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 June 30, 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)








5955
      T.G. Lee Blvd., Suite 201
            32822Orlando,
      Florida
            (Zip
      Code)(Address
      of principal executive offices)





1-407-855-5500


(Registrant’s
telephone number, including area code)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.


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 August
11, 2008, there were 17,110,016 shares of common stock, $.01 par value per
share, outstanding


Index





GALAXYNUTRITIONAL FOODS,
INC.





Indexto Form 10-Q


For
the Quarter Ended June 30, 2008











Page
      No.PART
      I.
            
            
            FINANCIAL
      INFORMATIONItem
      1.
            Financial
      StatementsBalance Sheets
            1Statements of Income
            2Statements of Cash Flows
            3Notes to Financial Statements
            4Item
      2.
            Management's Discussion and Analysis of Financial
      Conditionand
      Results of Operations
            12Item
      4T.
            Controls and Procedures
            20PART
      II.
            
            OTHER
      INFORMATIONItem
      1A.
            Risk Factors
            21Item
      6.
            Exhibits
            24SIGNATURES
            
            
            26








Index


PART I.  FINANCIAL
INFORMATION


GALAXY
NUTRITIONAL FOODS, INC.
 Balance Sheets
 
 JUNE
      30,
              
              
              MARCH
      31,Notes
              
              
              2008
              
              
              2008(Unaudited)ASSETS
              
              2CURRENT
      ASSETS:Cash
              
              
              
              
              $
              1,879,124
              
              
              $
              1,893,425Trade
      receivables, net
              
              
              
              
              
              2,284,251
              
              
              
              2,516,496Inventories,
      net
              
              
              
              
              
              157,098
              
              
              
              116,902Prepaid
      expenses and other
              
              
              
              
              
              219,205
              
              
              
              95,906Total
      current assets
              
              
              
              
              
              4,539,678
              
              
              
              4,622,729PROPERTY
      AND EQUIPMENT, NET
              
              
              
              
              
              70,003
              
              
              
              65,671OTHER
      ASSETS
              
              
              
              
              
              62,104
              
              
              
              68,463TOTAL
              
              
              
              
              $
              4,671,785
              
              
              $
              4,756,863LIABILITIES
      AND STOCKHOLDERS’ DEFICITCURRENT
      LIABILITIES:Secured
      borrowings
              
              2
              
              
              $
              --
              
              
              $
              --Accounts
      payable
              
              
              
              
              
              1,397,670
              
              
              
              1,393,810Accrued
      and other current liabilities
              
              
              
              
              
              959,434
              
              
              
              1,028,049Accrued
      employment contracts
              
              3
              
              
              
              142,325
              
              
              
              282,599Related
      party note payable
              
              1,2
              
              
              
              2,685,104
              
              
              
              2,685,104Total
      current liabilities
              
              
              
              
              
              5,184,533
              
              
              
              5,389,562COMMITMENTS
      AND CONTINGENCIES
              
              4
              
              
              
              --
              
              
              
              --STOCKHOLDERS’
      DEFICIT:Common
      stock
              
              
              
              
              
              171,100
              
              
              
              171,100Additional
      paid-in capital
              
              
              
              
              
              70,167,149
              
              
              
              70,167,149Accumulated
      deficit
              
              
              
              
              
              (70,850,997
              )
              
              
              (70,970,948
              )Total
      stockholders’ deficit
              
              
              
              
              
              (512,748
              )
              
              
              (632,699
              )TOTAL
              
              
              
              
              $
              4,671,785
              
              
              $
              4,756,863
 
 
 
 
 
 
 
 
 
 
 
 
 See
accompanying notes to financial statements
  1
 Index
  GALAXY
NUTRITIONAL FOODS, INC.
 Statements of Income
 (UNAUDITED)
 
 
 Three
      Months Ended June 30,
              
              Notes
              
              
              2008
              
              
              2007Net
      Sales
              
              
              
              
              $
              6,036,590
              
              
              $
              5,916,137Cost
      of Goods Sold
              
              
              
              
              
              4,075,755
              
              
              
              3,460,368GROSS
      MARGIN
              
              
              
              
              
              1,960,835
              
              
              
              2,455,769OPERATING
      EXPENSES:Selling
              
              
              
              
              
              753,518
              
              
              
              889,408Delivery
              
              
              
              
              
              238,731
              
              
              
              246,845General
      and administrative
              
              
              
              
              
              658,529
              
              
              
              623,616Employment
      contract expense - general and administrative
              
              3
              
              
              
              --
              
              
              
              346,447Research
      and development
              
              
              
              
              
              82,368
              
              
              
              83,277Total
      operating expenses
              
              
              
              
              
              1,733,146
              
              
              
              2,189,593INCOME
      FROM OPERATIONS
              
              
              
              
              
              227,689
              
              
              
              266,176INTEREST
      EXPENSE
              
              
              
              
              
              (107,738
              )
              
              
              (115,177
              )INCOME
      BEFORE TAXES
              
              
              
              
              
              119,951
              
              
              
              150,999INCOME
      TAX EXPENSE
              
              
              
              
              
              --
              
              
              
              --NET
      INCOME
              
              
              
              
              $
              119,951
              
              
              $
              150,999BASIC
      NET INCOME PER COMMON SHARE
              
              6
              
              
              $
              0.01
              
              
              $
              0.01DILUTED
      NET INCOME PER COMMON SHARE
              
              6
              
              
              $
              0.01
              
              
              $
              0.01














See
accompanying notes to financial statements.


2
 Index


GALAXY
NUTRITIONAL FOODS, INC.


Statements of Cash Flows


(UNAUDITED)











Three
      Months Ended June 30,
            
            Notes
            
            
            2008
            
            
            2007CASH
      FLOWS FROM OPERATING ACTIVITIES:
            
            7Net
      Income
            
            
            
            
            $
            119,951
            
            
            $
            150,999Adjustments
      to reconcile net income to net cash from (used in) operating
      activities:Depreciation
      and amortization
            
            
            
            
            
            11,876
            
            
            
            10,971Amortization
      of debt discount and financing costs
            
            
            
            
            
            6,359
            
            
            
            13,782Provision
      for future credits and doubtful accounts on trade
    receivables
            
            
            
            
            
            (199,313
            )
            
            
            (304,000
            )Inventory
      reserve
            
            
            
            
            
            (11,333
            )
            
            
            46,696(Increase)
      decrease in:Trade
      receivables
            
            
            
            
            
            431,558
            
            
            
            265,182Inventories
            
            
            
            
            
            (28,863
            )
            
            
            (29,820
            )Prepaid
      expenses and other
            
            
            
            
            
            (123,299
            )
            
            
            (10,833
            )Increase
      (decrease) in:Accounts
      payable
            
            
            
            
            
            3,860
            
            
            
            (460,034
            )Accrued
      and other liabilities
            
            
            
            
            
            (208,889
            )
            
            
            (59,189
            )NET
      CASH FROM (USED IN) OPERATING ACTIVITIES
            
            
            
            
            
            1,907
            
            
            
            (376,246
            )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
            
            
            
            
            
            (16,208
            )
            
            
            (9,311
            )NET
      CASH FROM (USED IN) INVESTING ACTIVITIES
            
            
            
            
            
            (16,208
            )
            
            
            (9,311
            )CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      borrowings on secured borrowings
            
            
            
            
            
            --
            
            
            
            2,751NET
      CASH FROM (USED IN) FINANCING ACTIVITIES
            
            
            
            
            
            --
            
            
            
            2,751NET
      INCREASE (DECREASE) IN CASH
            
            
            
            
            
            (14,301
            )
            
            
            (382,806
            )CASH,
      BEGINNING OF PERIOD
            
            
            
            
            
            1,893,425
            
            
            
            879,487CASH,
      END OF PERIOD
            
            
            
            
            $
            1,879,124
            
            
            $
            496,681


















































See
accompanying notes to financial statements.


3
 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-month period ended June 30, 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 globally 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.





The
Company’s ability to continue as a going concern depends upon successfully
refinancing or obtaining sufficient cash resources to pay its Convertible Note
and accrued interest thereon in the amount of $3,451,478 on October 19, 2008
(See Note 2) and obtaining positive cash flow from operations to sustain normal
business operations.  With its current cash balances and the ability
to borrow additional funds on its Commercial Finance Agreement, the Company
believes that it currently has the ability to repay a majority of the
Convertible Note and accrued interest thereon.  However, the payment
of the entire balance of $3,451,478 would likely seriously and adversely impact
its liquidity and put a cash strain on the Company without additional
financing.  Management is currently in discussions with Mr. Frederick
A. DeLuca, the Company’s largest stockholder, and others regarding options to
extend the maturity date, refinance, and/or convert all or a portion of the
Convertible Note and accrued interest thereon into equity on or before its
maturity on October 19, 2008.





The
Company’s current business plan continues to eliminate low margin private label
and Galaxy imitation business from its sales mix, which is expected to result in
slightly lower sales in fiscal 2009 than in fiscal
2008.  Additionally, the cost of goods sold is increasing due to
higher ingredient costs that began in the third quarter of fiscal 2008,
particularly casein, which will continue to negatively impact gross margins on a
majority of the Company’s products.  During fiscal 2008, management
implemented several initiatives in an effort to at least partially minimize the
negative effect of these ingredient 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.  The Company is continuing these initiatives throughout fiscal
2009.


4
 Index


There can
be no assurance that the Company will be successful in its business plan, its
negotiations with Mr. DeLuca and/or other parties or that the terms of any such
refinancing or conversions will not result in the issuance, or potential
issuance, of a significant amount of equity securities that will cause
substantial dilution to our stockholders. If the Company is not successful in
refinancing the Convertible Note or in otherwise entering into a financing,
sale, or other business transaction that infuses sufficient cash resources into
the Company in the near future, any collection actions by Mr. DeLuca or other
parties could have a material adverse affect on the liquidity and financial
condition of the Company and on its ability to secure additional financing, and
the Company may not be able to continue as a going concern. The
accompanying financial statements have been prepared on a going concern basis,
which assumes continuity of operations and realization of assets and liabilities
in the ordinary course of business.  The financial statements do not
include any adjustments that might result if the Company was forced to
discontinue its operations.





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





SFAS No.
123R applies to new awards and to awards modified, repurchased, or cancelled
after the effective date, as well as to the unvested portion of awards
outstanding as of the effective date. The Company uses the Black-Scholes
option-pricing model to value its new stock option grants under SFAS No. 123R.
SFAS No. 123R also requires the Company to estimate forfeitures in calculating
the expense related to stock-based compensation. Additionally, SFAS 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 months ended June 30, 2008 and 2007.  Therefore,
there were no assumptions under the Black-Scholes option-pricing model and
no stock-based compensation expense during the three months ended June 30, 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 12 other
countries.





5
 Index


Recent Accounting
Pronouncements


There
have been no significant pronouncements that were not already identified in the
Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2008
that are expected to have any impact on the Company’s results of operations,
financial position and cash flows.





Income
Taxes


The
Company follows the provisions of the Financial Accounting Standards Board
(“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 SFAS 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 SFAS No. 157, “Fair Value Measurements,”(“SFAS No. 157”) to value its financial assets and liabilities. The
adoption of SFAS No. 157 did not have a significant impact on the Company’s
results of operations, financial position or cash flows.  SFAS No. 157
defines fair value, establishes a framework for measuring fair value under GAAP
and expands disclosures about fair value measurements.  SFAS No. 157
defines fair value as the exchange price that would be paid by an external party
for an asset or liability (exit price).  SFAS 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:





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


·
            Level 2 – 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 June 30, 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.





SFAS No.
157 is effective for non-financial assets and liabilities for its 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, formerly known as Systran Financial Services
Corporation, 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


6
 Index


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 (6.50% on June 30, 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 ranging from 1% to 3%, depending upon
the timing of such termination, on the maximum principal amount available under
the Commercial Finance Agreement.  Although the Company had
approximately $1.7 million available to draw pursuant to this Commercial Finance
Agreement as of June 30, 2008, there were no amounts advanced, because the
Company did not need additional cash on such date.





In
accordance with SFAS 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 accrues interest at 12.5% per annum and
matures on October 19, 2008.  No interest or principal payments are
required under the Convertible Note until its maturity.  Principal,
together with any accrued and unpaid interest, on the Convertible Note is
convertible at any time prior to payment into shares of the Company’s common
stock at a conversion price of $0.35 per share.  The 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.





As a
result of the convertible features of the Convertible Note, Mr. DeLuca’s
ownership in the Company may increase from approximately 23% to nearly 52% by
October 2008.  The calculation of ownership assumes, among other
things, that Mr. DeLuca converts the entire amount of principal and all accrued
interest on the Convertible Note through October 19, 2008 at the stated
conversion rate of $0.35 per share into an aggregate of 9,861,364 shares and
exercises all of his currently outstanding warrants into 500,000 shares of the
Company’s common stock.  The closing price of the Company’s common
stock on June 30, 2008 as quoted on the OTC Bulletin Board was $0.15 per share.
Unless the market price of the Company’s common stock increases between now and
October 19, 2008, it is unlikely that Mr. DeLuca would choose to convert the
Convertible Note and accrued interest thereon at his conversion price of $0.35
per share.  If Mr. DeLuca does not choose to convert this Convertible
Note into stock and does not extend the maturity date of the Convertible Note,
then the Company will be required to pay principal plus accrued interest thereon
in the amount of $3,451,478 on October 19, 2008.





With its
current cash balances and the ability to borrow additional funds on its
Commercial Finance Agreement, the Company believes it currently has the ability
to repay a majority of the Convertible Note and accrued interest thereon by
October 19, 2008.  However, the payment of the entire balance of
$3,451,478 would likely seriously and adversely impact its liquidity and put a
cash strain on the Company without additional financing.  Management
is currently in discussions with Mr. DeLuca and others regarding options to
extend the maturity date, refinance, and/or convert all or a portion of the
Convertible Note and accrued interest thereon into equity on or before its
maturity on October 19, 2008.


7
 Index


There can
be no assurance that the Company will be successful in its business plan, its
negotiations with Mr. DeLuca and/or other parties or that the terms of any such
refinancing or conversions will not result in the issuance, or potential
issuance, of a significant amount of equity securities that will cause
substantial dilution to our stockholders. If the Company is not successful in
refinancing the Convertible Note or in otherwise entering into a financing,
sale, or other business transaction that infuses sufficient cash resources into
the Company in the near future, any collection actions by Mr. DeLuca or other
parties could have a material adverse affect on the liquidity and financial
condition of the Company and on its ability to secure additional financing, and
the Company may not be able to continue as a going concern.





The
Company recorded interest expense related to the Convertible Note in the amount
of $84,842 in the three months ended June 30, 2008 and
2007.  Additionally, the Company amortized $2,883 of debt discount to
interest expense in the three months ended June 30, 2007.  As of June
30, 2008, the outstanding principal balance on the Convertible Note is
$2,685,104.








(3)           Related Party
Transactions


Angelo S.
Morini


In a
Second Amended and Restated Employment Agreement effective October 13, 2003,
Angelo S. Morini, the Company’s Founder, 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 is
for a five-year period beginning October 13, 2003 and provides for an annual
base salary of $300,000, plus standard health insurance benefits, club dues and
an auto allowance.





Because
Mr. Morini is no longer performing ongoing services for the Company, the Company
accrued and expensed the five-year cost of this agreement in October
2003.  The total estimated costs expensed under this agreement were
$1,830,329 of which $104,049 remained unpaid but accrued as a current liability
as of June 30, 2008.  The obligation is being paid out in 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 order to pursue other opportunities.  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 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 nearly
equal bi-weekly installments through February 2009.  As of June 30,
2008, $38,276 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 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.








8
 Index


·
            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 will be required to pay a shortfall payment should it terminate
      the Supply Agreement prior to a stated date, other than as a result of a
      breach by Schreiber or change of control in the 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 of either the Company or Schreiber, then the shortfall payment
      obligation will terminate and be extinguished as of the date of such
      change of control. However, if there is a change of control of the Company
      in connection with a sale of the Company where the purchase price
      exceeds $50 million, then the Company’s obligation to potentially remit a
      shortfall payment will not terminate.  In such an event, the
      Company’s obligation to remit a shortfall payment to Schreiber would not
      terminate until March 17, 2011.





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..  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.





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.








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


Effective
April 1, 2006, SFAS No. 123R applies to new awards and to awards modified,
repurchased, or cancelled after the effective date, as well as to the unvested
portion of awards outstanding as of the effective date. The Company uses the
Black-Scholes option-pricing model to value its new stock option grants under
SFAS 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 months ended June 30, 2008 and 2007.
Therefore, there was no stock-based compensation expense nor any unrecognized
compensation cost related to nonvested stock for the three months ended June 30,
2008 and 2007.




9
 Index


The
following table summarizes the Company’s plan and non-plan stock options
outstanding as of June 30, 2008, as well as activity during the three 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
            —
            
            
            —Outstanding
      at  June 30, 2008
            3,642,963
            
            $
            2.72
            
            2.2
            
            $
            -0-Exercisable
      at June 30, 2008
            3,642,963
            
            $
            2.72
            
            2.2
            
            $
            -0-






There
were no options granted and thus no weighted-average fair value computed on
options during the three months ended June 30, 2008 and 2007.  At June
30, 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 June 30, 2008 as quoted on the OTC Bulletin Board was $0.15 per
share.  There were no options exercised during the three months ended
June 30, 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 June 30,
            
            2008
            
            
            2007Net
      income - basic
            
            $
            119,951
            
            
            $
            150,999Plus
      interest on convertible related party note payable
            
            
            84,842
            
            
            
            84,842Net
      income
            
            $
            204,793
            
            
            $
            235,841Weighted
      average shares outstanding – basic
            
            
            17,110,016
            
            
            
            17,110,016Potential
      shares issued upon conversion of  related party note
      payable
            
            
            9,323,278
            
            
            
            8,348,329Potential
      shares “in-the-money” under stock option and warrant
      agreements
            
            
            --
            
            
            
            740,000Less:  Shares
      assumed repurchased under the treasury stock method
            
            
            --
            
            
            
            (458,507
            )Weighted
      average shares outstanding –diluted
            
            
            26,433,294
            
            
            
            25,739,838Basic
      net income per common share
            
            $
            0.01
            
            
            $
            0.01Diluted
      net income per common share
            
            $
            0.01
            
            
            $
            0.01





Options
for 3,642,963 shares and warrants for 1,133,276 shares have not been included in
the computation of diluted net income per common share for the three months
ended June 30, 2008 as their effects were antidilutive.  Options for 4,552,755
shares and warrants for 1,077,857 shares have not been included in the
computation of diluted net income per common share for three months ended June
30, 2007 as their effects were antidilutive.








10
 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.





Three
      months ended June 30,
            
            2008
            
            
            2007Non-cash
      financing and investing activities:Cash
      paid for:Interest
            
            
            16,537
            
            
            
            16,553








(8)           Economic Dependence and
Segment Information


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 12 foreign countries.  For the three months
ended June 30, 2008 and 2007, the Company’s gross sales were $6,243,033 and
$6,509,600, respectively. Gross sales derived from foreign countries were
approximately $664,000 and $964,000, representing 11% and 15% of gross sales for
the three months ended June 30, 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 months ended June 30, 2008 and 2007:





Percentage
      of Gross Foreign SalesThree
      Months Ended June 30,Country
            
            2008
            
            
            2007Canada
            
            
            89
            %
            
            
            90
            %Other
            
            
            11
            %
            
            
            10
            %





The
Company had one customer that accounted for approximately 15% of gross sales for
the three months ended June 30, 2008.  The Company had one customer
that accounted for approximately 16% of gross sales for the three months ended
June 30, 2007.  There were no customers whose balance outstanding was
greater than 10% of accounts receivable as of June 30, 2008 or
2007.





Pursuant
to the Supply Agreement with Schreiber, the Company purchased approximately 97%
and 96% of its total raw material purchases from Schreiber for the three months
ended June 30, 2008 and 2007, respectively.











11
 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;




·
            Our
      estimates regarding capital requirements and need for additional
      financing;




·
            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:


·
            Basis
      of Presentation; Going Concern


·
            Business
      Environment


·
            Critical
      Accounting Policies


·
            Results
      of Operations


·
            Liquidity
      and Capital Resources


·
            Recent
      Accounting Pronouncements








Basis of Presentation; Going
Concern





Certain
matters discussed below under "Liquidity and Capital Resources" raise
substantial doubt about our ability to continue as a going concern. In addition,
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 full by October 19, 2008 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 financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States of America assuming


12
 Index


that we
will continue on a going concern basis.  This assumes the realization
of assets and the satisfaction of liabilities in the normal course of business.
Accordingly, our financial statements do not include any adjustments relating to
the recoverability of assets and classification of liabilities that might be
necessary should we be unable to continue as a going concern.








Business
Environment





General


Galaxy
Nutritional Foods, Inc. (our “Company”) develops and globally 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 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
product, brand, form and channel of sale to determine the outside factors
affecting the sales levels.  These reports provide management
information on which products, brands, forms and/or channel sales are increasing
or decreasing both in units sold and price per unit. By reviewing these reports
along with industry data from publications, syndicated retail consumption
reports, and conversations with major retailers, other manufacturers in the food
and beverage industry, and ingredient and service suppliers, we make decisions
on which brands to promote and analyze trends in the consumer
marketplace.





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
Parenting and Rice and Rice Vegan advertising in Vegetarian Times and VegNews.
Fiscal 2009 advertisements will 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 will continue in fiscal 2009, as well as an
education outreach on our new environmental program. 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.





Debt
Maturity and Going Concern Issues


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 together with any accrued and unpaid interest thereon, is
convertible at the election of Mr. DeLuca, at


13
 Index


any time
on or prior to October 19, 2008 into shares of our common stock at a conversion
price of $0.35 per share.  The closing price of our common stock on
August 11, 2008 as quoted on the OTC Bulletin Board was $0.24 per share. Unless
the market price of our common stock increases between now and October 19, 2008,
it is unlikely that Mr. DeLuca would choose to convert the Convertible Note and
accrued interest thereon at his conversion price of $0.35 per
share.  If Mr. DeLuca does not choose to convert this Convertible Note
into stock and does not extend the maturity date of the Convertible Note, then
we will be required to pay principal plus accrued interest thereon in the amount
of $3,451,478 on October 19, 2008.  With our current cash balances and
the ability to borrow additional funds on our Commercial Finance Agreement, we
believe that we currently have the ability to repay a majority of this
obligation.  However, the payment of the entire balance would likely
seriously and adversely impact our liquidity and put a cash strain on the
Company without additional financing.  Additionally, our ability to
repay could be adversely affected by any negative changes in our cash position
between now and the maturity date of such Convertible Note.





We are
currently in discussions with Mr. DeLuca and others regarding options to
extend the maturity date, refinance, and/or convert all or a portion of the
Convertible Note and accrued interest thereon into equity on or before its
maturity on October 19, 2008.  There can be no assurance that we will
be successful in our negotiations with Mr. DeLuca and/or other parties or that
the terms of any such refinancing or conversions will not result in the
issuance, or potential issuance, of a significant amount of equity securities
that will cause substantial dilution to our stockholders.  In the
event we are not successful, any collection actions by Mr. DeLuca could have a
material adverse affect on the liquidity and financial condition of our Company
and our ability to secure additional financing.  The default rate of
interest on our Convertible Note is 17.5%.  Additionally, a default on
our Convertible Note would trigger a cross default in our obligations under our
Commercial Finance Agreement which would result in an acceleration of our
obligations and subject us to a default rate of interest there
under.  To the extent we have any borrowings outstanding at such time,
such a cross default would further exacerbate our liquidity position and have a
material adverse affect on our financial condition and we may not be able to
continue as a going concern.





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:


14
 Index


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 $460,000 and $1,194,000
for known and anticipated future credits and doubtful accounts at June 30, 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 $27,200 and $46,696 for known and
anticipated future reductions in inventory value at June 30, 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 (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS
No. 123R requires companies to measure the cost of employee services received in
exchange for an award of equity instruments, including stock options, based on
the grant-date fair value of the award and to recognize it as compensation
expense over the period the employee is required to provide service in exchange
for the award, usually the vesting period.





SFAS No.
123R applies to new awards and to awards modified, repurchased, or cancelled
after the effective date, as well as to the unvested portion of awards
outstanding as of the effective date. We use the Black-Scholes option-pricing
model to value our new stock option grants under SFAS No. 123R. SFAS No. 123R
also requires us to estimate forfeitures in calculating the expense related to
stock-based compensation. In addition, SFAS No. 123R requires us to reflect cash
flows resulting from 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 months ended June 30, 2008 and 2007.  Therefore,
there were no assumptions under the Black-Scholes option-pricing model and
no stock-based compensation expense during the three months ended June 30, 2008
and 2007.








Results of
Operations





3-Months
      Ended June 30,2008
            
            
            2007
            
            
            $
              Change
            
            
            %
              ChangeNet
      Sales
            
            
            6,036,590
            
            
            
            5,916,137
            
            
            
            120,453
            
            
            
            2.0
            %Cost
      of Goods Sold
            
            
            4,075,755
            
            
            
            3,460,368
            
            
            
            615,387
            
            
            
            17.8
            %Gross
      Margin
            
            
            1,960,835
            
            
            
            2,455,769
            
            
            
            (494,934
            )
            
            
            -20.2
            %Gross
      Profit %
            
            
            32.5
            %
            
            
            41.5
            %





15
 Index


Sales


For the
three months ended June 30, 2008 and 2007, our gross sales before discounts,
returns and allowances were $6,243,033 and $6,509,600,
respectively.  The following chart sets forth the percentage of gross
sales derived from our product brands during the three months ended June 30,
2008 and 2007:





Percentage
      of Gross SalesThree
      Months Ended June 30,Brand
            
            2008
            
            
            2007Veggie
            
            
            68.7
            %
            
            
            66.7
            %Rice
            
            
            12.2
            %
            
            
            12.5
            %Private
      Label, Imitation & Other
            
            
            8.0
            %
            
            
            11.0
            %Wholesome
      Valley Organic
            
            
            3.8
            %
            
            
            2.1
            %Vegan
            
            
            3.7
            %
            
            
            3.6
            %Veggy
            
            
            3.6
            %
            
            
            4.1
            %





Although
gross sales decreased approximately 4%, our net sales, after discounts, returns
and allowances, in the three months ended June 30, 2008 increased 2% from net
sales in the three months ended June 30, 2007.  The reason for the
increase 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 months ended
June 30, 2008 remained similar to that in the prior year period except for the
continued reduction of the lower margin private label and imitation
business.





We
anticipate that our annual sales in fiscal 2009 will be 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 nine percentage points to 67% of net sales in the three
months ended June 30, 2008 compared to 58% of net sales in the three months
ended June 30, 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 more than 98%
in the three months ended June 30, 2008 compared to the three months ended June
30, 2007 due to a current worldwide shortage and, because we buy most of our
casein from foreign suppliers, a weaker US Dollar in relation to the Euro that
began in the third quarter of fiscal 2008. However, the first quarter fiscal
2009 average price of casein is approximately 47% higher than the annual fiscal
2008 average and less than 1% higher than the fourth quarter of fiscal 2008;
thereby indicating a possible stabilization in the cost of casein.





Forecasts
from our suppliers indicate that these historically high casein prices may
likely remain at these high levels throughout the remainder of fiscal
2009.  This dramatic increase in supply costs is expected to
substantially increase our cost of goods sold and correspondingly substantially
reduce our gross margins in fiscal 2009.





During
fiscal 2008 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 dollars declined 20% in the three months ended June 30, 2008 compared to
the three months ended June 30, 2007.  Additionally, gross profit
declined approximately 9 percentage points from an average of 42% in the three
months ended June 30, 2007 to 33% in the three months ended June 30,
2008.  This decrease in gross margin dollars and profits is primarily
due to the rapid increase in the cost of goods sold as stated
above.  We do not believe that we are able to pass 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 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.


16
 Index


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.





3-Months
      Ended June 30,2008
            
            
            2007
            
            
            $
              Change
            
            
            %
              ChangeNet
      Sales
            
            
            6,036,590
            
            
            
            5,916,137
            
            
            
            120,453
            
            
            
            2.0
            %Cost
      of Goods Sold
            
            
            4,075,755
            
            
            
            3,460,368
            
            
            
            615,387
            
            
            
            17.8
            %Gross
      Margin
            
            
            1,960,835
            
            
            
            2,455,769
            
            
            
            (494,934
            )
            
            
            -20.2
            %Operating
      Expenses:Selling
            
            
            753,518
            
            
            
            889,408
            
            
            
            (135,890
            )
            
            
            -15.3
            %Delivery
            
            
            238,731
            
            
            
            246,845
            
            
            
            (8,114
            )
            
            
            -3.3
            %General
      and administrative(1)
            
            
            658,529
            
            
            
            623,616
            
            
            
            34,913
            
            
            
            5.6
            %Employment
      contract expense(2)
            
            
            --
            
            
            
            346,447
            
            
            
            (346,447
            )
            
            
            -100.0
            %Research
      and development
            
            
            82,368
            
            
            
            83,277
            
            
            
            (909
            )
            
            
            -1.1
            %Total
      operating expenses
            
            
            1,733,146
            
            
            
            2,189,593
            
            
            
            (456,447
            )
            
            
            -20.8
            %Income
      from Operations
            
            
            227,689
            
            
            
            266,176
            
            
            
            (38,487
            )
            
            
            -14.5
            %Interest
      expense, net
            
            
            (107,738
            )
            
            
            (115,177
            )
            
            
            7,439
            
            
            
            -6.5
            %Income
      before Taxes
            
            
            119,951
            
            
            
            150,999
            
            
            
            (31,048
            )
            
            
            -20.6
            %Federal
      Income Tax Expense
            
            
            --
            
            
            
            --
            
            
            
            --
            
            
            
            0.0
            %NET
      INCOME
            
            
            119,951
            
            
            
            150,999
            
            
            
            (31,048
            )
            
            
            -20.6
            %Interest
      expense, net
            
            
            107,738
            
            
            
            115,177
            
            
            
            (7,439
            )
            
            
            -6.5
            %Depreciation
            
            
            11,876
            
            
            
            10,971
            
            
            
            905
            
            
            
            8.2
            %EBITDA, (a non-GAAP
      measure)
            
            
            239,565
            
            
            
            277,147
            
            
            
            (37,582
            )
            
            
            -13.6
            %EBITDA,
      as a % of Net Sales
            
            
            4.0
            %
            
            
            4.7
            %





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


(2)
            In
      our calculation of key financial measures, we exclude the 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 13% and 15% in the three
months ended June 30, 2008 and 2007, respectively. Historically, selling
expenses averaged 14%-15% of net sales.  We expect that fixed selling
expense amounts for advertising and market research in fiscal 2009 will be
consistent with fiscal 2008, but fiscal 2009 selling expenses will increase as a
percentage of sales compared to fiscal 2008 due to a higher percentage of
advertising and promotion costs on the products in our sales mix. Nearly all of
our promotional spending is directed toward our branded products and is
therefore tied more to our branded sales levels rather than overall
sales.  As we expect to further eliminate lower margin imitations
sales in fiscal 2009, our selling expenses as a percentage of overall sales may
slightly increase.


17
 Index


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 months ended June 30, 2008 and 2007 as
anticipated.  We anticipate that delivery expense for fiscal 2009 will
remain at approximately 4% of net sales.





General and
administrative


In the
three months ended June 30, 2008, legal fees declined by approximately $67,000
as a result of a change in our primary general counsel and as a result of less
time consuming legal transactions compared to the three months ended June 30,
2007.  However, this reduction in legal fees was offset by a $67,000
increase in employee costs due to increases in existing employee payroll and
benefits, as well as increases in consulting fees.  The net result was
a slight increase in general and administrative expenses of approximately 6% in
the first quarter of fiscal 2009 compared to the first quarter of fiscal
2008.





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 order to pursue other opportunities.  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 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 $38,276, the
remaining obligation is being paid out in nearly equal bi-weekly installments
through February 2009.





Research
and Development


Research
and development expenses decreased by less than $1,000 or 1% in the three months
ended June 30, 2008 compared to June 30, 2007.  We anticipate that
research and development costs will be slightly higher in fiscal 2009, based on
current plans for new product development and existing product reformulations to
improve taste and quality and to possibly reduce casein content.





Interest
expense


Interest
expense decreased slightly by approximately $7,000 or 6% in the three months
ended June 30, 2008 compared to the three months ended June 30, 2007. The
decrease in interest expense is primarily the result of 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.  Our current loan facility
with Commercial Finance Division accrues interest based on a variable prime plus
rate.  Prime rate is currently at 5.0% 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.








Liquidity and Capital
Resources





Future
Capital Needs


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 full by October 19, 2008 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 depends upon the outcome of our discussions with Mr. DeLuca and others
regarding options to extend the maturity date, 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 $3,451,478 on October
19, 2008 and obtaining positive cash flow from operations to sustain normal
business operations.





Our
current business plan continues to eliminate low margin private label and Galaxy
imitation business from our sales mix, which is expected to result in slightly
lower sales in fiscal 2009 than in fiscal 2008.  Additionally, the
cost of goods sold is increasing due to higher ingredient costs that began in
the third quarter of fiscal 2008, particularly casein, which
will


18
 Index


continue
to negatively impact gross margins on a majority of our
products.  During fiscal 2008, we implemented several initiatives in
an effort to at least partially minimize the negative effect of these ingredient
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.  We are continuing these
initiatives throughout fiscal 2009.  With our current cash balances
and the ability to borrow additional funds on our Commercial Finance Agreement,
we believe that we currently have the ability to repay a majority of the
Convertible Note and accrued interest thereon by October 19,
2008.  However, the payment of the entire balance of $3,451,478 would
likely seriously and adversely impact our liquidity and put a cash strain on the
Company without additional financing.





There can
be no assurance that we will be successful in our business plan, our
negotiations with Mr. DeLuca and/or other parties or that the terms of any such
refinancing or conversions will not result in the issuance, or potential
issuance, of a significant amount of equity securities that will cause
substantial dilution to our stockholders. If we are not successful in our
business plan, refinancing the Convertible Note or in otherwise entering into a
financing, sale, or other business transaction that infuses sufficient cash
resources into our Company in the near future, any collection actions by Mr.
DeLuca or other parties could have a material adverse affect on the liquidity
and financial condition of our Company and on our ability to secure additional
financing and we may not be able to continue as a going concern.








3-Months
      Ended June 30,
            
            2008
            
            
            2007
            
            
            $
              Change
            
            
            %
              ChangeCash
      from (used in) operating activities
            
            
            1,907
            
            
            
            (376,246
            )
            
            
            378,153
            
            
            
            -100.5
            %Cash
      from (used in) investing activities
            
            
            (16,208
            )
            
            
            (9,311
            )
            
            
            (6,897
            )
            
            
            74.1
            %Cash
      from (used in) financing activities
            
            
            --
            
            
            
            2,751
            
            
            
            (2,751
            )
            
            
            -100.0
            %Net
      increase (decrease) in cash
            
            
            (14,301
            )
            
            
            (382,806
            )
            
            
            368,505
            
            
            
            -96.3
            %





Operating
and Investing Activities


We are
continuing to provide positive cash flow from operations with faster collections
on accounts receivable and maximizing 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
three months ended June 30, 2008 and 2007, cash used in investing activities
related to our purchase of additional office equipment.





Financing
Activities


There
were no financing activities during the three months ended June 30, 2008 and
2007 except that related to our secured borrowings.





Debt
Financing


On June
23, 2006, we entered into a Receivables Purchase Agreement with Commercial
Finance Division, formerly known as Systran Financial Services Corporation, 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 (6.50% on June 30, 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.  A default in our obligations to Mr. DeLuca under
the Convertible Note would trigger a cross default under our Commercial Finance
Agreement.





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


19
 Index


1.5% and
we would be liable for an early termination premium ranging from 1% to 3%,
depending upon the timing of such termination, on the maximum principal amount
available under the Commercial Finance Agreement.  Although we had
approximately $1.7 million available to draw pursuant to this Commercial Finance
Agreement as of June 30, 2008, there were no amounts advanced, because we did
not need additional cash on such date.  The net amount of cash
provided under the Commercial Finance Agreement during the three months ended
June 30, 2008 and 2007 was $0 and $2,751, respectively.








Recent Accounting
Pronouncements


There
have been no significant pronouncements that were not already identified in our
Annual Report on Form 10-K for the fiscal year ended March 31, 2008 that are
expected to have any impact on our results of operations, financial position or
cash flows.














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.





Management
is responsible for establishing and maintaining adequate internal control over
financial reporting.  Under the supervision of management, including
the Chief Executive Officer ("CEO") and the Chief Financial Officer ("CFO"), we
conducted an evaluation of the effectiveness of our internal control over
financial reporting based on “Internal Control - Integrated
Framework,” published in 1992 by the Committee of Sponsoring
Organizations (“COSO”) of the Treadway Commission and subsequent guidance
prepared by the COSO specifically for smaller public companies. Based on that
evaluation, our management, including the CEO and CFO, concluded that our
internal control over financial reporting was 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 as of our
fiscal year ended March 31, 2008.  During the quarter ended June 30,
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.





Our
internal control over financial reporting includes policies and procedures that
pertain to the maintenance of records that accurately and fairly reflect, in
reasonable detail, transactions and dispositions of assets; and provide
reasonable assurances that: (1) transactions are recorded as necessary to permit
preparation of financial statements in accordance with accounting principles
generally accepted in the United States; (2) receipts and expenditures are being
made only in accordance with authorizations of management and the directors of
our Company; and (3) unauthorized acquisition, use, or disposition of our assets
that could have a material effect on our financial statements are prevented or
timely detected.





All
internal control systems, no matter how well designed, have inherent
limitations.  Therefore, even those systems determined to be effective
can provide only reasonable assurance with respect to financial statement
preparation and presentation.  Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





Our
annual report as of March 31, 2008 did not include an attestation report of
Cross Fernandez Riley LLP, our registered public accounting firm regarding
internal control over financial reporting.  Management's report was
not subject to attestation by the company's registered public accounting firm
pursuant to temporary rules of the Securities and Exchange Commission that
permit us to provide only management's report in our annual report.





20
 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 August 11, 2008, 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 Convertible Note together with any
accrued and unpaid interest thereon, is convertible at the election of Mr.
DeLuca, at any time on or prior to October 19, 2008 into shares of our common
stock at a conversion price of $0.35 per share.  The closing price of
our common stock on August 11, 2008 as quoted on the OTC Bulletin Board was
$0.24 per share. Unless the market price of our common stock increases between
now and October 19, 2008, it is unlikely that Mr. DeLuca would choose to convert
the Convertible Note and accrued interest thereon at his conversion price of
$0.35 per share.  If Mr. DeLuca does not choose to convert this
Convertible Note into stock and does not extend the maturity date of the
Convertible Note, then we will be required to pay principal plus accrued
interest thereon in the amount of $3,451,478 on October 19,
2008.  With our current cash balances and the ability to borrow
additional funds on our Commercial Finance Agreement, we believe that we
currently have the ability to repay a majority of this
obligation.  However, the payment of the entire balance would likely
seriously and adversely impact our liquidity and put a cash strain on the
Company without additional financing.  Additionally, our ability to
repay could be adversely affected by any negative changes in our cash position
between now and the maturity date of such Convertible Note.





We are
currently in discussions with Mr. DeLuca and others regarding options to extend
the maturity date, refinance, and/or convert all or a portion of the Convertible
Note and accrued interest thereon into equity on or before its maturity on
October 19, 2008.  There can be no assurance that we will be
successful in our negotiations with Mr. DeLuca and/or other parties or that the
terms of any such refinancing or conversions will not result in the issuance, or
potential issuance, of a significant amount of equity securities that will cause
substantial dilution to our stockholders.  In the event we are not
successful, any collection actions by Mr. DeLuca could have a material adverse
affect on the liquidity and financial condition of our Company and our ability
to secure additional financing.  The default rate of interest on our
Convertible Note is 17.5%.  Additionally, a default on our Convertible
Note would trigger a cross default in our obligations under our Commercial
Finance Agreement which would result in an acceleration of our obligations and
subject us to a default rate of interest there under.  To the extent
we have any borrowings outstanding at such time, such a cross default would
further exacerbate our liquidity position and have a material adverse affect on
our financial condition and we may not be able to continue as a going
concern.





We
may not be able 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 full by October 19, 2008 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 depends upon the outcome of our


21
 Index


discussions
with Mr. DeLuca and
others regarding options to extend the maturity date, 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 $3,451,478 on
October 19, 2008 and obtaining positive cash flow from operations to sustain
normal business operations. With our current cash balances and the ability to
borrow additional funds on our Commercial Finance Agreement, we believe that we
currently have the ability to repay a majority of the Convertible Note and
accrued interest thereon.  However, the payment of the entire balance
of $3,451,478 would likely seriously and adversely impact our liquidity and put
a cash strain on the Company without additional financing.





In order
to repay the Convertible Note and continue operating as a going concern, we may
also need to quickly raise capital.  To the extent that we issue any
of our securities in connection with our efforts to raise capital, any such
capital raised would not be registered under the Securities Act of 1933 and
would not be offered or sold in the United States absent registration
requirements.  Further, due to the low trading price of our common
stock, we would likely need to sell a significant amount of our
securities.





Our
current business plan continues to eliminate low margin private label and Galaxy
imitation business from our sales mix, which is expected to result in slightly
lower sales in fiscal 2009 than in fiscal 2008.  Additionally, the
cost of goods sold is increasing due to higher ingredient costs that began in
the third quarter of fiscal 2008, particularly casein, which will continue to
negatively impact gross margins on a majority of our products.  During
fiscal 2008, we implemented several initiatives in an effort to at least
partially minimize the negative effect of these ingredient 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.  We are continuing these initiatives throughout fiscal
2009.





There can
be no assurance that we will be successful in our business plan, our
negotiations with Mr. DeLuca and/or other parties or that the terms of any such
refinancing or conversions will not result in the issuance, or potential
issuance, of a significant amount of equity securities that will cause
substantial dilution to our stockholders. If we are not successful in
refinancing the Convertible Note or in otherwise entering into a financing,
sale, or other business transaction that infuses sufficient cash resources into
our Company in the near future, any collection actions by Mr. DeLuca or other
parties could have a material adverse affect on the liquidity and financial
condition of our Company and on our ability to secure additional financing, and
we may not be able to continue as a going concern.





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 current worldwide shortage and, because we buy most of our casein from
foreign suppliers,  a weaker US Dollar in relation to the Euro, the
average price of casein increased more than 98% in the three months ended June
30, 2008 compared to the three months ended June 30, 2007. However, the first
quarter fiscal 2009 average price of casein is approximately 47% higher than the
annual fiscal 2008 average and less than 1% higher than the fourth quarter of
fiscal 2008; thereby indicating a possible stabilization in the cost of
casein.  Forecasts from our suppliers indicate that these historically
high casein prices may likely remain at these high levels throughout fiscal
2009.  This dramatic increase in supply costs is expected to
substantially increase our cost of goods sold and correspondingly substantially
reduce our gross margins in fiscal 2009.





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 operations will


22
 Index


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





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


As of
August 11, 2008, Frederick DeLuca, a private investor, owned approximately 23%
of our outstanding common stock and held warrants and a convertible note which,
if exercised with accrued and unpaid interest on the convertible note as of such
date and assuming the exercise of no other outstanding options or warrants,
would give him ownership of approximately 51% of our outstanding common
stock.  Investors who purchase common stock in our Company may be
unable to elect any specific members of the board of directors or exercise
significant control over us or our business as a result of Mr. DeLuca’s
ownership of our common stock and our outstanding note obligations to Mr.
DeLuca. Additionally, Mr. DeLuca may be able to exercise significant influence
over our policies and Board composition.





Stockholders
may experience further dilution.


We have a
substantial number of outstanding options and warrants and the Convertible Note
to acquire shares of common stock.  As of August 11, 2008, we have a
total of 15,388,526 shares reserved for future issuance upon exercise of options
or warrants and conversion of the Convertible Note.  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 or note conversion could adversely affect the market price
of the common stock or result in substantial dilution to our existing
stockholders.  In addition, any future securities issuances by our
Company, especially in connection with the refinancing of the Convertible Note,
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.











23
 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


24
 Index


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.)





*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
      (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
      (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.)





*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.)





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.








25
 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:
August 13,
2008                                                         /s/
Michael E.
Broll


Michael
E. Broll


Chief
Executive Officer & Director


(Principal
Executive Officer)








Date:
August 13,
2008                                                         /s/
Salvatore J.
Furnari


Salvatore
J. Furnari


Chief
Financial Officer & Vice President of Finance


(Principal
Accounting and Financial Officer)








26
 Index