UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-Q


________________________________________________________________________________


(Mark
One)


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





For
the quarterly period ended December 31, 2008





OR





 ̈   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
            (IRS
      Employer Identification No.)incorporation
      or organization)





6280
      Hazeltine National Drive
            32822Orlando,
      Florida
            (Zip
      Code)(Address
      of principal executive offices)


1-407-855-5500


(Registrant’s
telephone number, including area code)





5955
      T.G. Lee Blvd, Suite 201Orlando,
      Florida 32822(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 þ                                No
 ̈





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





Large
accelerated filer   ̈                                                                      Accelerated
filer   ̈                                   Non-accelerated
filer   ̈Smaller reporting
company  þ


(Do not
check if a smaller


reporting
company)





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


Yes  ̈                                No
þ





On February 10, 2009, there were
27,051,294 shares of common stock, $.01 par value per share,
outstanding.









GALAXYNUTRITIONAL FOODS,
INC.





Index to Form 10-Q


For
the Quarter Ended December 31, 2008











Page
      No.PART
      I.
            
            
            FINANCIAL
      INFORMATIONItem
      1.
            Financial
      StatementsBalance Sheets
            1Statements of Income
            2Statement of Stockholders’ Equity
    (Deficit)
            3Statements of Cash Flows
            4Notes to Financial Statements
            5Item
      2.
            Management's Discussion and Analysis of Financial
      Conditionand
      Results of Operations
            14Item
      4T.
            Controls and Procedures
            23PART
      II.
            
            OTHER
      INFORMATIONItem
      1A.
            Risk Factors
            24Item
      5.
            Other Information
            26Item
      6.
            Exhibits
            27SIGNATURES
            
            
            30








Index


PART I.  FINANCIAL
INFORMATION


GALAXY
NUTRITIONAL FOODS, INC.


Balance Sheets





DECEMBER
      31,
                
                
                MARCH
      31,Notes
                
                
                2008
                
                
                2008(Unaudited)ASSETS
                
                
                2CURRENT
      ASSETS:Cash
                
                
                
                
                
                $
                2,901,079
                
                
                $
                1,893,425Trade
      receivables, net
                
                
                
                
                
                
                2,172,812
                
                
                
                2,516,496Inventories,
      net
                
                
                
                
                
                
                163,667
                
                
                
                116,902Prepaid
      expenses and other
                
                
                
                
                
                
                186,752
                
                
                
                95,906Total
      current assets
                
                
                
                
                
                
                5,424,310
                
                
                
                4,622,729PROPERTY
      AND EQUIPMENT, NET
                
                
                
                
                
                
                51,504
                
                
                
                65,671OTHER
      ASSETS
                
                
                
                
                
                
                49,385
                
                
                
                68,463TOTAL
                
                
                
                
                
                $
                5,525,199
                
                
                $
                4,756,863LIABILITIES
      AND STOCKHOLDERS’ EQUITY (DEFICIT)CURRENT
      LIABILITIES:Secured
      borrowings
                
                
                2
                
                
                $
                --
                
                
                $
                --Accounts
      payable
                
                
                
                
                
                
                1,801,681
                
                
                
                1,393,810Accrued
      and other current liabilities
                
                
                
                
                
                
                393,858
                
                
                
                1,028,049Accrued
      employment contracts
                
                
                3
                
                
                
                2,154
                
                
                
                282,599Related
      party note payable
                
                
                1,2
                
                
                
                --
                
                
                
                2,685,104Total
      current liabilities
                
                
                
                
                
                
                2,197,693
                
                
                
                5,389,562COMMITMENTS
      AND CONTINGENCIES
                
                
                4
                
                
                
                --
                
                
                
                --STOCKHOLDERS’
      EQUITY (DEFICIT):Common
      stock
                
                
                
                
                
                
                270,513
                
                
                
                171,100Additional
      paid-in capital
                
                
                
                
                
                
                73,488,033
                
                
                
                70,167,149Accumulated
      deficit
                
                
                
                
                
                
                (70,431,040
                )
                
                
                (70,970,948
                )Total
      stockholders’ equity (deficit)
                
                
                
                
                
                
                3,327,506
                
                
                
                (632,699
                )TOTAL
                
                
                
                
                
                $
                5,525,199
                
                
                $
                4,756,863







See
accompanying notes to financial statements


1
 Index


GALAXY
NUTRITIONAL FOODS, INC.


Statements of Income


(UNAUDITED)








THREE
      MONTHS ENDED
                    DECEMBER
      31,
                  
                  
                  NINE
      MONTHS ENDED
                    DECEMBER
      31,Notes
                  
                  
                  2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Net
      Sales
                  
                  
                  
                  
                  $
                  6,261,613
                  
                  
                  $
                  6,446,099
                  
                  
                  $
                  18,413,893
                  
                  
                  $
                  18,763,360Cost
      of Goods Sold
                  
                  
                  
                  
                  
                  4,310,492
                  
                  
                  
                  4,145,200
                  
                  
                  
                  12,514,672
                  
                  
                  
                  11,346,406GROSS
      MARGIN
                  
                  
                  
                  
                  
                  1,951,121
                  
                  
                  
                  2,300,899
                  
                  
                  
                  5,899,221
                  
                  
                  
                  7,416,954OPERATING
      EXPENSES:Selling
                  
                  
                  
                  
                  
                  770,199
                  
                  
                  
                  871,797
                  
                  
                  
                  2,300,375
                  
                  
                  
                  2,702,038Delivery
                  
                  
                  
                  
                  
                  265,134
                  
                  
                  
                  263,923
                  
                  
                  
                  758,191
                  
                  
                  
                  772,786General and administrative
                  
                  
                  
                  
                  
                  550,944
                  
                  
                  
                  672,530
                  
                  
                  
                  1,800,850
                  
                  
                  
                  1,883,647Employment contract expense-general and administrative
                  
                  
                  3
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  346,447Research and development
                  
                  
                  
                  
                  
                  
                  75,409
                  
                  
                  
                  86,511
                  
                  
                  
                  218,685
                  
                  
                  
                  249,506Loss on disposal of assets
                  
                  
                  
                  
                  
                  
                  --
                  
                  
                  
                  512
                  
                  
                  
                  --
                  
                  
                  
                  512Total
      operating expenses
                  
                  
                  
                  
                  
                  
                  1,661,686
                  
                  
                  
                  1,895,273
                  
                  
                  
                  5,078,101
                  
                  
                  
                  5,954,936INCOME
      FROM OPERATIONS
                  
                  
                  
                  
                  
                  
                  289,435
                  
                  
                  
                  405,626
                  
                  
                  
                  821,120
                  
                  
                  
                  1,462,018INTEREST
      EXPENSE, NET
                  
                  
                  
                  
                  
                  
                  (65,356
                  )
                  
                  
                  (110,261
                  )
                  
                  
                  (281,212
                  )
                  
                  
                  (343,313
                  )INCOME
      BEFORE TAXES
                  
                  
                  
                  
                  
                  
                  224,079
                  
                  
                  
                  295,365
                  
                  
                  
                  539,908
                  
                  
                  
                  1,118,705INCOME
      TAX EXPENSE
                  
                  
                  
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  (12,000
                  )NET
      INCOME
                  
                  
                  
                  
                  
                  $
                  224,079
                  
                  
                  $
                  295,365
                  
                  
                  $
                  539,908
                  
                  
                  $
                  1,106,705BASIC
      NET INCOME PER COMMON SHARE
                  
                  
                  6
                  
                  
                  $
                  0.01
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.03
                  
                  
                  $
                  0.06DILUTED
      NET INCOME PER COMMON SHARE
                  
                  
                  6
                  
                  
                  $
                  0.01
                  
                  
                  $
                  0.01
                  
                  
                  $
                  0.03
                  
                  
                  $
                  0.05








See
accompanying notes to financial statements.


2
 Index


GALAXY
NUTRITIONAL FOODS, INC.


Statement of Stockholders’ Equity (Deficit)


Nine
Months Ended December 31, 2008


(UNAUDITED)








Common
      StockNotes
                  
                  
                  Shares
                  
                  
                  Par
      Value
                  
                  
                  Additional
                    Paid-In
      Capital
                  
                  
                  Accumulated
      Deficit
                  
                  
                  TotalBalance
      at March 31, 2008
                  
                  
                  
                  
                  
                  17,110,016
                  
                  
                  $
                  171,100
                  
                  
                  $
                  70,167,149
                  
                  
                  $
                  (70,970,948
                  )
                  
                  $
                  (632,699
                  )Conversion
      of related party note into common stock
                  
                  
                  2
                  
                  
                  
                  9,941,278
                  
                  
                  
                  99,413
                  
                  
                  
                  3,380,034
                  
                  
                  
                  --
                  
                  
                  
                  3,479,447Costs
      associated with issuance of common stock
                  
                  
                  2
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  (59,150
                  )
                  
                  
                  --
                  
                  
                  
                  (59,150
                  )Net
      income
                  
                  
                  
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  --
                  
                  
                  
                  539,908
                  
                  
                  
                  539,908Balance
      at December 31, 2008
                  
                  
                  
                  
                  
                  
                  27,051,294
                  
                  
                  $
                  270,513
                  
                  
                  $
                  73,488,033
                  
                  
                  $
                  (70,431,040
                  )
                  
                  $
                  3,327,506






















































See
accompanying notes to financial statements


3
 Index


GALAXY
NUTRITIONAL FOODS, INC.


Statements of Cash Flows


(UNAUDITED)











Nine
      Months Ended December 31,
                    
                    Notes
                    
                    
                    2008
                    
                    
                    2007CASH
      FLOWS FROM (USED IN) OPERATING ACTIVITIES:
                    
                    
                    7Net
      Income
                    
                    
                    
                    
                    
                    $
                    539,908
                    
                    
                    $
                    1,106,705Adjustments
      to reconcile net income to net cash from (used in) operating
      activities:Depreciation
      and amortization
                    
                    
                    
                    
                    
                    
                    33,950
                    
                    
                    
                    33,308Amortization
      of debt discount and financing costs
                    
                    
                    
                    
                    
                    
                    19,078
                    
                    
                    
                    36,117Provision
      for future credits and doubtful accounts on trade
    receivables
                    
                    
                    
                    
                    
                    
                    (387,233
                    )
                    
                    
                    (632,500
                    )Inventory
      reserve
                    
                    
                    
                    
                    
                    
                    (31,533
                    )
                    
                    
                    5,615Loss
      on disposal of assets
                    
                    
                    
                    
                    
                    
                    --
                    
                    
                    
                    512(Increase)
      decrease in:Trade
      receivables
                    
                    
                    
                    
                    
                    
                    730,917
                    
                    
                    
                    703,643Inventories
                    
                    
                    
                    
                    
                    
                    (15,232
                    )
                    
                    
                    271,259Prepaid
      expenses and other
                    
                    
                    
                    
                    
                    
                    (90,846
                    )
                    
                    
                    (3,007
                    )Increase
      (decrease) in:Accounts
      payable
                    
                    
                    
                    
                    
                    
                    407,871
                    
                    
                    
                    (308,204
                    )Accrued
      and other liabilities
                    
                    
                    
                    
                    
                    
                    (120,293
                    )
                    
                    
                    (79,443
                    )NET
      CASH FROM OPERATING ACTIVITIES
                    
                    
                    
                    
                    
                    
                    1,086,587
                    
                    
                    
                    1,134,005CASH
      FLOWS FROM (USED IN) INVESTING ACTIVITIES:Purchase
      of property and equipment
                    
                    
                    
                    
                    
                    
                    (19,783
                    )
                    
                    
                    (14,345
                    )NET
      CASH USED IN INVESTING ACTIVITIES
                    
                    
                    
                    
                    
                    
                    (19,783
                    )
                    
                    
                    (14,345
                    )CASH
      FLOWS FROM (USED IN) FINANCING ACTIVITIES:Net
      payments on secured borrowings
                    
                    
                    
                    
                    
                    
                    --
                    
                    
                    
                    (556,886
                    )Costs
      associated with issuance of common stock
                    
                    
                    2
                    
                    
                    
                    (59,150
                    )
                    
                    
                    --NET
      CASH USED IN FINANCING ACTIVITIES
                    
                    
                    
                    
                    
                    
                    (59,150
                    )
                    
                    
                    (556,886
                    )NET
      INCREASE IN CASH
                    
                    
                    7
                    
                    
                    
                    1,007,654
                    
                    
                    
                    562,774CASH,
      BEGINNING OF PERIOD
                    
                    
                    
                    
                    
                    
                    1,893,425
                    
                    
                    
                    879,487CASH,
      END OF PERIOD
                    
                    
                    
                    
                    
                    $
                    2,901,079
                    
                    
                    $
                    1,442,261

















See
accompanying notes to financial statements.


4
 Index


GALAXY
NUTRITIONAL FOODS, INC.


Notes to Financial Statements


(UNAUDITED)





(1)           Summary of Significant
Accounting Policies


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, 2008 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, 2008.  Interim
results of operations for the three and nine months ended December 31, 2008 may
not necessarily be indicative of the results to be expected for the full
year.





Nature of Business and Going
Concern


The
Company develops and internationally markets plant-based cheese alternatives,
organic dairy and other organic and natural food products to grocery and natural
foods retailers, mass merchandisers and food service accounts. Galaxy
Nutritional Foods Veggie®, the leading brand in the grocery cheese alternative
category and the 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: Galaxy Nutritional
Foods Rice®, Veggy®, Vegan®, Rice Vegan®, and Wholesome Valley Organic®. Galaxy
Nutritional Foods, Inc. is dedicated to developing nutritious and delicious food
products made with high quality natural ingredients that exceed the expectations
of today’s health conscious consumers. The Company is also committed to reducing
its environmental impact as part of its Eat Green for Body & EarthTM program
that offsets carbon emissions associated with product shipping and emphasizes
the use of organic ingredients.  The Company headquarters are located
in Orlando, Florida, and its common stock is quoted on the OTC Bulletin Board
under the symbol “GXYF.”





Schreiber
Foods, Inc., a Wisconsin corporation (“Schreiber”), manufactures and distributes
substantially all of the Company’s products in accordance with a Supply
Agreement that was signed on June 30, 2005 (See Note 4).  Schreiber
uses the Company’s formulas and processes to manufacture products for the
Company’s customers.  The prices for such products are based on cost
plus a processing fee as determined by the parties from time to
time.





As of
March 31, 2008, the Company’s ability to continue as a going concern depended
upon successfully refinancing or obtaining sufficient cash resources to pay its
Convertible Note and accrued interest thereon (see Note 2) and obtaining
positive cash flow from operations to sustain normal business
operations.





On
November 18, 2008, the Company, Mr. Frederick A. DeLuca and Galaxy Partners,
L.L.C., a Minnesota limited liability company (“Galaxy Partners”) entered into a
Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the
Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to
Galaxy Partners his 3,869,842 shares of the Company’s common stock and assigned
to Galaxy Partners all of his right, title and interest in and to the
Convertible Note. In connection with the Purchase Agreement and in accordance
with the terms of the Convertible Note, Galaxy Partners converted all of the
outstanding principal and accrued interest under the Convertible Note totaling $3,479,447
into 9,941,278 shares of the Company’s common stock. As a result of the Purchase Agreement andconversion of the Convertible Note into 9,941,278 shares, Galaxy Partners
acquired an aggregate of 13,811,120 shares of the Company’s common stock and
consequently became the majority stockholder, owning approximately 51.1% of the
27,051,294 issued and outstanding shares of the Company’s common
stock.  As a result of the conversion of the Convertible Note, the
strength of the Company’s balance sheet greatly improved with no further debt
obligations and stockholders’ equity greater than $3
million.  Therefore, management does not believe there currently is
any remaining issue with the Company’s ability to operate as a going concern in
the near future.








5
 Index





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 ranges from 4 months to one year, the Company historically averages
less than 2% of gross sales 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.





Non-Cash Compensation
Related to Stock-Based Transactions


Statement
of Financial Accounting Standard (“FAS”) No. 123 (revised 2004), “Share-Based Payment,” (“FAS
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.





FAS 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
option-pricing model to value its new stock option grants under FAS No. 123R.
FAS No. 123R also requires the Company to estimate forfeitures in calculating
the expense related to stock-based compensation. Additionally, FAS No. 123R
requires the Company to reflect cash flows resulting from excess tax benefits
related to those options as a cash inflow from financing activities rather than
as a reduction of taxes paid.





There
were no issuances of stock awards or vesting of prior unvested stock awards
during the three and nine months ended December 31, 2008 and
2007.  Therefore, there were no assumptions under the Black-Scholes
option-pricing model and no stock-based compensation expense during the
three and nine months ended December 31, 2008 and 2007.





Net Income per Common
Share


Basic net
income per common share is computed by dividing net income by the weighted
average shares outstanding. Diluted net income per common share is computed by
dividing adjusted net income by the weighted average shares outstanding plus
potential common shares which would arise from the exercise of stock options and
warrants using the treasury stock method and conversion of convertible debt
using the if-converted method.





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 trade receivables, inventory reserves, valuation of deferred taxes
and valuation of non-cash compensation related to stock-based
transactions.  Actual results could differ from these
estimates.





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 10 other
countries.





Recent Accounting
Pronouncements





In
February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB
Staff Position (“FSP”) 157-1, “Application of FASB Statement No.
157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address
Fair Value Measurements for Purposes of Lease Classification or Measurement
under Statement 13,” (“FSP FAS 157-1”).  FSP FAS 157-1 amends
FAS No. 157 to remove certain leasing transactions from its scope and is
effective upon the initial adoption of FAS No. 157 which the Company adopted
beginning April 1, 2008.  Additionally in February 2008, FASB issued
FSP FAS 157-2, “Effective Date
of FASB Statement No. 157,”which amends FAS No. 157 by delaying its
effective date by one year for non-financial assets and non-financial
liabilities, except for items that are recognized or disclosed at fair value in
the financial statements on a recurring basis.  Accordingly, the
Company will begin applying fair value measurements for all non-financial assets
and non-financial liabilities on April 1, 2009.


6
 Index


In May
2008, FASB issued FSP APB 14-1, “Accounting for Convertible Debt
Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement)” (“FSP APB 14-1”). This FSP specifies that issuers of such
instruments should separately account for the liability and equity components in
a manner that will reflect the entity's nonconvertible debt borrowing rate when
interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008
and interim periods within those fiscal years, and is applied retrospectively to
all periods presented. The Company is currently evaluating the impact of
adopting FSP APB 14-1 on its results of operations and financial
position.





In June
2008, FASB issued FSP EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating
Securities.” The FSP concluded that unvested share-based payment awards
that contain nonforfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities under FASB No. 128, “Earnings per Share,” and
should be included in the computation of earnings per share under the two-class
method. The two-class method is an earnings allocation formula used to determine
earnings per share for each class of common stock according to dividends
declared and participation rights in undistributed earnings. FSP EITF 03-6-1 is
effective for financial statements issued for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years, and is applied
retrospectively to all periods presented.  The Company does not expect
that the adoption of this FSP will have a material impact on its results of
operations or financial position.





In June
2008, the FASB’s Emerging Issues Task Force reached a consensus regarding EITF
Issue No. 07-5, “Determining
Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own
Stock” (EITF 07-5). EITF 07-5 outlines a two-step approach to evaluate
the instrument’s contingent exercise provisions, if any, and to evaluate the
instrument’s settlement provisions when determining whether an equity-linked
financial instrument (or embedded feature) is indexed to an entity’s own stock.
EITF 07-5 is effective for fiscal years beginning after December 15, 2008 and
must be applied to outstanding instruments as of the beginning of the fiscal
year of adoption as a cumulative-effect adjustment to the opening balance of
retained earnings. Early adoption is not permitted. The Company is currently
evaluating the impact of adopting EITF 07-5 on its results of operations and
financial position.





The
Recent Accounting Pronouncements should be read in conjunction with the
pronouncements included in the Company’s Annual Report on Form 10-K for the
fiscal year ended March 31, 2008.





Income
Taxes


The
Company follows the provisions of the FASB 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.  The Company has not recognized a liability as a result of the
implementation of FIN 48.  A reconciliation of the beginning and
ending amount of unrecognized tax benefits has not been provided since there is
no unrecognized benefit as of the date of adoption.  The Company has
not recognized interest expense or penalties as a result of the implementation
of FIN 48.  If there were an unrecognized tax benefit, the Company
would recognize interest accrued related to unrecognized tax benefits in
interest expense and penalties in operating expenses.  The Company
files income tax returns in the U.S. federal jurisdiction and in various
states.





Deferred
income taxes are recognized for the tax consequences of temporary differences
between the financial reporting bases and the tax bases of the Company’s assets
and liabilities in accordance with FAS No. 109, “Accounting for Income Taxes.”
Valuation allowances are established when necessary to reduce deferred tax
assets to the amount expected to be realized.  Income tax expense is
the tax payable or refundable for the period plus or minus the change during the
period in deferred tax assets and liabilities.





Financial
Instruments


In April
2008, the Company adopted FAS No. 157, “Fair Value Measurements,”(“FAS No. 157”) to value its financial assets and liabilities. The
adoption of FAS No. 157 did not have a significant impact on the Company’s
results of operations, financial position or cash flows.  FAS No.
157 defines fair value, establishes a framework for measuring fair value under
GAAP and expands disclosures about fair value measurements.  FAS No.
157 defines fair value as the exchange price that would be paid by an external
party for an asset or liability (exit price).  FAS No. 157 also
establishes a fair value hierarchy which requires an entity to maximize the use
of observable inputs and minimize the use of unobservable inputs when measuring
fair value.  Three levels of inputs may be used to measure fair
value:




7
 Index


·
            Level 1 – Active market
      provides quoted prices for identical assets or
  liabilities;


·
            Level2 – Inputs other than
      quoted prices included within Level 1 that are either directly or
      indirectly observable with market data;
and


·
            Level 3 – Unobservable
      inputs that are supported by little or no market activity, therefore
      requiring an entity to develop its own assumptions about the assumptions
      that market participants would use in
pricing.





Fair
value estimates discussed herein are based upon certain market assumptions and
pertinent information available to management as of December 31, 2008. The
Company uses the market approach to measure fair value for its Level 1 financial
assets and liabilities.  The market approach uses prices and other
relevant information generated by market transactions involving identical or
comparable assets or liabilities.  The respective carrying value of
certain on-balance-sheet financial instruments approximated their fair
values.  These financial instruments which include cash, trade
receivables, secured borrowings, related party note payable, accounts payable
and accrued liabilities are valued using Level 1 inputs and are immediately
available without market risk to principal.  Fair values were assumed
to approximate carrying values for these financial instruments since they are
short term in nature and their carrying amounts approximate fair values or they
are receivable or payable on demand.  The Company does not have other
financial assets that would be characterized as Level 2 or Level 3
assets.





FAS No.
157 is effective for non-financial assets and liabilities for the Company’s
fiscal year beginning April 1, 2009.  The Company is currently
assessing the impact of this pronouncement as it relates to non-financial assets
and liabilities.








(2)           Secured Borrowings and
Related Party Note Payable


Secured
Borrowings


On June
23, 2006, the Company entered into a Receivables Purchase Agreement with
Commercial Finance Division, a subsidiary of Textron Financial Corporation
(“Commercial Finance”), whereby Commercial Finance provides financing to the
Company through advances against certain trade receivable invoices due to the
Company (the “Commercial Finance Agreement”).  The Commercial Finance
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 Commercial Finance 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 are currently
set at 7% and $100,000, respectively.  Advances under the Commercial
Finance Agreement bear interest at a variable rate equal to the prime rate plus
1.5% per annum (4.75% on December 31, 2008).  However, the Commercial
Finance Agreement requires a $4,500 minimum monthly interest charge to be
assessed.   The Company is also obligated to pay a $1,500 monthly
service fee.





The
initial term of the Commercial Finance Agreement ends on June 23, 2009 and may
renew automatically for consecutive twelve-month terms unless terminated
sooner.  The Commercial Finance Agreement may be accelerated in the
event of certain defaults by the Company including among other things, a default
in the Company’s payment and/or performance of any obligation to Commercial
Finance or any other financial institution, creditor, or bank; and any change in
the conditions, financial or otherwise, of the Company which reasonably causes
Commercial Finance to deem itself insecure.  In such an event,
interest on the Company’s borrowings would accrue at the greater of twelve
percent per annum or the variable rate of prime plus 1.5% and the Company would
be liable for an early termination premium of 1% on the maximum principal amount
available under the Commercial Finance Agreement.  Although the
Company had approximately $1.5 million available to draw pursuant to this
Commercial Finance Agreement as of December 31, 2008, there were no amounts
advanced, because the Company did not need additional cash on such
date.





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





Related Party Note
Payable


Pursuant
to a Note Purchase Agreement dated July 19, 2006, as amended on March 14, 2007,
the Company issued an unsecured convertible note for $2,685,104 (the
“Convertible Note”) to Mr. Frederick A. DeLuca.  The proceeds from the
Convertible Note were used to repay or refinance several notes totaling $2.4
million that matured on June 15, 2006 and a $285,104 registration rights penalty
owed to Mr. DeLuca. The Convertible Note accrued interest at 12.5% per annum and
matured on October 19, 2008.  No interest or principal payments were
required under the Convertible Note until its maturity.  Principal,
together with any accrued and unpaid interest, on the Convertible Note was
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


8
 Index


closing
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 was amortized from July 2006 through October 2007.





The
Company recorded interest expense related to the Convertible Note in the amount
of $45,684 and $216,300 in the three and nine months ended December 31, 2008,
respectively and  $85,774 and $256,390 in the three and nine months
ended December 31, 2007, respectively.   Additionally, the
Company amortized $1,289 and $7,960 of debt discount to interest expense in the
three and nine months ended December 31, 2007, respectively.





On
November 18, 2008, the Company, Mr. DeLuca and Galaxy Partners entered into a
Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the
Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to
Galaxy Partners his 3,869,842 shares of the Company’s common stock and assigned
to Galaxy Partners all of his right, title and interest in and to the
Convertible Note. In connection with the Purchase Agreement and in accordance
with the terms of the Convertible Note, Galaxy Partners converted all of the
outstanding principal and accrued interest under the Convertible Note totaling
$3,479,447 into 9,941,278 shares of the Company’s common stock.  The
Company recorded $59,150 of stock issuance costs related to these transactions
to additional paid in capital in the three months ended December 31,
2008.





(3)           Related Party
Transactions


Change in
Control


As a
result of the Purchase Agreement and conversion of the Convertible Note into
9,941,278 shares described in Note 2, Galaxy Partners acquired an aggregate of
13,811,120 shares of the Company’s common stock and consequently became the
majority stockholder, owning approximately 51.1% of the 27,051,294 issued and
outstanding shares of the Company’s common stock.  Galaxy Partners is
comprised of seven members.  In consideration of the conversion of the
Convertible Note, the Company agreed to expand the size of its Board from 4 to 7
members and elected three of the seven members of Galaxy Partners to the Board -
David B. Johnson, Timothy S. Krieger and Michael D. Slyce.  Mr.
Krieger holds a 40% individual ownership in Galaxy Partners. Mr. Johnson and Mr.
Slyce each hold a 7.5% individual ownership in Galaxy Partners.  As
the sole Governor/Director and CEO of Galaxy Partners, Mr. Krieger has the sole
voting authority over all the 13,811,120 shares held by Galaxy
Partners.





In
connection with the Purchase Agreement, Galaxy Partners obtained financing in
the amount of $5,500,000 (the “Financing”) from Robert O. Schachter, who is one
of the seven members of Galaxy Partners.  Pursuant to the terms of the
Financing, the membership interests of Galaxy Partners owned by the majority of
the remaining members of Galaxy Partners, including those owned by Messrs.
Johnson, Krieger and Slyce, were pledged to Mr. Schachter.  In the
event of default under the Financing, Mr. Schachter would be entitled to
foreclose on the pledged interests, in which event Mr. Schachter would then
indirectly own a majority of the Company’s common stock, which would constitute
a further change in control of the Company.





Consulting Agreement between
Galaxy Partners and the Chairman of the Board


Effective
November 18, 2008 with the closing of the Purchase Agreement and upon waiving
his rights under the 2007 Stay, Severance and Sales Bonus Plan (see Note 4),
David H. Lipka, Chairman of the Board, entered into a Consulting Agreement with
Galaxy Partners and Fairway Dairy and Ingredients LLC, an affiliate of Galaxy
Partners (“Fairway”).  Under the Consulting Agreement, and in view of
Galaxy Partner’s substantial investment in the Company, Mr. Lipka has been
engaged as an independent consultant of Galaxy Partners to serve for three years
as, and in the capacity of, an adviser and consultant to the management of
Galaxy Partners and Fairway.  In exchange for his services, Mr. Lipka
is to receive aggregate consideration of $500,000, $300,000 of which was paid by
Galaxy Partners upon the execution of the Purchase Agreement.  The
Company is not a party to the Consulting Agreement and has no obligations under
it.





Michael E. Broll


Effective
with the signing of the Purchase Agreement on November 18, 2008, Mr. Broll
entered into an amendment to his employment agreement with the Company, whereby
he would continue as its Chief Executive Officer and Board member through March
31, 2009.  Mr. Broll also serves as President of the
Company.  In the event that the parties do not enter into a new
employment arrangement, then upon receipt of Mr. Broll’s resignation as the
Company’s Chief Executive Officer and from the Company’s Board of Directors on
March 31, 2009, in consideration of his staying with the Company during the
transition period subsequent to the change of control in the Company and in
recognition of his waiver of his rights under the 2007 Stay, Severance and Sales
Bonus Plan (see Note 4), the Company will pay Mr.


9
 Index


Broll
compensation of $20,000 per month for 25 consecutive months beginning on April
1, 2009 less any applicable federal and/or state taxes.





Angelo S.
Morini


In a
Second Amended and Restated Employment Agreement effective October 13, 2003,
Angelo S. Morini, the Company’s Founder, 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.   Mr. Morini remained a director of
the Company until his resignation on March 8, 2007.  The agreement was
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 was 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 cost expensed and accrued under this
agreement in October 2003 was $1,830,329 and it was paid in full through nearly
equal monthly installments ending in October 2008.





Christopher
Morini


On June
1, 2007, Christopher E. Morini resigned from his position as Vice President of
New Business Development.  In accordance with the Separation and
General Release Agreement which became effective on June 9, 2007, between the
Company and Mr. C. Morini, the Company accrued $346,447 for wages, health
insurance benefits and payroll taxes and expensed them under Employment Contract
Expense - General and Administrative in the Company’s Statement of Income in
June 2007.  After an initial lump sum payment of approximately
$100,087, the remaining obligation is being paid out in bi-weekly installments
through February 2009.  As of December 31, 2008, $2,154 remained
unpaid but accrued as a current liability.








(4)           Commitments and
Contingencies


Supply
Agreement


Schreiber
manufactures and distributes substantially all of the Company’s products in
accordance with a Supply Agreement that was signed on June 30, 2005 and amended
on November 3, 2006 and March 17, 2008.  Schreiber uses the Company’s
formulas and processes to manufacture products for the Company’s
customers.  The prices for such products are based on cost plus a
processing fee as determined by the parties from time to time.  The
major terms of the Supply Agreement are as follows:


·
            The
      Initial Term of the Supply Agreement is a period of fifteen years from
      June 30, 2005 to June 30, 2020.


·
            Schreiber
      may terminate the Supply Agreement prior to the end of the Initial Term,
      without penalty, upon provision of written notice to the Company issued at
      least six (6) months prior to such proposed termination
      date.  In such an event, the Company will use its commercially
      reasonable efforts to transition production of its products to a new
      supplier.  In the event the Company is unable to transition
      production for one or more of its products within such six (6) month
      period, upon the Company’s request, Schreiber will continue to provide
      such products to the Company, under the terms of the Supply Agreement, for
      an additional six (6) months after the date that would otherwise have been
      the effective date of such
termination.


·
            The
      Company may terminate the Supply Agreement prior to the end of the Initial
      Term, without penalty, upon provision of written notice to Schreiber
      issued at least six (6) months prior to such proposed termination date,
      provided that the effective date for such termination by the Company shall
      not be prior to December 31, 2012, unless a change of control of the
      Company shall have occurred, in which case the effective date for such
      termination by the Company shall not be prior to December 31,
      2010.  As a result of the change in control in November 2008
      (Note 3), the date is now set at December 31,
  2010.


·
            Schreiber
      may increase the processing fee component of the price once in any
      twelve-month period to reflect changes in labor and benefits, materials,
      utilities and energy.  If the proposed price exceeds the price
      at which the Company can obtain such item (either on its own or through
      another private labeling source), then the Company may elect such
      alternative source for such item.


·
            The
      Company may be required to pay a termination fee to Schreiber should it
      terminate the Supply Agreement prior to March 17, 2011.  The
      termination fee would total $5,100,000 if the Company terminates the
      Supply Agreement prior to March 17, 2009, $3,400,000 if the Company
      terminates the Supply Agreement prior to March 17, 2010 and $1,700,000 if
      the Company terminates the Supply Agreement prior to March 17,
      2011.  If the termination of the agreement is a result of a
      breach or termination by Schreiber, no termination fee would be
      due.  In addition, if there is a change of control in either the
      Company or Schreiber, the Company can terminate the agreement and no
      termination fee will be due unless the change of control results from the
      sale of the Company for a purchase price in excess of $50
      million.


10
 Index


As a result of the change in control in November 2008 (Note 3), the Company is
no longer subject to the termination fee described above.





Stay, Severance, Sales Bonus
Plan


On
December 10, 2007, the Company adopted a Stay Bonus, Severance Bonus and Sales
Bonus Plan (the “Plan”) to provide incentives and protections to certain key
executives and directors pursuant to a “Company Sale” (as defined), which
generally includes an acquisition of at least 60% of the Company’s outstanding
equity securities or acquisition of all or substantially all of the Company’s
assets prior to September 1, 2009.  The Plan provides for a stay bonus
pool up to $475,000 to be paid following the Company’s receipt of a definitive
purchase offer (as defined in the Plan) upon the earlier of the consummation of
a sale of the Company pursuant to such purchase offer or the termination of the
purchase offer (other than as a result of a breach by the
Company).  The stay bonus pool is to be paid $125,000 to David H.
Lipka, the Company’s Chairman, and $100,000 to Michael E. Broll, the Company’s
Chief Executive Officer.  The remaining $250,000 of the stay bonus
pool is currently unallocated and may be granted to other key executives at the
discretion of Messrs Lipka and Broll.  The Plan also provides for a
severance bonus of $125,000 to be paid to David H. Lipka and $100,000 to be paid
to Michael E. Broll in the event their positions are terminated other than for
Cause (as defined in the Plan) or they resign within one year after the
consummation of a sale of the Company.  Finally, the Plan provides for
a sales bonus pool to be determined based on a range of selling
prices.  The sales bonus pool will range from a minimum of $250,000 if
the sale is in excess of a specified minimum sales target and will increase up
to a maximum of 1.8% of the total sales price.  The sales bonus pool
will be allocated 55.5% to David H. Lipka and 44.5% to Michael E. Broll upon the
consummation of a sale of the Company. The Plan was approved unanimously by the
Board of Directors and separately by the two independent members of the
Board.





The
Purchase Agreement entered into on November 18, 2008 (Note 2) did not trigger a
change in control as defined in the Plan. However, effective November 18, 2008
with the closing of the Purchase Agreement, Mr. Lipka agreed to waive his rights
under the Plan (Note 3).  In accordance with the amendment to his
employment agreement on November 18, 2008, Mr. Broll also agreed to waive his
rights under the Plan if he does not continue his employment with the Company
after March 31, 2009 (Note 3).





Litigation


The
Company is currently a party to certain legal proceedings, claims, disputes and
litigation arising in the ordinary course of business. 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.





In June
2007, a civil action lawsuit was filed in Allegheny County, Pennsylvania by
Shawn Fuhr and his wife, Raquel Fuhr against All-Fill Corporation, Schreiber
Foods, Inc., Galaxy Nutritional Foods, Inc. and others.  Mr. Fuhr was
seeking damages against the defendants for injuries he sustained while cleaning
a machine that was manufactured by All-Fill, originally purchased and used by
Galaxy Nutritional Foods and then ultimately sold by Schreiber to his employer,
Castle Cheese, Inc.  On September 20, 2008, the parties reached a
settlement agreement totaling $3,362,500, of which $2,612,500 was apportioned to
Galaxy.  Zurich North America Insurance, the Company’s insurance
company, presided over all litigation matters and paid all litigation expenses
and settlement claims directly.  Therefore, there was no affect on
operations or the Company’s financial statements as a result of this
claim.








(5)
            Non-Cash Compensation
      Related to Stock-Based
Transactions


Effective
April 1, 2006, FAS 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 option-pricing model to value its new stock option grants under
FAS No. 123R.





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 March 31, 2008, there was no remaining
unrecognized compensation cost related to nonvested stock, and there were no
stock-based transactions during the three and nine months ended December 31,
2008 and 2007. Therefore, there was no stock-based compensation expense nor any
unrecognized compensation cost related to nonvested stock for the three and nine
months ended December 31, 2008 and 2007.


11
 Index


The
following table summarizes the Company’s plan and non-plan stock options
outstanding as of December 31, 2008, as well as activity during the nine months
then ended:


Shares
                              
                              Weighted-
                                Average
                                Exercise Price
                              
                              Weighted-
                                Average
                                Remaining
      Contractual Term in Years
                              
                              Aggregate
      Intrinsic ValueOutstanding
      at March 31, 2008
                              3,642,963
                              
                              $
                              2.72Granted
                              —
                              
                              
                              —Exercised
                              —
                              
                              
                              —Forfeited
      or expired
                              (215,144
                              )
                              
                              3.21Outstanding
      at  December 31, 2008
                              3,427,819
                              
                              $
                              2.69
                              
                              1.7
                              
                              $
                              -0-Exercisable
      at December 31, 2008
                              3,427,819
                              
                              $
                              2.69
                              
                              1.7
                              
                              $
                              -0-




There
were no options granted and thus no weighted-average fair value computed on
options during the three and nine months ended December 31, 2008 and
2007.  At December 31, 2008, 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, 2008 as quoted on
the OTC Bulletin Board was $0.20 per share.  There were no options
exercised during the three and nine months ended December 31, 2008 and 2007 and
therefore, no intrinsic value or cash received from option
exercises.








(6)           Earnings Per
Share


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


Three
      Months Ended
                                    December
      31,
                                  
                                  
                                  Nine
      Months Ended
                                    December
      31,2008
                                  
                                  
                                  2007
                                  
                                  
                                  2008
                                  
                                  
                                  2007Net
      income - basic
                                  
                                  $
                                  224,079
                                  
                                  
                                  $
                                  295,365
                                  
                                  
                                  $
                                  539,908
                                  
                                  
                                  $
                                  1,106,705Plus
      interest on convertible related party note payable
                                  
                                  
                                  --
                                  
                                  
                                  
                                  85,774
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  256,390Net
      income - diluted
                                  
                                  $
                                  224,079
                                  
                                  
                                  $
                                  381,139
                                  
                                  
                                  $
                                  539,908
                                  
                                  
                                  $
                                  1,363,095Weighted
      average shares outstanding – basic
                                  
                                  
                                  21,756,483
                                  
                                  
                                  
                                  17,110,016
                                  
                                  
                                  
                                  18,664,470
                                  
                                  
                                  
                                  17,110,016Potential
      shares issued upon conversion of  related party note
      payable
                                  
                                  
                                  --
                                  
                                  
                                  
                                  8,835,803
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  8,348,329Potential
      shares “in-the-money” under stock option and warrant
      agreements
                                  
                                  
                                  --
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  740,000Less:  Shares
      assumed repurchased under the treasury stock method
                                  
                                  
                                  --
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  --
                                  
                                  
                                  
                                  (662,069
                                  )Weighted
      average shares outstanding –diluted
                                  
                                  
                                  21,756,483
                                  
                                  
                                  
                                  25,945,819
                                  
                                  
                                  
                                  18,664,470
                                  
                                  
                                  
                                  25,536,276Basic
      net income per common share
                                  
                                  $
                                  0.01
                                  
                                  
                                  $
                                  0.02
                                  
                                  
                                  $
                                  0.03
                                  
                                  
                                  $
                                  0.06Diluted
      net income per common share
                                  
                                  $
                                  0.01
                                  
                                  
                                  $
                                  0.01
                                  
                                  
                                  $
                                  0.03
                                  
                                  
                                  $
                                  0.05





Options
for 3,597,394 and 3,627,406 shares and warrants for 617,442 and 952,058 shares
have not been included in the computation of diluted net income per common share
for the three and nine months ended December 31, 2008, respectively, as their
effects were antidilutive.  Options for 4,352,124 and 4,150,420 shares
and warrants for 1,158,001 and 997,662 shares have not been included in the
computation of diluted net income per common share for three and nine months
ended December 31, 2007, respectively, as their effects were
antidilutive.











12
 Index





(7)           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,
                    
                    2008
                    
                    
                    2007Non-cash financing and investing
      activities:Accrued
      interest converted into common stock
                    
                    $
                    794,343
                    
                    
                    $
                    --Related
      party note payable converted into common stock
                    
                    
                    2,685,104
                    
                    
                    
                    --Cash paid for:Interest
                    
                    $
                    45,834
                    
                    
                    $
                    50,805








(8)           Economic Dependence and
Segment Information


Pursuant
to the Supply Agreement with Schreiber, the Company purchased approximately 99%
and 98% of its total raw material purchases from Schreiber for the three and
nine months ended December 31, 2008, respectively, and approximately 100% and
99% of its total raw material purchases from Schreiber for the three and nine
months ended December 31, 2007, respectively.





For the
three months ended December 31, 2008 and 2007, the Company’s gross sales were
$6,551,093 and $6,888,900, respectively. For the nine months ended December 31,
2008 and 2007, the Company’s gross sales were $19,109,219 and $20,317,013,
respectively.





The
Company had one customer that accounted for approximately 19% and 17% of gross
sales for the three and nine months ended December 31, 2008,
respectively.  The Company had one customer that accounted for
approximately 16% of gross sales for the three and nine months ended December
31, 2007.  There were no customers whose balance outstanding was
greater than 10% of accounts receivable as of December 31, 2008 or
2007.





The
Company has one operating segment and sells to customers throughout the United
States, Puerto Rico, and the U.S. controlled Virgin Islands (together considered
the United States) and 10 foreign countries.  Gross sales derived from
foreign countries were approximately $677,000 and $999,000, representing 10% and
15% of gross sales for the three months ended December 31, 2008 and 2007,
respectively.  Gross sales derived from foreign countries were
approximately $2,107,000 and $2,759,000, representing 11% and 14% of gross sales
for the nine months ended December 31, 2008 and 2007,
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 gross sales to each foreign
country, which accounted for 10% or more of the Company’s foreign gross sales
for the three and nine months ended December 31, 2008 and 2007:





Percentage
      of Gross Foreign SalesThree
      Months Ended
                    December
      31,
                  
                  
                  Nine
      Months Ended
                    December
      31,Country
                  
                  2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Canada
                  
                  
                  96
                  %
                  
                  
                  85
                  %
                  
                  
                  85
                  %
                  
                  
                  87
                  %Other
                  
                  
                  5
                  %
                  
                  
                  15
                  %
                  
                  
                  15
                  %
                  
                  
                  13
                  %








(9)           Subsequent
Event


On
February 9, 2009, Andromeda Acquisition Corp. (“Andromeda”) announced that it
plans to make a cash tender offer to purchase all outstanding shares of the
Company for $0.36 per share.  Andromeda is a Delaware wholly-owned
subsidiary of MW1 LLC (“MW1”) formed solely for the purpose of making the tender
offer.  Currently, the sole member of MW1 is Mill Road Capital, L.P.,
a Delaware limited partnership formed by a core group of professionals to invest
in small public companies.  Andromeda announced that it plans to
commence the offer on or about February 13, 2009 and end the offer on or about
March 16, 2009.  Additionally, it is expected that Galaxy Partners,
the Company’s 51.1% majority shareholder, along with Mill Road Capital, L.P.
will contribute their 14,370,728 combined shares of the Company’s common stock
to MW1 prior to the expiration of the offer.


13
 Index


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:





·
            Paying
      or refinancing certain debt
obligations;




·
            Improving
      cash flows from operations;




·
            Marketing
      our existing products and those under
  development;




·
            Our
      estimates of future revenue and
profitability;




·
            Our
      expectations and forecasts regarding future expenses, including cost of
      goods sold (casein, in particular), delivery, selling, general and
      administrative, and research and development
  expenses;




·
            Competition
      in our market; and




·
            Our
      ability to operate as a going
concern.




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 and our Form 10-K for the fiscal year ended March 31, 2008.  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 2009”, “fiscal 2008”, or “fiscal 2007” refer to our fiscal years
ending March 31, 2009, 2008, and 2007, 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


·
            Critical
      Accounting Policies


·
            Results
      of Operations


·
            Liquidity
      and Capital Resources


·
            Recent
      Accounting Pronouncements








Business
Environment





General


Galaxy
Nutritional Foods, Inc. (our “Company”) develops and internationally markets
plant-based cheese alternatives, organic dairy and other organic and natural
food products to grocery and natural foods retailers, mass merchandisers and
food service accounts. Galaxy Nutritional Foods 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: Galaxy Nutritional Foods Rice®, Veggy®, Vegan®, Rice Vegan®, and
Wholesome Valley Organic®. Galaxy Nutritional Foods, Inc. is dedicated to
developing nutritious and delicious food products made with high quality natural
ingredients that exceed the expectations of today’s health conscious consumers.
We are also committed to reducing our environmental impact as part of
our Eat Green for Body & EarthTM program that offsets carbon emissions
associated with product shipping and emphasizes the use of


14
 Index


organic
ingredients.  Our Company headquarters are located in Orlando,
Florida, and our common stock is quoted on the OTC Bulletin Board under the
symbol “GXYF.”





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 products typically sell
at a premium over the price of 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 and profitability
by  brand, product, customer and channel of sale to determine the
outside factors affecting the sales levels.  Marketing analyzes retail
scan and internal sales data along with consumer insights for recommendations on
pricing, product mix, new product and packaging opportunities and to assess
market and competitive conditions.





Our
fiscal 2009 marketing plan is focused on consumer-centric strategies and
non-price based programs to increase brand awareness and purchase
intent.  Consumer marketing programs include Veggie print advertising
in Fitness and Parentingand Rice and Rice
Vegan advertising in Vegetarian Times and VegNews.  Fiscal
2009 advertisements feature online coupon offers.  In addition to
print advertising, we expanded consumer marketing efforts to include online
advertising with various campaigns targeting our Veggie and Vegan
brands.  Our public relations and media outreach continues to focus on
consumer education and on our new environmental program.  As part of
our public relations campaign, we partnered with Holistic Health Counselor and
Gourmet Natural Foods Chef, Alex Jamieson. As a media spokesperson, Chef
Jamieson assists in outreach to women’s food and health
magazines.  Our Eat Green for Body & EarthTM campaign addresses the
environmental impact of our business and communicates this message to our end
consumers.  The initiative, in addition to carbon offsets, emphasizes
the use of organic ingredients, which do not release synthetic fertilizers and
pesticides into the environment.  Additionally, we have “greened” our
offices by putting the environmentally conscious motto “reduce, reuse, recycle”
into practice.  This program is being expanded in fiscal 2009 to
include a notation of “Carbon Free Shipping” on our product labels.





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





Conversion
of Related Party Note Payable and Change in Control


Pursuant
to a Note Purchase Agreement dated July 19, 2006 as modified on March 14, 2007,
we issued an unsecured convertible note for $2,685,104 (the “Convertible Note”)
to Mr. Frederick A. DeLuca, the Company’s largest stockholder.  The
Convertible Note accrued interest at 12.5% per annum and matured on October 19,
2008.  No interest or principal payments were required under the
Convertible Note until its maturity.  The Convertible Note together
with any accrued and unpaid interest thereon, was convertible into shares of our
common stock at a conversion price of $0.35 per share.





On
November 18, 2008, our Company, Mr. DeLuca and Galaxy Partners, L.L.C., a
Minnesota limited liability company (“Galaxy Partners”) entered into a Stock
Purchase Agreement (the “Purchase Agreement”).  Pursuant to the
Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to
Galaxy Partners his 3,869,842 shares of our common stock and assigned to Galaxy
Partners all of his right, title and interest in and to the Convertible Note. In
connection with the Purchase Agreement and in accordance with the terms of the
Convertible Note, Galaxy Partners converted all of the outstanding principal and
accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278
shares of our common stock.  As a result of the Purchase Agreement and
conversion of the Convertible Note into 9,941,278 shares, Galaxy Partners
acquired an aggregate of 13,811,120 shares of our common stock and consequently
became the majority stockholder in our Company, owning approximately 51.1% of
the 27,051,294 issued and outstanding shares of our common
stock.  Galaxy Partners is comprised of seven members.  In
consideration of the conversion of the Convertible Note, we agreed to expand the
size of our Board from 4 to 7 members and elected three of the seven members of
Galaxy Partners to the Board - David B. Johnson, Timothy S. Krieger and Michael
D. Slyce.  Mr. Krieger holds a 40% individual ownership in Galaxy
Partners.   Mr. Johnson and Mr. Slyce each hold a 7.5% individual
ownership in Galaxy Partners.  As the sole Governor/Director and CEO
of Galaxy Partners, Mr. Krieger has the sole voting authority over all the
13,811,120 shares held by Galaxy Partners.


15
 Index


In
connection with the Purchase Agreement, Galaxy Partners obtained financing in
the amount of $5,500,000 (the “Financing”) from Robert O. Schachter, who is one
of the seven members of Galaxy Partners.  Pursuant to the terms of the
Financing, the membership interests of Galaxy Partners owned by the majority of
the remaining members of Galaxy Partners, including those owned by Messrs.
Johnson, Krieger and Slyce, were pledged to Mr. Schachter.  In the
event of default under the Financing, Mr. Schachter would be entitled to
foreclose on the pledged interests, in which event Mr. Schachter would then
indirectly own a majority of our common stock, which would constitute a further
change in control of our Company.





As a
result of the change in control, we are no longer subject to a termination fee
from Schreiber in the event that we terminate the Supply Agreement prior to
March 17, 2011.  However, the Purchase Agreement entered into on
November 18, 2008 did not trigger a change in control or obligation as defined
in the 2007 Stay Bonus, Severance Bonus and Sales Bonus Plan.





Measurements
of Financial Performance


On a
monthly basis, we compare the statements of income, balance sheets and
statements of cash flows to budgeted expectations to identify variances and
opportunities for cost savings.  In addition, we analyze sales and
profitability relative to budgeted amounts for individual products, brand
groups, channels of distribution and individual customers.  These
reports are also tailored to provide us with information on promotional costs by
product and customers.  Areas that are performing below expectations
are reviewed to determine actions that we can take to improve
performance.   Additionally, marketing uses this information to
tailor our promotions to make them more effective and profitable.





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 related to stock-based
      transactions


·
            EBITDA
      excluding non-cash compensation related to stock-based
      transactions


·
            Volume
      and margin analysis by individual inventory
  items


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








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 trade receivables which is made up of reserves for promotions,
discounts and bad debts, inventory reserves, valuation of deferred taxes and
valuation of compensation expense on stock-based awards.  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 critical and 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, 2008.  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.  Based on historical
experience, we make reserves for anticipated future customer credits for
rebates, sales promotions, coupons, spoils and other reasons that relate to
current period sales.  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


16
 Index


$274,000
and $862,000 for known and anticipated future credits and doubtful accounts at
December 31, 2008 and 2007, 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.  Actual
bad debt expense averages less than 1% of gross sales.





Inventory


Inventories
are valued at the lower of cost or market.  Cost is determined using a
weighted average method which approximates the first-in, first out
method.  We review our inventory valuation each month and write off or
reserve for inventory based on known or anticipated obsolete, discontinued and
damaged goods.  In addition, we reduce the value of any finished good
item to market value when that value is believed to be less than the cost of the
item. Based on this analysis, we reserved $7,000 and $5,615 for known and
anticipated future reductions in inventory value at December 31, 2008 and 2007,
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 or our
Company.





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 since we have not established a history of taxable
income.





Valuation
of Non-Cash Stock-Based Compensation


Statement
of Financial Accounting Standard (“FAS”) No. 123 (revised 2004), “Share-Based Payment,” (“FAS
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.





FAS 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 option-pricing
model to value our new stock option grants under FAS No. 123R. FAS No. 123R also
requires us to estimate forfeitures in calculating the expense related to
stock-based compensation. In addition, FAS No. 123R requires us to reflect cash
flows resulting from excess tax benefits related to those options as a cash
inflow from financing activities rather than as a reduction of taxes
paid.





There
were no issuances of stock awards or vesting of prior unvested stock awards
during the three and nine months ended December 31, 2008 and
2007.  Therefore, there were no assumptions under the Black-Scholes
option-pricing model and no stock-based compensation expense during the
three and nine months ended December 31, 2008 and 2007.








Results of
Operations





3-Months
      Ended December 31,
                
                
                9-Months
      Ended December 31,2008
                
                
                2007
                
                
                $ Change
                
                
                %
      Change
                
                
                2008
                
                
                2007
                
                
                $ Change
                
                
                %
      ChangeNet
      Sales
                
                $
                6,261,613
                
                
                $
                6,446,099
                
                
                $
                (184,486
                )
                
                
                -2.9
                %
                
                $
                18,413,893
                
                
                $
                18,763,360
                
                
                $
                (349,467
                )
                
                
                -1.9
                %Cost
      of Goods Sold
                
                
                4,310,492
                
                
                
                4,145,200
                
                
                
                165,292
                
                
                
                4.0
                %
                
                
                12,514,672
                
                
                
                11,346,406
                
                
                
                1,168,266
                
                
                
                10.3
                %Gross
      Margin
                
                $
                1,951,121
                
                
                $
                2,300,899
                
                
                $
                (349,778
                )
                
                
                -15.2
                %
                
                $
                5,899,221
                
                
                $
                7,416,954
                
                
                $
                (1,517,733
                )
                
                
                -20.5
                %Gross
      Profit %
                
                
                31.2
                %
                
                
                35.7
                %
                
                
                
                
                
                
                
                
                
                
                32.0
                %
                
                
                39.5
                %





Sales


For the
three months ended December 31, 2008 and 2007, our gross sales before discounts,
returns and allowances were $6,551,093 and $6,888,900, respectively. For the
nine months ended December 31, 2008 and 2007, our gross sales before discounts,
returns and allowances were $19,109,219 and $20,317,013,
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, 2008 and 2007:


17
 Index





Three
      Months Ended
                  December
      31,
                
                
                Nine
      months Ended
                  December
      31,Brand
                
                2008
                
                
                2007
                
                
                2008
                
                
                2007Veggie
                
                
                66.0
                %
                
                
                65.2
                %
                
                
                67.1
                %
                
                
                66.7
                %Rice
                
                
                14.6
                %
                
                
                12.9
                %
                
                
                12.9
                %
                
                
                12.1
                %Private
      Label, Imitation and Other
                
                
                8.1
                %
                
                
                10.3
                %
                
                
                9.2
                %
                
                
                10.4
                %Vegan
                
                
                4.4
                %
                
                
                4.0
                %
                
                
                4.1
                %
                
                
                3.7
                %Veggy
                
                
                3.5
                %
                
                
                4.2
                %
                
                
                3.4
                %
                
                
                4.3
                %Wholesome
      Valley Organic
                
                
                3.4
                %
                
                
                3.4
                %
                
                
                3.3
                %
                
                
                2.8
                %





Although
gross sales decreased approximately 5% and 6% in the three and nine months ended
December 31, 2008, respectively, compared to the same periods ended December 31,
2007, our net sales, after discounts, returns and allowances, decreased only 3%
and 2% in the three and nine months ended December 31, 2008, respectively,
compared to the same periods ended December 31, 2007.  The reason for
the lower decrease in net sales is the strategic decision to reduce certain
vendor promotions and discounts in order to help offset some of the increase in
cost of goods sold as detailed below.  The sales mix in the three and
nine months ended December 31, 2008 remained similar to that in the prior year
periods.





We
anticipate that our annual net sales in fiscal 2009 will be slightly lower than
sales reported in fiscal 2008 reflecting the lower baseline sales projected
after further elimination of lower margin imitation business.





Cost
of Goods Sold


Cost of
goods sold increased five percentage points to 69% of net sales in the three
months ended December 31, 2008 compared to 64% of net sales in the three months
ended December 31, 2007.  Cost of goods sold increased seven
percentage points to 68% of net sales in the nine months ended December 31, 2008
compared to 61% of net sales in the nine months ended December 31,
2007.  This increase in cost of goods sold as a percentage of net
sales is primarily due to increased prices in casein. Casein is a dried skim
milk protein that is the principal raw ingredient used in most of our
products.  The average price of casein increased 21% in the three
months ended December 31, 2008 compared to the three months ended December 31,
2007 and increased 64% in the nine months ended December 31, 2008 compared to
the nine months ended December 31, 2007 due to a worldwide shortage and a weaker
US Dollar that began in the third quarter of fiscal 2008. In the first nine
months of fiscal 2009, the average price of casein is approximately 41% higher
than the annual fiscal 2008 average.  However, the second and third
quarters of fiscal 2009 saw a 3% and 6% quarter to quarter decrease; thereby
indicating a possible stabilization and reversal in the cost of
casein.





Forecasts
from our suppliers indicate that although these historically high casein prices
are subsiding, our average fiscal 2009 prices will remain significantly higher
than our average prices paid in fiscal 2008. This dramatic increase in supply
costs has and will continue to substantially increase our cost of goods sold and
correspondingly substantially reduce our gross margins in fiscal
2009.  However, based on additional discussions with casein suppliers,
we do expect that casein prices in fiscal 2010 will significantly
decline.  Management is in the process of evaluating the effects of
reduced pricing for fiscal 2010.





During
fiscal 2008 and the first half of fiscal 2009, we implemented several
initiatives in an effort to at least partially minimize the negative effect of
these casein price increases. These strategies included reducing promotional
spending and consumer advertising and increasing customer pricing on certain
affected product lines, as well as, proposing reformulations on existing
products to reduce the amount of required casein and expanding and accelerating
the roll-out of new products which do not require casein.





Gross
Margin


Gross
margin declined 15% and 21% in the three and nine months ended December 31, 2008
compared to the three and nine months ended December 31,
2007.  Additionally, gross profit declined approximately 5 percentage
points from an average of 36% in the three months ended December 31, 2007 to 31%
in the three months ended December 31, 2008, and approximately 8 percentage
points from an average of 40% in the nine months ended December 31, 2007 to 32%
in the nine months ended December 31, 2008.  This decrease in gross
margin and profits is primarily due to the rapid increase in the cost of goods
sold (primarily casein) as stated above.  We do not believe that we
could have passed this entire cost increase on to our consumers through
immediate price increases without causing substantial reductions in our sales
volumes.





We
anticipate that in fiscal 2009, gross margins on a majority of our products will
be lower than those in fiscal 2008 since the cost increases primarily took place
in the third and fourth quarter of fiscal 2008.  We further anticipate
that gross


18
 Index


margins
as a percentage of net sales for fiscal 2009 will be approximately five to ten
percentage points lower than our fiscal 2008 annual
average.  Additionally, we anticipate that our income from operations
will continue to be materially and adversely affected by the decline in gross
margins in fiscal 2009.





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.  The non-GAAP measures are key
factors upon which we prepare and review our budgets and forecasts. In 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 related to stock-based transactions, certain employment contract
expenses and disposal costs.  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 31,2008
                      
                      
                      2007
                      
                      
                      $ Change
                      
                      
                      %
      Change
                      
                      
                      2008
                      
                      
                      2007
                      
                      
                      $ Change
                      
                      
                      %
      ChangeNet
      Sales
                      
                      $
                      6,261,613
                      
                      
                      $
                      6,446,099
                      
                      
                      $
                      (184,486
                      )
                      
                      
                      -2.9
                      %
                      
                      $
                      18,413,893
                      
                      
                      $
                      18,763,360
                      
                      
                      $
                      (349,467
                      )
                      
                      
                      -1.9
                      %Cost
      of Goods Sold
                      
                      
                      4,310,492
                      
                      
                      
                      4,145,200
                      
                      
                      
                      165,292
                      
                      
                      
                      4.0
                      %
                      
                      
                      12,514,672
                      
                      
                      
                      11,346,406
                      
                      
                      
                      1,168,266
                      
                      
                      
                      10.3
                      %Gross
      Margin
                      
                      
                      1,951,121
                      
                      
                      
                      2,300,899
                      
                      
                      
                      (349,778
                      )
                      
                      
                      -15.2
                      %
                      
                      
                      5,899,221
                      
                      
                      
                      7,416,954
                      
                      
                      
                      (1,517,733
                      )
                      
                      
                      -20.5
                      %Operating
      Expenses:Selling
                      
                      
                      770,199
                      
                      
                      
                      871,797
                      
                      
                      
                      (101,598
                      )
                      
                      
                      -11.7
                      %
                      
                      
                      2,300,375
                      
                      
                      
                      2,702,038
                      
                      
                      
                      (401,663
                      )
                      
                      
                      -14.9
                      %Delivery
                      
                      
                      265,134
                      
                      
                      
                      263,923
                      
                      
                      
                      1,211
                      
                      
                      
                      0.5
                      %
                      
                      
                      758,191
                      
                      
                      
                      772,786
                      
                      
                      
                      (14,595
                      )
                      
                      
                      -1.9
                      %General and administrative
                      
                      
                      550,944
                      
                      
                      
                      672,530
                      
                      
                      
                      (121,586
                      )
                      
                      
                      -18.1
                      %
                      
                      
                      1,800,850
                      
                      
                      
                      1,883,647
                      
                      
                      
                      (82,797
                      )
                      
                      
                      -4.4
                      %Employment contract expense(1)
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      0.0
                      %
                      
                      
                      -
                      
                      
                      
                      346,447
                      
                      
                      
                      (346,447
                      )
                      
                      
                      -100.0
                      %Research and development
                      
                      
                      75,409
                      
                      
                      
                      86,511
                      
                      
                      
                      (11,102
                      )
                      
                      
                      -12.8
                      %
                      
                      
                      218,685
                      
                      
                      
                      249,506
                      
                      
                      
                      (30,821
                      )
                      
                      
                      -12.4
                      %Loss on disposal of assets
                      
                      
                      -
                      
                      
                      
                      512
                      
                      
                      
                      (512
                      )
                      
                      
                      -100.0
                      %
                      
                      
                      -
                      
                      
                      
                      512
                      
                      
                      
                      (512
                      )
                      
                      
                      -100.0
                      %Total operating expenses
                      
                      
                      1,661,686
                      
                      
                      
                      1,895,273
                      
                      
                      
                      (233,587
                      )
                      
                      
                      -12.3
                      %
                      
                      
                      5,078,101
                      
                      
                      
                      5,954,936
                      
                      
                      
                      (876,835
                      )
                      
                      
                      -14.7
                      %Income
      from Operations
                      
                      
                      289,435
                      
                      
                      
                      405,626
                      
                      
                      
                      (116,191
                      )
                      
                      
                      -28.6
                      %
                      
                      
                      821,120
                      
                      
                      
                      1,462,018
                      
                      
                      
                      (640,898
                      )
                      
                      
                      -43.8
                      %Interest
      expense, net
                      
                      
                      (65,356
                      )
                      
                      
                      (110,261
                      )
                      
                      
                      44,905
                      
                      
                      
                      -40.7
                      %
                      
                      
                      (281,212
                      )
                      
                      
                      (343,313
                      )
                      
                      
                      62,101
                      
                      
                      
                      -18.1
                      %Income
      before Taxes
                      
                      
                      224,079
                      
                      
                      
                      295,365
                      
                      
                      
                      (71,286
                      )
                      
                      
                      -24.1
                      %
                      
                      
                      539,908
                      
                      
                      
                      1,118,705
                      
                      
                      
                      (578,797
                      )
                      
                      
                      -51.7
                      %Federal
      Income Tax Expense
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      0.0
                      %
                      
                      
                      -
                      
                      
                      
                      (12,000
                      )
                      
                      
                      12,000
                      
                      
                      
                      -100.0
                      %NET
      INCOME
                      
                      
                      224,079
                      
                      
                      
                      295,365
                      
                      
                      
                      (71,286
                      )
                      
                      
                      -24.1
                      %
                      
                      
                      539,908
                      
                      
                      
                      1,106,705
                      
                      
                      
                      (566,797
                      )
                      
                      
                      -51.2
                      %Interest
      expense, net
                      
                      
                      65,356
                      
                      
                      
                      110,261
                      
                      
                      
                      (44,905
                      )
                      
                      
                      -40.7
                      %
                      
                      
                      281,212
                      
                      
                      
                      343,313
                      
                      
                      
                      (62,101
                      )
                      
                      
                      -18.1
                      %Taxes
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      0.0
                      %
                      
                      
                      -
                      
                      
                      
                      12,000
                      
                      
                      
                      (12,000
                      )
                      
                      
                      -100.0
                      %Depreciation
                      
                      
                      10,967
                      
                      
                      
                      11,246
                      
                      
                      
                      (279
                      )
                      
                      
                      -2.5
                      %
                      
                      
                      33,950
                      
                      
                      
                      33,308
                      
                      
                      
                      642
                      
                      
                      
                      1.9
                      %EBITDA, (a non-GAAP
      measure)
                      
                      $
                      300,402
                      
                      
                      $
                      416,872
                      
                      
                      $
                      (116,470
                      )
                      
                      
                      -27.9
                      %
                      
                      $
                      855,070
                      
                      
                      $
                      1,495,326
                      
                      
                      $
                      (640,256
                      )
                      
                      
                      -42.8
                      %EBITDA,
      as a % of Net Sales
                      
                      
                      4.8
                      %
                      
                      
                      6.5
                      %
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      4.6
                      %
                      
                      
                      8.0
                      %





(1)
            In
      our calculation of key financial measures, we exclude the employment
      contract expenses related to Christopher Morini, because we believe that
      this item does not reflect expenses related to our current on-going
      operations.





Selling


Selling
expense is partly a function of sales through variable costs such as brokerage
commissions and promotional costs and partly fixed with certain fixed costs for
marketing campaigns and employee salaries and benefits.  Selling
expense as a percentage of net sales was approximately 12% and 14% in the three
months ended December 31, 2008 and 2007, respectively.  Selling
expense as a percentage of net sales was also approximately 13% and 14% in the
nine months ended December 31, 2008 and 2007,
respectively.  Historically, selling expenses averaged 14%-15% of net
sales.  However,


19
 Index


selling
expenses as a percentage of net sales have decreased by two percentage points
due to lower direct advertising costs and reduced travel expenses in the three
and nine months ended December 31, 2008 compared to the three and nine months
ended December 31, 2007.  Direct advertising costs primarily in print
advertising were approximately $196,000 lower and travel and entertainment
expenses were approximately $51,000 lower in the first nine months of fiscal
2009 due to a reduction in spending to help offset the higher cost of goods
sold.





We expect
that fixed selling expense amounts for advertising and market research in fiscal
2009 will be lower than fiscal 2008 due to the reasons disclosed above and
selling expense as a percentage of net sales will average 13%-14%.





Delivery


Delivery
expense is primarily a function of sales as our primary supplier drop-ships
products to our customers and charges a fixed, per-pound contractual delivery
fee that is subject to adjustment from time to time.  Delivery costs
averaged 4% of net sales in the three and nine months ended December 31, 2008
and 2007 as anticipated.  We anticipate that delivery expense for
fiscal 2009 will remain at approximately 4% of net sales.





General
and Administrative


During
the three and nine months ended December 31, 2008, general and administrative
expenses decreased approximately $122,000 or 18% and $83,000 or 4%,
respectively, compared to the three and nine months ended December 31,
2007.  Legal fees declined by approximately $127,000 as a result of a
change in our primary general counsel and as a result of less time consuming
legal transactions compared to the nine months ended December 31,
2007.  Additionally, director and officer (“D&O”) insurance costs
decreased by approximately $37,000 due to lower policy
limits.  However, this reduction in legal fees and D&O insurance
was offset by a $72,000 increase in employee costs due to increases in existing
employee payroll and benefits.





Excluding
the effects of non-cash compensation related to stock-based transactions, which
cannot be predicted, we anticipate that in fiscal 2009 general and
administrative expenses will remain consistent with the total expense in fiscal
2008.





Employment
Contract Expense


On June
1, 2007, Christopher Morini resigned from his position as Vice President of New
Business Development.  In accordance with the Separation and General
Release Agreement which became effective on June 9, 2007, between our Company
and Mr. C. Morini, we accrued $346,447 for wages, health insurance benefits, and
payroll taxes and expensed them under Employment Contract Expense-General and
Administrative in the Statement of Operations in June 2007.  After an
initial lump sum payment of approximately $100,087, the remaining obligation is
being paid out in bi-weekly installments through February 2009.





Research
and Development


Research
and development expenses decreased by approximately $11,000 and $31,000 in the
three and nine months ended December 31, 2008, respectively, compared to the
three and nine months ended December 31, 2007.  During fiscal 2008, we
incurred higher charges to reformulate our Rice Shred products and to develop a
new product line for our Wholesome Valley Organic brand.  These
charges were lower during fiscal 2009 due to less reformulations and product
development in the first nine months of fiscal 2009..  However, we
anticipate that research and development costs in fiscal 2009 will be comparable
to the prior fiscal year as reformulation charges are expected to increase in
the fourth quarter of fiscal 2009.





Interest
Expense


Interest
expense decreased by approximately $45,000 or 40% and $62,000 or 18% in the
three and nine months ended December 31, 2008, respectively, compared to the
three and nine months ended December 31, 2007. The decrease in interest expense
is primarily the result of the conversion of the related party note payable in
November 2008 (see discussion below under Financing Activities) and no
debt discount amortization and less loan costs remaining to be
amortized.





We
anticipate that our interest expense will remain lower in fiscal 2009 due to
lower debt balances and interest rates, as well as, the conversion of the
related party note payable.  Our current loan facility with Commercial
Finance Division accrues interest based on a variable prime plus
rate.  Prime rate is currently at 3.25% and it is uncertain if this
will change during fiscal 2009.  Any changes in the prime rate would
affect our interest expense in fiscal 2009 based on the amount we have
outstanding under our loan facility.





20
 Index





Liquidity and Capital
Resources





Future
Capital Needs


As a
result of the conversion of the Convertible Note (see discussion below under
Financing Activities),
the strength of our balance sheet greatly improved with no further debt
obligations and our stockholders’ equity greater than $3 million. We also
anticipate that stabilized gross margins will continue to provide positive
operating cash flow in fiscal 2009.  With these improvements and over
$3 million in cash currently available, we believe that we will have enough cash
to meet our current liquidity needs in fiscal 2009 and fiscal 2010.





9-Months
      Ended December 31,
                      
                      2008
                      
                      
                      2007
                      
                      
                      $ Change
                      
                      
                      % ChangeCash
      from (used in) operating activities
                      
                      $
                      1,086,587
                      
                      
                      $
                      1,134,005
                      
                      
                      $
                      (47,418
                      )
                      
                      
                      -4.2
                      %Cash
      from (used in) investing activities
                      
                      
                      (19,783
                      )
                      
                      
                      (14,345
                      )
                      
                      
                      (5,438
                      )
                      
                      
                      37.9
                      %Cash
      from (used in) financing activities
                      
                      
                      (59,150
                      )
                      
                      
                      (556,886
                      )
                      
                      
                      497,736
                      
                      
                      
                      -89.4
                      %Net
      increase (decrease) in cash
                      
                      $
                      1,007,654
                      
                      
                      $
                      562,774
                      
                      
                      $
                      444,880
                      
                      
                      
                      79.1
                      %





Operating
and Investing Activities


We are
continuing to provide positive cash flow from operations due to timely
collections on accounts receivable and maximization of our vendor terms. We
continually review our accounts receivable collection, inventory levels and
accounts payable practices in order to maximize cash flow from
operations.





In the
nine months ended December 31, 2008 and 2007, cash used in investing activities
related to our purchase of additional office equipment.





Financing
Activities


Debt
Financing


On June
23, 2006, we entered into a Receivables Purchase Agreement with Commercial
Finance Division, a subsidiary of Textron Financial Corporation (“Commercial
Finance”), whereby Commercial Finance provides financing to our Company through
advances against certain trade receivable invoices due to our Company (the
“Commercial Finance Agreement”).  The Commercial Finance 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 Commercial Finance 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 are currently set at 7% and $100,000, respectively.  Advances
under the Commercial Finance Agreement bear interest at a variable rate equal to
the prime rate plus 1.5% per annum (4.75% on December 31,
2008).  However, the Commercial Finance Agreement requires a $4,500
minimum monthly interest charge to be assessed.   We are also
obligated to pay a $1,500 monthly service fee.





The
initial term of the Commercial Finance Agreement ends on June 23, 2009 and may
renew automatically for consecutive twelve-month terms unless terminated
sooner.  The Commercial Finance Agreement may be accelerated in the
event of certain defaults by our Company including among other things, a default
in our payment and/or performance of any obligation to Commercial Finance or any
other financial institution, creditor, or bank; and any change in the
conditions, financial or otherwise, of our Company which reasonably causes
Commercial Finance to deem itself insecure.  In such an event,
interest on our borrowings would accrue at the greater of twelve percent per
annum or the variable rate of prime plus 1.5% and we would be liable for an
early termination premium of 1% on the maximum principal amount available under
the Commercial Finance Agreement.  Although we had approximately $1.5
million available to draw pursuant to this Commercial Finance Agreement as of
December 31, 2008, there were no amounts advanced, because we did not need
additional cash on such date.  The net amount of cash used to pay down
our obligation under our Commercial Finance Agreement during the nine months
ended December 31, 2008 and 2007 was $0 and $556,886, respectively.





Equity
Financing


On
November 18, 2008, our Company, Frederick A. DeLuca and Galaxy Partners, L.L.C.,
a Minnesota limited liability company (“Galaxy Partners”) entered into a Stock
Purchase Agreement (the “Purchase Agreement”).  Pursuant to the
Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to
Galaxy Partners his 3,869,842 shares of our common stock and assigned to Galaxy
Partners all of his right, title and interest in and to an unsecured convertible
note for $2,685,104 (the “Convertible Note”). In connection with the Purchase
Agreement and in accordance with the terms of the Convertible Note, Galaxy
Partners converted all of the outstanding principal and accrued interest under
the Convertible Note totaling $3,479,447 into 9,941,278 shares of our common
stock.  We recorded $59,150 of stock issuance costs related to these
transactions to additional paid in capital in the three months ended December
31, 2008.  As a result of the Purchase


21
 Index


Agreement
and conversion of the Convertible Note into 9,941,278 shares, Galaxy Partners
acquired an aggregate of 13,811,120 shares of our common stock and consequently
became the majority stockholder in our Company, owning approximately 51.1% of
the 27,051,294 issued and outstanding shares of our common stock.








Recent Accounting
Pronouncements





In
February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB
Staff Position (“FSP”) 157-1, “Application of FASB Statement No.
157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address
Fair Value Measurements for Purposes of Lease Classification or Measurement
under Statement 13,” (“FSP FAS 157-1”).  FSP FAS 157-1 amends
FAS No. 157 to remove certain leasing transactions from its scope and is
effective upon the initial adoption of FAS No. 157 which we adopted beginning
April 1, 2008.  Additionally in February 2008, FASB issued FSP FAS
157-2, “Effective Date of FASB
Statement No. 157,”which amends FAS No. 157 by delaying its effective
date by one year for non-financial assets and non-financial liabilities, except
for items that are recognized or disclosed at fair value in the financial
statements on a recurring basis.  Accordingly, we will begin applying
fair value measurements for all non-financial assets and non-financial
liabilities on April 1, 2009.





In May
2008, FASB issued FSP APB 14-1, “Accounting for Convertible Debt
Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash
Settlement),” (“FSP APB 14-1”). This FSP specifies that issuers of such
instruments should separately account for the liability and equity components in
a manner that will reflect the entity's nonconvertible debt borrowing rate when
interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008
and interim periods within those fiscal years, and is applied retrospectively to
all periods presented. We are currently evaluating the impact of adopting FSP
APB 14-1 on our results of operations and financial position.





In June
2008, FASB issued FSP EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating
Securities.” The FSP concluded that unvested share-based payment awards
that contain nonforfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities under FASB No. 128, “Earnings per Share,” and
should be included in the computation of earnings per share under the two-class
method. The two-class method is an earnings allocation formula used to determine
earnings per share for each class of common stock according to dividends
declared and participation rights in undistributed earnings. FSP EITF 03-6-1 is
effective for financial statements issued for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years, and is applied
retrospectively to all periods presented.  We do not expect that the
adoption of this FSP will have a material impact on our results of operations or
financial position.





In June
2008, the FASB’s Emerging Issues Task Force reached a consensus regarding EITF
Issue No. 07-5, “Determining
Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own
Stock” (EITF 07-5). EITF 07-5 outlines a two-step approach to evaluate
the instrument’s contingent exercise provisions, if any, and to evaluate the
instrument’s settlement provisions when determining whether an equity-linked
financial instrument (or embedded feature) is indexed to an entity’s own stock.
EITF 07-5 is effective for fiscal years beginning after December 15, 2008 and
must be applied to outstanding instruments as of the beginning of the fiscal
year of adoption as a cumulative-effect adjustment to the opening balance of
retained earnings. Early adoption is not permitted. We are currently evaluating
the impact of adopting EITF 07-5 on our results of operations and financial
position.





The
Recent Accounting Pronouncements should be read in conjunction with the
pronouncements included in our Annual Report on Form 10-K for the fiscal year
ended March 31, 2008.











22
 Index


Item 4T. Controls and Procedures


Management
is responsible for the preparation of our financial statements and related
information. Management uses its best judgment to ensure that the financial
statements present fairly, in all material respects, our financial position and
results of operations in conformity with generally accepted accounting
principles.





As of
December 31, 2008, 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, 2008, 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.








23
 Index


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, 2008,
the following are some of the factors as of February 10, 2009, 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
may be required to repay our Convertible Note to Mr. DeLuca.


Pursuant
to a Note Purchase Agreement dated July 19, 2006 as modified on March 14, 2007,
we issued an unsecured convertible note for $2,685,104 (the “Convertible Note”)
to Mr. Frederick A. DeLuca, the Company’s largest stockholder.  The
Convertible Note accrued interest at 12.5% per annum and matured on October 19,
2008.  No interest or principal payments were required under the
Convertible Note until its maturity.  The Convertible Note together
with any accrued and unpaid interest thereon, was convertible into shares of our
common stock at a conversion price of $0.35 per share.





On
November 18, 2008, our Company, Mr. DeLuca and Galaxy Partners, L.L.C., a
Minnesota limited liability company (“Galaxy Partners”) entered into a Stock
Purchase Agreement (the “Purchase Agreement”).  Pursuant to the
Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to
Galaxy Partners his 3,869,842 shares of our common stock and assigned to Galaxy
Partners all of his right, title and interest in and to the Convertible Note. In
connection with the Purchase Agreement and in accordance with the terms of the
Convertible Note, Galaxy Partners converted all of the outstanding principal and
accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278
shares of our common stock.    Therefore, there is no
further risk factor associated with repayment of the Convertible
Note.





We
may not be able to continue as a going concern on a long-term
basis.


We
received a report from our independent accountants relating to our audited
financial statements as of March 31, 2008 containing a paragraph stating that
because we may be required to pay the Convertible Note and accrued interest
thereon in fiscal 2009 which may leave us with insufficient cash funds to
continue operations, there is substantial doubt as to our ability to continue as
a going concern.  Our ability to continue as a going concern depended
upon the outcome of our discussions with Mr. DeLuca and others
regarding options to refinance and/or convert all or a portion of the
Convertible Note and accrued interest thereon into equityor
successfully obtaining sufficient cash resources to pay this
obligation.





In
connection with the Purchase Agreement discussed above and in accordance with
the terms of the Convertible Note, Galaxy Partners converted all of the
outstanding principal and accrued interest under the Convertible Note totaling
$3,479,447 into 9,941,278 shares of our common stock.    As
a result of the conversion of the Convertible Note, the strength of our balance
sheet greatly improved with no further debt obligations and our stockholders’
equity greater than $3 million.  Therefore, management does not
believe there is any further risk associated with our ability to operate as a
going concern in the near future.





24
 Index


We
may be required to pay substantial penalties under our Supply
Agreement.


On March
17, 2008, we entered into a Second Amendment to our Supply Agreement dated June
30, 2005 with Schreiber Foods, Inc. (“Schreiber”).  The Second
Amendment required us to pay a shortfall payment should we terminate the Supply
Agreement prior to a stated date, other than as a result of a breach by
Schreiber or change of control in our Company.  The shortfall payment
starts at $5,100,000 as of March 17, 2008 and declines by $1,700,000 per
contract year until March 17, 2011, at which time the shortfall payment is
eliminated.  If there is a change of control in either our Company or
Schreiber, then the shortfall payment obligation will terminate and be
extinguished as of the date of such change of control. As a result of the change
in control in November 2008, we are no longer subject to the termination fee
described above and therefore, there is no longer a risk factor associated with
the stated penalties under our Supply Agreement.








We
may not be able come to a mutual agreement with our Chief Executive Officer and
may need to seek a new Chief Executive Officer.


Effective
with the signing of the Purchase Agreement on November 18, 2008, Michael E.
Broll entered into an amendment to his employment agreement with our Company,
whereby he would continue as our Chief Executive Officer and Board member
through March 31, 2009.  Mr. Broll also serves as our
President.  In the event the parties do not enter into a new
employment arrangement, then upon receipt of Mr. Broll’s resignation as our
Company’s Chief Executive Officer and from our Board of Directors on March 31,
2009, in consideration of his staying with our Company during the transition
period subsequent to the change of control in our Company and in recognition of
his waiver of his rights under our 2007 Stay, Severance and Sales Bonus Plan, we
will pay Mr. Broll compensation of $20,000 per month for 25 consecutive months
beginning on April 1, 2009 less any applicable federal and/or state
taxes.





In the
event that Mr. Broll resigns from our Company on March 31, 2009, we will need to
seek someone to replace him as Chief Executive Officer. To date, the Board has
not identified a candidate for the position of Chief Executive
Officer.  In the event of Mr. Broll’s resignation, we may need to hire
an executive recruitment firm to assist in finding a suitable candidate for such
position and pay a substantial fee in connection with any such
placement.  In addition, while we anticipate that certain members of
our Board may take a greater role in the management and direction of our Company
until a new Chief Executive Officer is hired, the Company may be adversely
impacted if there is a significant period of time without the services and
direction of a top executive officer.





The
main ingredient in many of our products is subject to volatility and limited
availability.  Price increases for this commodity adversely affect our
business.


Our
Supply Agreement with Schreiber is based on cost plus a processing
fee.  Currently, the major cost ingredient in our products is casein,
a dried skim milk protein that is purchased from foreign
suppliers.  Because casein is purchased from foreign suppliers, its
availability is subject to a variety of factors, including but not limited to,
trade regulations, foreign supply and exchange rate
fluctuations.  These factors could have an adverse effect on our
business and our ability to compete with competitors that do not rely on foreign
suppliers.  We cannot assure you that we could obtain casein from U.S.
sources if the foreign supply of casein were reduced or
terminated.  Even if we could obtain casein from U.S. sources, the
prices for the casein would likely be significantly higher than we have paid
historically.  Any of these events would negatively affect our
business, results of operations and cash flows.





Additionally,
due to a worldwide shortage and a weaker US Dollar that began in the third
quarter of fiscal 2008, the average price of casein increased more than 21% and
64% in the three and nine months ended December 31, 2008, respectively, compared
to the three and nine months ended December 31, 2007. In the first nine months
of fiscal 2009, the average price of casein is approximately 41% higher than the
annual fiscal 2008 average.  However, the second and third quarters of
fiscal 2009 saw a 3% and 6% quarter to quarter decrease; thereby indicating a
possible stabilization and reversal in the cost of casein.  Forecasts
from our suppliers indicate that although these historically high casein prices
are subsiding, our average fiscal 2009 prices will remain significantly higher
than our average prices paid in fiscal 2008. This dramatic increase in supply
costs has and will continue to substantially increase our cost of goods sold and
correspondingly substantially reduce our gross margins in fiscal
2009.  However, based on additional discussions with casein suppliers,
we do expect that casein prices in fiscal 2010 will significantly decline and
that our gross margins will improve.  Management is in the process of
evaluating the effects of reduced pricing for fiscal 2010.





We
implemented several strategic plans of action in an effort to at least partially
minimize the negative effect of these casein price increases. These strategies
included reducing promotional spending and consumer advertising and increasing
customer pricing on certain affected product lines, as well as, proposing
reformulations on existing products to reduce the amount of required casein and
expanding and accelerating the roll-out of new products which do not require
casein.  Although we implemented these strategic plans of action, we
anticipate that gross margins on a majority of our products and as a whole will
remain lower in fiscal 2009 compared to fiscal 2008.  Additionally, we
anticipate that our income from


25
 Index


operations
for fiscal 2009 will continue to be adversely affected by the lower gross
margins when comparing to prior years unless the cost of casein
declines.





One
entity owns a majority of our outstanding shares, which could materially limit
the ownership rights of investors.


As a
result of the Purchase Agreement and conversion of the Convertible Note into
9,941,278 shares, Galaxy Partners acquired an aggregate of 13,811,120 shares of
our common stock on November 18, 2008 and consequently became the majority
stockholder in our Company, owning approximately 51.1% of the 27,051,294 issued
and outstanding shares of our common stock.  At the present time,
Galaxy Partners has three representatives out of a total of seven directors on
our Board and exerts significant influence on the policies and direction of our
Company.  As a result of its ownership of a majority of our
outstanding common stock, at the next annual meeting of stockholders at which
members of the Board are elected, Galaxy Partners could control the outcome of
the vote on all persons who are submitted for election to the Board, and
thereafter effectively control the policies and direction of our
Company.  Galaxy Partners can similarly significantly affect, if not
control, the outcome of any other matter submitted to a vote of the stockholders
of our Company. Investors who purchase common stock in our Company will 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 Galaxy Partners’
ownership of our common stock.





Stockholders
may experience further dilution.


We have a
total of 3,932,962 shares reserved for future issuance upon the exercise of
options or warrants outstanding as of February 10, 2009.  None of
these securities are “in the money,” as of such date.  “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 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.








Item
5.                Other
Information





On
February 9, 2009, Andromeda Acquisition Corp. (“Andromeda”) announced that it
plans to make a cash tender offer to purchase all outstanding shares of our
Company for $0.36 per share.  Andromeda is a Delaware wholly-owned
subsidiary of MW1 LLC (“MW1”) formed solely for the purpose of making the tender
offer.  Currently, the sole member of MW1 is Mill Road Capital, L.P.,
a Delaware limited partnership formed by a core group of professionals to invest
in small public companies.  Andromeda announced that it plans to
commence the offer on or about February 13, 2009 and end the offer on or about
March 16, 2009.  Additionally, it is expected that Galaxy Partners
L.L.C., the Company’s 51.1% majority shareholder, along with Mill Road Capital,
L.P. will contribute their 14,370,728 combined shares of our Company’s common
stock to MW1 prior to the expiration of the offer.  As a result of the
tender offer, we will postpone our Annual Meeting of Stockholders (“Annual
Meeting”) originally scheduled for Tuesday, February 10, 2009 until after the
conclusion of the tender offer period.





26
 Index


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
              
              Amended
      and Restated Bylaws of Galaxy Nutritional Foods, Inc. dated February 6,
      2008 (Filed as Exhibit 3.2 on Form 10-Q for the fiscal quarter ended
      December 31, 2007.)





*4.1
              
              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.)





*4.2
              
              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.)





*10.1
            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.)





*10.2
            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.)





*10.3
            Second
      Amendment to the Employment Agreement dated May 3, 2007 between Galaxy
      Nutritional Foods, Inc. and Michael E. Broll. (Filed as Exhibit 10.41 on
      Form 8-K filed May 9, 2007.)





*10.4
            Third
      Amendment to the Employment Agreement dated December 10, 2007 between
      Galaxy Nutritional Foods, Inc. and Michael E. Broll (Filed as Exhibit
      10.44 on Form 10-Q for the fiscal quarter ended December 31,
      2007.)





*10.5
            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.)





*10.6
            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.)





*10.7
            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.)





*10.8
            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.)





*10.9
            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.)





*10.10
            Separation
      and General Release Agreement dated June 1, 2007 between Galaxy
      Nutritional Foods, Inc. and Christopher Morini (Filed as Exhibit 10.43 on
      Form 10-K for the fiscal year ended March 31,
  2007.)





*10.11
            Stay,
      Severance and Sales Bonus Plan effective December 10, 2007 (Filed as
      Exhibit 10.45 on Form 10-Q for the fiscal quarter ended December 31,
      2007.)





*10.12
            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.)


27
 Index





*10.13
            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.)





*10.14
            Second
      Amendment to Supply Agreement dated March 17, 2008 between Schreiber
      Foods, Inc. and Galaxy Nutritional Foods, Inc (Filed as Exhibit 10.46
      on Form 8-K filed March 21, 2008)





*10.15
            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.)





*10.16
            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.)





*10.17
            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.)





*10.18
            Note
      Modification Agreement dated March 14, 2007 between Galaxy Nutritional
      Foods, Inc. and Frederick A. DeLuca  (Filed as Exhibit 10.40 on
      Form 8-K filed March 20, 2007.)





*10.19
            Receivables
      Purchase Agreement, together with Addendum, dated June 23, 2006 between
      Galaxy Nutritional Foods, Inc. and Systran Financial Services Corporation,
      now Commercial Finance Division (Filed as Exhibit 10.30 on Form 8-K filed
      June 29, 2006.)





*10.20
            First
      Amendment to Receivables Purchase Agreement dated March 28, 2007 between
      Galaxy Nutritional Foods, Inc. and Systran Financial Services Corporation,
      now Commercial Finance Division (Filed as Exhibit 10.42 on Form 10-K for
      the fiscal year ended March 31,
2007.)





*10.21
            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.)





*10.22
            Stock
      Purchase Agreement, dated November 18, 2008, by and among Galaxy Partners,
      L.L.C., Galaxy Nutritional Foods, Inc. and Frederick A. DeLuca (Filed as
      Exhibit 10.1 on Form 8-K filed November 21,
  2008.)





*10.23
            Amendment
      to Employment Agreement effective as of November 18, 2008 by and among
      Michael E. Broll and Galaxy Nutritional Foods, Inc. (Filed as Exhibit 10.2
      on Form 8-K filed November 21,
2008.)





*10.24
            David
      Lipka Waiver of Rights dated November 13, 2008 under the Company’s 2007
      Stay Bonus, Severance Bonus and Sales Plan (Filed as Exhibit 10.3 on Form
      8-K filed November 21, 2008.)





10.25
            Lease
      Agreement dated January 14, 2009 between Galaxy Nutritional Foods, Inc.
      and Lake Point Business Park, LLC (Filed
      herewith.)





*14.1
            Code
      of Ethics (Filed as Exhibit 14.1 on Form 10-K for the fiscal year ended
      March 31, 2007.)





*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.)


28
 Index





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.








29
 Index


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 11,
2009                                                       /s/
Michael E.
Broll


Michael
E. Broll


Chief
Executive Officer & Director


(Principal
Executive Officer)








Date:
February11,
2009                                                        /s/
Salvatore J.
Furnari


Salvatore
J. Furnari


Chief
Financial Officer & Vice President of Finance


(Principal
Accounting and Financial Officer)











30
 Index