months and total disposal costs
      incurred is as follows:





**Employee
                Termination Costs**
            
            **Excess
                Facilities**
            
            **Other
                Exit Costs**
            
            **Total**Nine
                months Ended December 31, 2005
            
            $
            411,412
            
            $
            396,197
            
            $
            534,595
            
            $
            1,342,204Nine
                months Ended December 31, 2006
            
            
            --
            
            
            117,472
            
            
            166,075
            
            
            283,547Total
                Costs Incurred from inception through December 31, 2006
            
            $
            451,002
            
            $
            635,951
            
            $
            843,084
            
            $
            1,930,037





27


We
      anticipate that in future periods, there may be additional disposal costs
      related to professional fees and leasehold repair charges that are in dispute
      between our Company and the landlord on our former leasehold manufacturing
      facility. We exited this facility and the lease expired in November
      2006.





***Impairment
      of property and equipment and loss on sale of assets***


In
      light
      of the Schreiber transactions discussed above under *Recent
      Material Developments,* we
      determined that it was more likely than not that a majority of our fixed assets
      related to production activities would be sold or disposed prior to the end
      of
      their useful life. In accordance with SFAS No. 144, *“Accounting
      for the Impairment or Disposal of Long-Term Assets,”* we wrote
      down the value of our assets to their estimated fair values in June 2005. We
      estimated the fair value based on the $8,700,000 sales price to Schreiber and
      the anticipated sales price related to any other assets to be held for sale
      plus
      future cash flows related to the assets from July 1, 2005 until the end of
      production in November 2005. Based on this estimate, we recorded an impairment
      of property and equipment of $7,896,554 in order to reflect a net fair value
      of
      our equipment in June 2005.





All
      assets continued to be used and depreciated under Property and Equipment until
      the sale of substantially all of our production machinery and equipment on
      December 8, 2005. For the three and nine months ended December 31, 2006, we
      recorded a loss of $19,775 and $44,280, respectively, on the sale of assets
      sold
      or abandoned upon the exit of our leasehold facilities. For the three and nine
      months ended December 31, 2005, we recorded a loss of $65,360 and $70,966,
      respectively, on the sale of assets sold or abandoned after production ceased
      in
      December 2005.





***Other
      income and expense***


Interest
      expense decreased $623,217 or 50% in the nine months ended December 31, 2006
      compared to the nine months ended December 31, 2005. In the nine months ended
      December 31, 2006, we saw interest expense related to our debt facilities
      decrease by approximately $456,000 due to the lower principal balances and
      the
      payment in full of our property taxes with the proceeds from the sale of our
      manufacturing equipment to Schreiber. Amortization of loan costs decreased
      by
      approximately $136,000 due to lower loan fees charged by our new lenders.
      Additionally, pursuant to several Note and Warrant Purchase Agreements entered
      into in fiscal 2006 and fiscal 2007, we issued warrants to purchase up to
      800,000 shares of our common stock. We recorded the initial fair value of the
      warrants of $18,000 and $444,731 in fiscal 2007 and fiscal 2006, respectively,
      as a discount to debt. During the nine months ended December 31, 2006 and 2005,
      we amortized $133,419 and $165,376 of this non-cash debt discount as interest
      expense.





Our
      current loan facility accrues interest based on a variable prime plus rate.
      Due
      to the increases in the prime rate (currently at 8.25%), we will experience
      higher interest rates in fiscal 2007 as compared to fiscal 2006 (in which the
      prime rate averaged 6.7%). However, we anticipate that our interest expense
      will
      decrease nearly 50% in fiscal 2007, despite the higher interest rates, due
      to
      lower debt balances and lower non-cash debt discount amortization.




In
      accordance with EITF 00-19, if a contract requires settlement in registered
      shares, then we may be required to record the value of the securities as a
      liability and/or temporary equity. Any changes in the fair value of the
      securities based on the Black-Scholes pricing model after the initial valuation
      are marked to market during reporting periods. During the three and nine months
      ended December 31, 2005, we recorded a gain (loss) on the fair value of warrants
      of ($8,269) and $388,731, respectively, related to the change in the fair values
      of the warrants during the period. There were no warrants that required a
      revaluation of fair value during the three and nine months ended December 31,
      2006.






**Liquidity
      and Capital Resources**





**9-Months
                Ended December 31,**
            
            **2006**
            
            **2005**
            
            **$
                Change**
            
            **%
                Change**Cash
                from (used in) operating activities
            
            
            780,090
            
            
            (787,181
            )
            
            1,567,271
            
            
            -199.1
            %Cash
                from investing activities
            
            
            57,524
            
            
            8,442,722
            
            
            (8,385,198
            )
            
            -99.3
            %Cash
                used in financing activities
            
            
            (952,062
            )
            
            (7,838,369
            )
            
            6,886,307
            
            
            -87.9
            %Net
                increase (decrease) in cash
            
            
            (114,448
            )
            
            (182,828
            )
            
            68,380
            
            
            -37.4
            %





28





***Future
      Capital Needs***


Our
      current business plan eliminates certain low margin private label and Galaxy
      imitation business from our sales mix. The elimination of these low margin
      items
      and the elimination of excess overhead that was part of our former manufacturing
      operations should continue to result in higher gross margins with lower
      operating costs and produce positive cash flows from operations in fiscal
      2007.  With
      the
      reduction in overall debt and property taxes, we expect to see annual interest
      savings in excess of $800,000 in fiscal 2007. Additionally, we anticipate that
      improved operating income will provide a substantial increase in positive
      operating cash flow in fiscal 2007.





As a result
      of the successful refinancing of the $2.4 million short-term notes and line
      of
      credit for our receivables financing and the positive cash flow that we are
      currently experiencing from operations, we believe that we have sufficient
      cash
      resources to meet our needs for general operations excluding the related party
      note payable through December 31, 2007. It is unlikely at this time that we
      will
      have enough cash from operations to repay the $2,685,104 related party note
      payable and accrued interest thereon that matures in October 2007 if the Note
      Holder chooses not to convert the note into common shares or refinance or renew
      this loan. If the Note Holder demands a cash repayment of the related party
      note
      payable and we cannot generate enough cash from operations or alternative
      financing, we will be unable to satisfy the note by its maturity date. In such
      an event, the Note Holder could exercise his rights under the loan documents,
      which could include, among other things, declaring a default under the loan
      which would then trigger interest to accrue at 17.5% per annum. Additionally,
      a
      default to our Note Holder would trigger a default under our Systran Agreement.
      In such an event, Systran could exercise its rights under its loan documents,
      which could include, among other things, declaring a default and pursuing
      foreclosure on our assets that are pledged as collateral for the advances on
      our
      accounts receivable invoices. If these events occurred, it would be
      substantially more difficult for us to effectively continue the operation of
      our
      business, and it
      is
      unlikely that we would be able to continue as a going concern .
      Management has commenced discussions with the Note Holder regarding possible
      conversion, extension or other alternatives related to the note.




See *Debt
      Financing* for
      further details.





***Operating
      and Investing Activities***


We
      completed the sale of substantially all of our manufacturing and production
      equipment and fully implemented the outsourcing of our production to Schreiber
      in December 2005. Without the cash-flow burden of carrying inventory and higher
      operating expenses due to excess plant capacity, we are experiencing improved
      cash flows from operations from the higher margins and faster collections on
      accounts receivable. We are continually reviewing our accounts receivable
      collection practices in order to maximize cash flow from
      operations.





Cash
      from
      investing activities primarily related to a decrease in security deposits and
      cash received from the sale of assets upon the exit of our leasehold facilities
      during the nine months ended December 31, 2006.





For
      the
      nine months ended December 31, 2005, we received $8,747,075 in proceeds from
      the
      sale of equipment primarily related to the sale of substantially all of our
      manufacturing and production equipment to Schreiber on December 8, 2005 for
      $8,700,000. This sale was approved by our stockholders at a Special Meeting
      held
      on December 5, 2005. The $8,700,000 in proceeds was used to pay $1,319,583
      for
      tangible personal property taxes due primarily on the sold assets and $7,374,299
      to Beltway Capital Partners LLC (successor by assignment of Wachovia Bank,
      N.A.)
      for the termination of our term loan. The remaining proceeds balance of $6,118
      was used to reduce our asset-based line of credit from Textron Financial
      Corporation.





***Financing
      Activities***





**9-Months
                Ended December 31,**
            
            **2006**
            
            **2005**Net
                borrowings (payments) on line of credit and bank
                overdrafts
            
            
            (745,225
            )
            
            (3,219,757
            )Issuances
                of debt
            
            
            1,200,000
            
            
            2,400,000Payments
                of debt and capital leases
            
            
            (1,406,837
            )
            
            (8,725,110
            )Issuances
                of stock & associated costs
            
            
            -
            
            
            1,706,498Cash
                used in financing activities
            
            
            (952,062
            )
            
            (7,838,369
            )





29


Debt
      Financing


*Secured
      Borrowings*


On
      June
      23, 2006, we
      entered into a Receivables Purchase Agreement with Systran
      Financial Services Corporation, a subsidiary of Textron Financial Corporation
      (“Systran”), whereby Systran will provide financing to our Company through
      advances against certain trade receivable invoices due to our Company (the
      “Systran Agreement”). The Systran Agreement is secured by our accounts
      receivable and all other assets. Generally, subject to a maximum principal
      amount of $3,500,000 which can be borrowed under the Systran Agreement, the
      amount available for borrowing is equal to 85%
      of
      our eligible accounts receivable invoices less a dilution reserve and any
      required fixed dollar reserves .
      The
      dilution and fixed dollar reserves have been initially set at 7% and $100,000,
      respectively. Advances under the Systran Agreement bear interest at
      a variable
      rate equal to the prime rate plus 1.5% per annum (9.75% on December 31, 2006).
      We paid a one-time closing fee of $35,000 and are also obligated to pay a $1,500
      monthly service fee. The
      initial term of the Systran Agreement ends on June 23, 2009 and may renew
      automatically for consecutive twelve-month terms unless terminated sooner.





On
      June
      23, 2006, Systran advanced $2,379,262 under the Systran Agreement of which
      $1,839,086 was used to pay in full and terminate our obligations under our
      line
      of credit with Textron Financial Corporation which was to terminate on June
      27,
      2006.





*Related
      Party Notes Payable*


Pursuant
      to a Note and Warrant Purchase Agreement dated September 12, 2005, we received
      $1,200,000 as a loan from Mr. Frederick A. DeLuca, a greater than 10%
      shareholder. In October 2005, pursuant to several Note and Warrant Purchase
      Agreements dated September 28, 2005, we received a $600,000 loan from Conversion
      Capital Master, Ltd., a $485,200 loan from SRB Greenway Capital (Q.P.), L.P.,
      a
      $69,600 loan from SRB Greenway Capital, L.P. and a $45,200 loan from SRB
      Greenway Offshore Operating Fund, L.P. The combined total of these loans was
      $2,400,000. The loans were evidenced by unsecured promissory notes (the “Notes”)
      held by the above referenced parties (the “Note Holders”). The Notes required
      monthly interest-only payments at 3% above the bank prime rate of interest
      per
      the Federal Reserve Bank and matured on June 15, 2006.





We
      did
      not have the short-term liquidity to pay our related party Note Holders on
      the
      $2.4 million Notes that matured on June 15, 2006 in accordance with their
      original terms. We received a letter on June 20, 2006 from all the Note Holders,
      other than Mr. DeLuca, notifying the Company that its failure to pay the amounts
      due and owing on the maturity date constituted a default on $1.2 million of
      the
      Notes held by those Note Holders. Pursuant to the terms of the Notes, since
      we
      did not cure the default within 10 days after receipt of the notice of default,
      we were obligated to pay interest at the default rate of 8% above the Prime
      Rate
      beginning July 1, 2006. We
      amortized the final $126,979 of debt discount costs related to the above
      transaction in the three months ended June 30, 2006.





Pursuant
      to a Note Purchase Agreement dated July 19, 2006, we issued a new unsecured
      convertible note for $2,685,104 (the “Convertible Note”) to Mr. DeLuca. The
      proceeds from the Convertible Note were used to repay or refinance the above
      mentioned $2.4 million Notes that matured on June 15, 2006 and a $285,104
      registration rights penalty owed to Mr. DeLuca. The Convertible Note accrues
      interest at 12.5% per annum. No interest or principal payments are required
      under the Convertible Note until its maturity on October 19, 2007. Principal,
      together with any accrued and unpaid interest, on the Convertible Note is
      convertible at any time prior to payment into shares of our common stock at
      a
      conversion price of $0.35 per share. The market price of our common stock as
      quoted on the OTC Bulletin Board on July 19, 2006 was $0.28. As additional
      consideration for making the loan, we issued Mr. DeLuca a warrant (the
“Warrant”) to purchase up to 200,000 shares of our common stock at an exercise
      price equal to $0.35 per share. The Warrant is fully vested and can be exercised
      on or before the expiration date of July 19, 2009. In July 2006, we recorded
      the
      $18,000 fair value of the Warrant as a discount to debt that is being amortized
      from July 2006 through October 2007.








**Recent
      Accounting Pronouncements**





In
      July
      2006, the FASB issued Interpretation No. 48, *“Accounting
      for Uncertainty in Income Taxes - An Interpretation of FASB Statement No.
      109”* (“FIN
      48”). ** FIN
      48
      provides guidance on the financial statement recognition and measurement of
      a
      tax position taken or expected to be taken in a tax return. FIN 48 also provides
      guidance on derecognition, classification, interest and penalties, accounting
      in
      interim periods, disclosures, and transition. FIN 48 is effective for fiscal
      years beginning after December 15, 2006. We
      are
      currently evaluating the impact of this standard on our financial statements.





In
      September 2006, the FASB issued SFAS 157, "Fair Value Measurements." SFAS 157
      simplifies and codifies guidance on fair value measurements under generally
      accepted accounting principles. This standard defines fair value, establishes
      a
      framework for measuring fair value and prescribes expanded disclosures about
      fair value measurements. SFAS 157 is effective for financial statements issued
      for fiscal years beginning after November 15, 2007, and interim periods within
      those fiscal years, with early adoption permitted. We are currently evaluating
      the effect, if any, the adoption of SFAS 157 will have on our financial
      condition, results of operations and cash flows.





30


In
      September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108,
“Considering the Effects of Prior Year Misstatements when quantifying
      Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108
      requires companies to evaluate the materiality of identified unadjusted errors
      on each financial statement and related financial statement disclosure using
      both the rollover approach and the iron curtain approach. The rollover approach
      quantifies misstatements based on the amount of the error in the current year
      financial statements whereas the iron curtain approach quantifies misstatements
      based on the effects of correcting the misstatement existing in the balance
      sheet at the end of the current year, irrespective of the misstatement’s year(s)
      origin. Financial statements would require adjustment when either approach
      results in quantifying a misstatement that is material. Correcting prior year
      financial statements for immediate errors would not require previously filed
      reports to be amended. SAB 108 is effective for the first fiscal year ending
      after November 15, 2006. We do not expect the impact of SAB 108 on our financial
      condition, results of operations and cash flows to be material.








**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk**





Our
      exposure to market risk results primarily from fluctuations in interest rates.
      The interest rate on our outstanding debt to Systran as of December 31, 2006
      is
      floating and based on the prevailing market interest rate. For market-based
      debt, interest rate changes generally do not affect the market value of the
      debt
      but do impact future interest expense and hence earnings and cash flows,
      assuming other factors remain unchanged. A theoretical 1% increase or decrease
      in market rates in effect on December 31, 2006 with respect to our debt as
      of
      such date would increase or decrease interest expense and hence reduce or
      increase the net income of our Company by approximately $12,000 per year or
      $3,000 per quarter.




Our
      sales
      during the quarters ended December 31, 2006 and 2005, which were denominated
      in
      a currency other than U.S. Dollars, were less than 7% of gross sales and no
      net
      assets were maintained in a functional currency other than U. S. Dollars during
      such periods. While we believe that the effects of changes in foreign currency
      exchange rates have not historically been significant to our operations or
      net
      assets, we are unable to forecast the effects that foreign currency exchange
      rates may have on our future operations.








**Item
      4. Controls and Procedures**





As
      of
      December 31, 2006, an evaluation was performed under the supervision and with
      the participation of our management, including the Chief Executive Officer
      ("CEO"), and the Chief Financial Officer ("CFO"), of the effectiveness of the
      design and operation of our disclosure controls and procedures to insure that
      we
      record, process, summarize and report in a timely and effective manner the
      information required to be disclosed in reports filed with or submitted to
      the
      Securities and Exchange Commission. Based on that evaluation, our management,
      including the CEO and CFO, concluded that our disclosure controls and procedures
      were effective in timely bringing to their attention material information
      related to our Company required to be included in our periodic Securities and
      Exchange Commission filings. During the quarter ended December 31, 2006, there
      were no changes in our internal controls over financial reporting or in other
      factors that materially affected, or are reasonably likely to materially affect
      those controls.





31


**PART
      II. OTHER INFORMATION**





**Item
      1A.**  **Risk
      Factors**





Statements
      other than historical information contained in this Form 10-Q are considered
      “forward-looking statements” as defined under the Private Securities Litigation
      Reform Act of 1995. These statements relate to future events or our future
      financial performance. These forward-looking statements are based on our current
      expectations, estimates and projections about our industry, management’s beliefs
      and certain assumptions made by our Company. Words such as “anticipate,”
“expect,” “intend,” “plan,” “believe,” “seek,” “project,” “estimate,” “may,”
“will,” “could,” “should,” “potential,” or “continue” or the negative or
      variations of these words or similar expressions are intended to identify
      forward-looking statements. Although we believe that these forward-looking
      statements are reasonable at the time they are made, these statements are not
      guarantees of future performance and are subject to certain risks, uncertainties
      and assumptions that are difficult to predict. Therefore, actual results may
      differ materially from our historical results and those expressed or forecasted
      in any forward-looking statement as a result of a variety of factors as set
      forth below. We are not required and undertake no obligation to publicly update
      or revise any forward-looking statements for any reason, even if new information
      becomes available or other events occur in the future.





In
      addition to the other information in this Form 10-Q and risk factors previously
      disclosed in our Annual Report on Form 10-K for the year ended March 31, 2006,
      the following are some of the factors as of February 9, 2007, that could cause
      our Company’s actual results to differ materially from the expected results
      described in or underlying our Company’s forward-looking statements. These
      factors should be considered carefully while evaluating our business and
      prospects. If any of the following risks actually occur, they could seriously
      harm our business, financial condition, results of operations or cash flows.





***We
      have incurred significant losses.***


We
      have
      incurred substantial losses in recent years and, as a result, have a
      stockholders deficit of $2,172,733 as of December 31, 2006. Losses for the
      years
      ended March 31, 2006, 2005 and 2004 were $24,148,553, $3,859,783 and $3,299,277,
      respectively. We received a report from our independent accountants relating
      to
      our audited financial statements as of March 31, 2006 containing a paragraph
      stating that because we were then in
      default of our notes payable, had suffered recurring losses from operations
      and
      at March 31, 2006 had deficiencies in working capital and equity ,
      there
      was substantial doubt as to our ability to continue as a going concern. Our
      ability to continue as a going concern depended upon successfully obtaining
      sufficient cash resources to refinance our $2.4 million of unsecured notes
      payable that matured on June 15, 2006 and obtaining positive cash flow from
      operations to sustain normal business operations.





Pursuant
      to a Note Purchase Agreement dated July 19, 2006, we issued a new unsecured
      convertible note for $2,685,104.17 (the “Convertible Note”) to Frederick A.
      DeLuca, a greater than 10% shareholder. The proceeds from the Convertible Note
      were used to repay or refinance $2,400,000 in unsecured promissory notes that
      matured on June 15, 2006 (including one such note in the principal amount of
      $1,200,000 owned by Mr. DeLuca) and a $285,104.17 registration rights penalty
      owed to Mr. DeLuca. The Convertible Note accrues interest at 12.5% per annum.
      No
      interest or principal payments are required under the Convertible Note until
      its
      maturity on October 19, 2007. Principal, together with any accrued and unpaid
      interest, on the Convertible Note is convertible at any time prior to payment
      into shares of our common stock at a conversion price of $0.35 per share. The
      market price of our common stock as quoted on the OTC Bulletin Board on July
      19,
      2006 was $0.28. As additional consideration for making the loan, we issued
      Mr.
      DeLuca a warrant (the “Warrant”) to purchase up to 200,000 shares of our common
      stock at an exercise price equal to $0.35 per share. The Warrant is fully vested
      and can be exercised on or before the expiration date of July 19, 2009.





Our
      fiscal 2007 business plan eliminated certain low margin private label and Galaxy
      imitation business from our sales mix. The elimination of these low margin
      items
      and the elimination of excess overhead that was part of our former manufacturing
      operations should continue to result in higher gross margins with lower
      operating costs and produce positive cash flows from operations throughout
      the
      remainder of fiscal 2007.





As a result
      of the successful refinancing of the $2.4 million short-term notes and line
      of
      credit for our receivables financing and the positive cash flow that we are
      currently experiencing from operations, we believe that we have sufficient
      cash
      resources to meet our needs for general operations excluding the related party
      note payable through December 31, 2007. It is unlikely at this time that we
      will
      have enough cash from operations to repay the $2,685,104 related party note
      payable and accrued interest thereon that matures in October 2007 if the Note
      Holder chooses not to convert the note into common shares or refinance or renew
      this loan. If the Note Holder demands a cash repayment of the related party
      note
      payable and we cannot generate enough cash from operations or alternative
      financing, we will be unable to satisfy the note by its maturity date. In such
      an event, the Note Holder could exercise his rights under the loan documents,
      which could include, among other things, declaring a default under the loan
      which would then trigger interest to accrue at 17.5% per annum. Additionally,
      a
      default to our Note Holder would trigger a default under our Systran Agreement.
      In such an event, Systran could exercise its rights under its loan documents,
      which could include, among other things, declaring a default and pursuing
      foreclosure on our assets that are pledged as collateral for the advances on
      our
      accounts receivable invoices. If these events occurred, it would be
      substantially more difficult for us to effectively continue the operation of
      our
      business, and it
      is
      unlikely that we would be able to continue as a going concern .
      Management has commenced discussions with the Note Holder regarding possible
      conversion, extension or other alternatives related to the note.





32


***We
      may be required to pay substantial penalties under our Supply Agreement and
      may
      not have the ability to do so.***


The
      initial term of the Supply Agreement with Schreiber is for a period of five
      years from the effective date of September 1, 2005 and is renewable at our
      option for up to two additional five-year periods (for a total term of up to
      fifteen years). If we do not exercise our first option to extend the term,
      then
      we will be obligated to pay Schreiber $1,500,000. If we exercise our first
      option to extend the term, but do not exercise our second option to extend
      the
      term, then we will be obligated to pay Schreiber $750,000.




Additionally,
      the Supply Agreement originally provided for a contingent short-fall payment
      obligation up to $8,700,000 by our Company if a specified production level
      was
      not met during the one-year period from September 1, 2006 to August 31, 2007.
      If
      a contingent short-fall payment was accrued after such one-year period, it
      may
      be reduced by the amount by which production levels in the one-year period
      from
      September 1, 2007 to August 31, 2008 exceeded the specified target level of
      production, if any. The short-fall payment is based on a formula that calculates
      the payment as follows: ((required pounds shipped - actual pounds shipped)
      /
      required pounds shipped) * $8,700,000. In November 2006, the Supply Agreement
      was amended so that the short-fall payment obligation would not be measured
      until the one year period from September 1, 2009 to August 31, 2010, and the
      target level of production was reduced by approximately 22%. Although we have
      significantly improved our gross margins by discontinuing production of low
      margin products, our total sales (and the corresponding volume of our products
      being produced) have been substantially reduced.  We will need to greatly
      increase our present production volume before the measuring period from
      September 1, 2009 to August 31, 2010 in order to avoid a substantial shortfall
      payment.  Based on our present production volume, the estimated short-fall
      payment could exceed $6,100,000.





In
      either
      event, we may not have the ability to pay the required payments and Schreiber
      may use its contractual rights in order to collect and may cease production
      and
      shipment of our products. Such an action would have a material adverse affect
      on
      the liquidity and financial condition of our Company and it is unlikely that
      we
      would be able to continue as a going concern .





***A
      private investor owns a large percentage of the outstanding shares, which could
      materially limit the ownership rights of investors.***


As
      of
      February 9, 2007, Frederick DeLuca, a private investor, owned approximately
      23%
      of our outstanding common stock and held warrants and a convertible note which,
      if exercised with accrued and unpaid interest on the convertible note as of
      such
      date and assuming the exercise of no other outstanding options or warrants,
      would give him ownership of approximately 49% of our outstanding common stock.
      Investors who purchase common stock in our Company may be unable to elect any
      specific members of the board of directors or exercise significant control
      over
      us or our business as a result of Mr. Deluca’s ownership. Additionally, Mr.
      DeLuca may be able to exercise significant influence over our policies and
      Board
      composition.





***Stockholders
      may experience further dilution.***


We
      have a
      substantial number of outstanding options, warrants and a convertible note
      to
      acquire shares of common stock. As of February 9, 2007, we have a total of
      14,876,031 shares reserved for issuance upon exercise of options, warrants
      and a
      convertible note that we have granted. Of this total, 8,955,139 are exercisable
      securities that are “in the money.” “In the money” generally means that the
      current market price of the common stock is above the exercise price of the
      shares subject to the option, warrant or note conversion. The issuance of common
      stock upon the exercise of these options and warrants or note conversion could
      adversely affect the market price of the common stock or result in substantial
      dilution to our existing stockholders. In addition, any future securities
      issuances by our Company could
      result in the issuance, or potential issuance, of a significant amount of equity
      securities that will cause substantial dilution to our stockholders,
      particularly given the current low trading price of our common
      stock.





***Because
      we sell food products, we face the risk of exposure to product liability
      claims.***


We,
      like
      any other seller of food products, face the risk of exposure to product
      liability claims in the event that our manufacturer’s quality control procedures
      fail and the consumption of our products causes injury or illness. In July
      2006,
      we initiated a voluntary product recall on one of our Vegan products after
      we
      discovered that the product produced by a sub-manufacturer may contain traces
      of
      undeclared milk ingredients. The recall was limited to our Vegan Parmesan Flavor
      Soy Topping with expiration codes between April 2007 and May 2007 of which
      we
      had sold approximately $65,000. Most direct costs associated with the recall
      are
      reimbursed by the manufacturer. With respect to product liability claims, our
      insurance may not continue to be available at a reasonable cost, or, if
      available, may not be adequate to cover liabilities. We generally seek
      contractual indemnification and insurance coverage from parties supplying us
      products, but this indemnification or insurance coverage is limited, as a
      practical matter, to the creditworthiness of the indemnifying party, and their
      carriers, if any, as well as the limits of any insurance provided by suppliers.
      If we do not have adequate insurance or contractual indemnification available,
      product liability claims relating to defective products could have a material
      adverse effect on our financial condition, results of operations and cash flows.


33


**Item
      6.**  **Exhibits**





The
      following exhibits are filed as part of this Form 10-Q:




***Exhibit
                No***
            
            ***Exhibit
                Description**** 3.1
            
            Restated
                Certificate of Incorporation of the Company as filed with the Secretary
                of
                State of the State of Delaware on December 23, 2002 (Filed as Exhibit
                3.2
                on Form 10-Q for the fiscal quarter ended December 31,
                2002.)* 3.2
            
            By-laws
                of the Company, as amended (Filed as Exhibit 3.2 to Registration
                Statement
                on Form S-18, No. 33-15893-NY.)* 4.18
            
            Securities
                Purchase Agreement dated as of October 6, 2004 between Galaxy Nutritional
                Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 4.18 on Form
                8-K
                filed October 8, 2004.)* 4.19
            
            Registration
                Rights Agreement dated as of October 6, 2004 between Galaxy Nutritional
                Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 4.19 on Form
                8-K
                filed October 8, 2004.)* 4.20
            
            Warrant
                to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as
                of
                October 6, 2004 in favor of Frederick A. DeLuca (Filed as Exhibit
                4.20 on
                Form 8-K filed October 8, 2004.)* 4.21
            
            Stock
                Repurchase Agreement dated as of October 6, 2004 by and among Galaxy
                Nutritional Foods, Inc., BH Capital Investments L.P. and Excalibur
                Limited
                Partnership (Filed as Exhibit 4.21 on Form 8-K filed October 8,
                2004.)* 4.22
            
            Registration
                Rights Agreement dated as of October 6, 2004 by and among Galaxy
                Nutritional Foods, Inc., BH Capital Investments L.P. and Excalibur
                Limited
                Partnership (Filed as Exhibit 4.22 on Form 8-K filed October 8,
                2004.)* 4.23
            
            Warrant
                to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as
                of
                October 6, 2004 in favor of BH Capital Investments L.P. (Filed as
                Exhibit
                4.23 on Form 8-K filed October 8, 2004.)* 4.24
            
            Warrant
                to Purchase Securities of Galaxy Nutritional Foods, Inc. dated as
                of
                October 6, 2004 in favor of Excalibur Limited Partnership (Filed
                as
                Exhibit 4.24 on Form 8-K filed October 8, 2004.)* 4.25
            
            Investor
                relations contract between Galaxy Nutritional Foods, Inc. and R.J.
                Falkner
                dated as of September 29, 2004 (Filed as Exhibit 4.25 on Form S-3
                filed
                March 14, 2005.)* 4.26
            
            Asset
                Purchase Agreement dated June 30, 2005 between Galaxy Nutritional
                Foods,
                Inc. and Schreiber Foods, Inc. (Filed as Exhibit 4.25 on Form 8-K
                filed
                July 6, 2005.)* 4.27
            
            Warrant
                to Purchase Securities of Galaxy Nutritional Foods, Inc. dated July
                19,
                2006 in favor of Frederick A. DeLuca (Filed as Exhibit 4.27 on Form
                8-K
                filed July 25, 2006.)* 4.28
            
            Convertible
                Note in the principal amount of $2,685,104.17 dated as of July 19,
                2006 by
                Galaxy Nutritional Foods, Inc. in favor of Frederick A. DeLuca (Filed
                as
                Exhibit 4.26 on Form 8-K filed July 25, 2006.)* 10.1
            
            Master
                Distribution and License Agreement dated as of May 22, 2003 between
                Galaxy
                Nutritional Foods, Inc. and Fromageries Bel S.A. (Filed as Exhibit
                10.22
                on Form 8-K filed June 2, 2003.)* 10.2
            
            Loan
                and Security Agreement dated as of May 27, 2003 between Galaxy Nutritional
                Foods, Inc. and Textron Financial Corporation (Filed as Exhibit 10.1
                on
                Form 8-K filed June 2, 2003.)* 10.3
            
            Patent,
                Copyright and Trademark Collateral Security Agreement dated as of
                May 27,
                2003 between Galaxy Nutritional Foods, Inc. and Textron Financial
                Corporation (Filed as Exhibit 10.2 on Form 8-K filed June 2,
                2003.)




34




* 10.4
            
            Renewal
                Promissory Note in the principal amount of $10.131,984.85 dated as
                of May
                28, 2003 by Galaxy Nutritional Foods, Inc. in favor of Wachovia Bank
                (Filed as Exhibit 10.3 on Form 8-K filed June 2, 2003.)* 10.5
            
            Renewal
                Promissory Note in the principal amount of $501,000.00 dated as of
                May 28,
                2003 by Galaxy Nutritional Foods, Inc. in favor of Wachovia Bank
                (Filed as
                Exhibit 10.4 on Form 8-K filed June 2, 2003.)* 10.6
            
            Amendment
                of Loan Agreement dated as of May 28, 2003 between Galaxy Nutritional
                Foods, Inc. and Wachovia Bank (Filed as Exhibit 10.5 on Form 8-K
                filed
                June 2, 2003.)* 10.7
            
            Amendment
                of Security Agreement dated as of May 28, 2003 between Galaxy Nutritional
                Foods, Inc. and Wachovia Bank (Filed as Exhibit 10.6 on Form 8-K
                filed
                June 2, 2003.)* 10.8
            
            Waiver
                Letter from Textron Financial Corporation to the Company dated August
                13,
                2003 (Filed as Exhibit 10.53 on Form 10-Q for the fiscal quarter
                ended
                June 30, 2003.)* 10.9
            
            Second
                Amended and Restated Employment Agreement dated as of October 13,
                2003
                between Galaxy Nutritional Foods, Inc. and Angelo S. Morini (Filed
                as
                Exhibit 10.1 on Form 8-K filed October 20, 2003.)* 10.10
            
            Settlement
                Agreement dated May 6, 2004 between Galaxy Nutritional Foods, Inc.
                and
                Schreiber Foods, Inc. (Filed as Exhibit 10.1 on Form 8-K filed May
                11,
                2004.)* 10.11
            
            Modification
                Letter on the Security Agreement dated as of May 21, 2004 between
                Galaxy
                Nutritional Foods, Inc. and Wachovia Bank (Filed as Exhibit 10.11
                on Form
                10-K for the fiscal year ended March 31, 2004*.*)* 10.12
            
            Second
                Amendment to Loan and Security Agreement dated June 25, 2004 between
                Galaxy Nutritional Foods, Inc. and Textron Financial Corporation
                (Filed as
                Exhibit 10.12 on Form 10-K for the fiscal year ended March 31,
                2004*.*)* 10.13
            
            Third
                Amendment to Lease Agreement dated June 10, 2004 between Galaxy
                Nutritional Foods, Inc. and Cabot Industrial Properties, L.P. (Filed
                as
                Exhibit 10.13 on Form 10-K for the fiscal year ended March 31,
                2004*.*)* 10.14
            
            Separation
                and Settlement Agreement dated July 8, 2004 between Galaxy Nutritional
                Foods, Inc. and Christopher J. New (Filed as Exhibit 10.14 on Form
                8-K
                filed July 13, 2004.)* 10.15
            
            Employment
                Agreement dated July 8, 2004 between Galaxy Nutritional Foods, Inc.
                and
                Michael E. Broll (Filed as Exhibit 10.15 on Form 8-K filed July 13,
                2004.)* 10.16
            
            Third
                Amendment to Loan and Security Agreement dated November 10, 2004
                between
                Galaxy Nutritional Foods, Inc. and Textron Financial Corporation
                (Filed as
                Exhibit 10.16 on Form 10-Q for the fiscal quarter ended December
                31,
                2004.)* 10.17
            
            Fourth
                Amendment to Loan and Security Agreement dated June 3, 2005 between
                Galaxy
                Nutritional Foods, Inc. and Textron Financial Corporation (Filed
                as
                Exhibit 10.17 on Form 8-K filed June 22, 2005.)* 10.18
            
            Letter
                Agreement dated June 17, 2005 between Galaxy Nutritional Foods, Inc.
                and
                Textron Financial Corporation (Filed as Exhibit 10.18 on Form 8-K
                filed
                June 22, 2005.)* 10.19
            
            Supply
                Agreement dated June 30, 2005 between Galaxy Nutritional Foods, Inc.
                and
                Schreiber Foods, Inc. Portions of the Supply Agreement have been
                omitted
                as indicated by asterisks pursuant to a request for confidential
                treatment
                in accordance with Section 552(b)(4) of the Freedom of Information
                Act
                ("FOIA"), 5 U.S.C. 552(b)(4) (Filed as Exhibit 10.19 on Form 8-K
                filed
                July 6, 2005.)




35




* 10.20
            
            Loan
                Modification Agreement June 30, 2005 between Galaxy Nutritional Foods,
                Inc. and Wachovia Bank N.A (formerly SouthTrust Bank). (Filed as
                Exhibit
                10.20 on Form 8-K filed July 6, 2005.)* 10.21
            
            Termination,
                Settlement and Release Agreement dated July 20, 2005 between Galaxy
                Nutritional Foods, Inc. and Fromageries Bel S.A. (Filed as Exhibit
                10.21
                on Form 8-K filed July 26, 2005.)* 10.22
            
            Note
                and Warrant Purchase Agreement dated September 12, 2005 between Galaxy
                Nutritional Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit
                10.22 on
                Form 8-K filed September 16, 2005.)* 10.23
            
            Note
                and Warrant Purchase Agreement dated September 28, 2005 between Galaxy
                Nutritional Foods, Inc. and Conversion Capital Master, Ltd. (Filed
                as
                Exhibit 10.23 on Form 8-K filed October 4, 2005.)* 10.24
            
            Note
                and Warrant Purchase Agreement dated September 28, 2005 between Galaxy
                Nutritional Foods, Inc. andSRB
                Greenway Capital, L.P.(Filed as Exhibit 10.24 on Form 8-K filed October 4,
                2005.)* 10.25
            
            Note
                and Warrant Purchase Agreement dated September 28, 2005 between Galaxy
                Nutritional Foods, Inc. andSRB
                Greenway Capital (Q.P.), L.P.(Filed as Exhibit 10.25 on Form 8-K filed October 4,
                2005.)* 10.26
            
            Note
                and Warrant Purchase Agreement dated September 28, 2005 between Galaxy
                Nutritional Foods, Inc. andSRB
                Greenway Offshore Operating Fund, L.P.(Filed as Exhibit 10.26 on Form 8-K filed October 4,
                2005.)*
                10.27
            
            First
                Amendment to Note and Warrant Purchase Agreement dated October 7,
                2005
                between Galaxy Nutritional Foods, Inc. and Frederick A. DeLuca (Filed
                as
                Exhibit 10.27 on Form 10-Q for the fiscal quarter ended September
                30,
                2005.)* 10.28
            
            Fifth
                Amendment to Loan and Security Agreement dated November 14, 2005
                between
                Galaxy Nutritional Foods, Inc. and Textron Financial Corporation
                (Filed as
                Exhibit 10.28 on Form 10-Q for the fiscal quarter ended September
                30,
                2005.)* 10.29
            
            Sixth
                Amendment to Loan and Security Agreement dated May 26, 2006 between
                Galaxy
                Nutritional Foods, Inc. and Textron Financial Corporation (Filed
                as
                Exhibit 10.29 on Form 8-K filed June 1, 2006.)* 10.30
            
            Receivables
                Purchase Agreement, together with Addendum, dated June 23, 2006 between
                Galaxy Nutritional Foods, Inc. and Systran Financial Services Corporation
                (Filed as Exhibit 10.30 on Form 8-K filed June 29,
                2006.)* 10.31
            
            Note
                Purchase Agreement dated July 19, 2006 between Galaxy Nutritional
                Foods,
                Inc. and Frederick A. DeLuca (Filed as Exhibit 10.31 on Form 8-K
                filed
                July 25, 2006.)* 10.32
            
            Termination
                Agreement dated July 31, 2006 between Galaxy Nutritional Foods, Inc.
                and
                CLP Industrial Properties (Filed as Exhibit 10.32 on Form 8-K filed
                August
                3, 2006.)* 10.33
            
            Non-plan
                Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated
                August 7, 2006 in favor of Peter J. Jungsberger (Filed as Exhibit
                10.33 on
                Form 10-Q for the fiscal quarter ended June 30, 2006.)* 10.34
            
            Non-plan
                Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated
                August 7, 2006 in favor of Robert S. Mohel (Filed as Exhibit 10.34
                on Form
                10-Q for the fiscal quarter ended June 30, 2006.)* 10.35
            
            Non-plan
                Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated
                August 17, 2006 in favor of David H. Lipka (Filed as Exhibit 10.35
                on Form
                8-K filed August 21, 2006.)* 10.36
            
            Non-plan
                Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated
                August 17, 2006 in favor of Michael E. Broll (Filed as Exhibit 10.36
                on
                Form 8-K filed August 21, 2006.)* 10.37
            
            Non-plan
                Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated
                August 17, 2006 in favor of Angelo S. Morini (Filed as Exhibit 10.37
                on
                Form 8-K filed August 21, 2006.)




36




* 10.38
            
            Sublease
                Agreement dated October 3, 2006 between Galaxy Nutritional Foods,
                Inc. and
                Oracle Corporation (Filed as Exhibit 10.38 on Form 8-K filed October
                10,
                2006.)* 10.39
            
            Letter
                Agreement accepted November 9, 2006 between Galaxy Nutritional Foods,
                Inc.
                and Schreiber Foods, Inc. amending the Supply Agreement dated June
                30,
                2005 between the parties. Portions of the Letter Agreement have been
                omitted as indicated by asterisks pursuant to a request for confidential
                treatment in accordance with Section 552(b)(4) of the Freedom of
                Information Act ("FOIA"), 5 U.S.C. 552(b)(4) (Filed as Exhibit 10.39
                on
                Form 10-Q for the fiscal quarter ended September 30,
                2006.)* 14.1
            
            Code
                of Ethics (Filed as Exhibit 14.1 on Form 10-K for the fiscal year
                ended
                March 31, 2005.)* 20.1
            
            Audit
                Committee Charter (Filed as Exhibit 20.1 on Form 10-Q for the fiscal
                quarter ended September 30, 2003.)* 20.2
            
            Compensation
                Committee Charter (Filed as Exhibit 20.2 on Form 10-Q for the fiscal
                quarter ended September 30, 2003.)31.1
            
            Section
                302 Certification of our Chief Executive Officer(*Filed
                herewith.*)31.2
            
            Section
                302 Certification of our Chief Financial Officer (*Filed
                herewith.*)32.1
            
            Section
                906 Certification of our Chief Executive Officer (*Filed
                herewith.*)32.2
            
            Section
                906 Certification of our Chief Financial Officer (*Filed
                herewith.*)





*
            Previously
                filed and incorporated herein by
                reference.


37


**SIGNATURES**








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










**GALAXY
              NUTRITIONAL FOODS, INC.**Date:
                February 13, 2007
            /s/
                Michael E. BrollMichael
                E. BrollChief
                Executive Officer(Principal
                Executive Officer)Date:
                February 13, 2007
            /s/
                Salvatore J. FurnariSalvatore
                J. FurnariChief
                Financial Officer(Principal
                Accounting and Financial Officer)








38