**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-Q**





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




FOR
      THE
      QUARTERLY PERIOD ENDED **SEPTEMBER
      30, 2006**




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 1-15445**





**FAMILYMEDS
      GROUP, INC.**


**(Exact
      name of registrant as specified in its charter)**










**NEVADA**
            **34-1755390****(State
                or other jurisdiction of**
              **incorporation
                or organization)**
            **(I.R.S.
                    Employer**
                  **Identification
                    No.)**




**312
      Farmington Avenue, Farmington, CT 06032**


**(Address
      of principal executive offices)**




**(860)
      676-1222**


**(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 x No  ̈




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of
      the
      Securities Exchange Act of 1934).




Large
      accelerated filer  ̈   Accelerated
      filer  ̈ Non-accelerated
      filer x




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Securities Exchange Act of
      1934).    Yes  ̈ No x




As
      of
      November 10, 2006, there were 6,693,762 shares of common stock, par value $0.001
      per share, outstanding.










**FAMILYMEDS
      GROUP, INC. AND SUBSIDIARIES**


**FORM
      10-Q**


**FOR
      THE THREE AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2006**


**TABLE
      OF CONTENTS**




**Page No.****PART
                I -****FINANCIAL
                INFORMATION**Item
                1. Condensed Consolidated Financial Statements of Familymeds Group,
                Inc.
                (formerly known as DrugMax, Inc.) and Subsidiaries
            1Condensed
                Consolidated Balance Sheets as of September 30, 2006 (unaudited)
                and
                December 31, 2005
            1Condensed
                Consolidated Statements of Operations Three and Nine Month
                Periods Ended September 30, 2006 and October 1, 2005 (unaudited)
            2Condensed
                Consolidated Statements of Cash Flows Nine Month Periods Ended September
                30, 2006 and October 1, 2005 (unaudited)
            3Notes
                to Condensed Consolidated Financial Statements
            4Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            14Item
                3. Quantitative and Qualitative Disclosures About Market Risk
            30Item
                4. Controls and Procedures
            30**PART
                II -****OTHER
                INFORMATION**Item
                1. Legal Proceedings
            31Item
                1A. Risk Factors
            31Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            32Item
                3. Default upon Senior Securities
            32Item
                4. Submission of Matters to a Vote of Security Holders
            32Item
                5. Other Information
            32Item
                6. Exhibits
            32**SIGNATURES**
            33




i




**PART
      I - FINANCIAL INFORMATION**




**Item
      1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**FAMILYMEDS
                  GROUP, INC. AND SUBSIDIARIES****(formerly
                  DRUGMAX, INC.)****CONDENSED
                  CONSOLIDATED BALANCE SHEETS****SEPTEMBER
                  30, 2006 AND DECEMBER 31, 2005****(in
                  thousands, except share data)****(Unaudited)**
  **ASSETS**
              
              **September
                  30,**
                **2006**
              
              **December
                  31,**
                **2005**CURRENT
                  ASSETS:Cash
                  and cash equivalents
              
              $
              895
              
              $
              6,681Trade
                  receivables, net of allowance for doubtful accounts of
                  approximately$2,769
                  and $2,777 in 2006 and 2005, respectively
              
              
              14,637
              
              
              12,855Inventories
              
              
              23,569
              
              
              30,631Prepaid
                  expenses and other current assets
              
              
              1,537
              
              
              2,487Total
                  current assets
              
              
              40,638
              
              
              52,654PROPERTY
                  AND EQUIPMENT—Net of accumulated depreciation and
                  amortizationof
                  approximately $14,385 and $13,080 in 2006 and 2005,
                  respectively
              
              
              6,542
              
              
              4,959GOODWILL
              
              
              1,355
              
              
              1,355INTANGIBLE
                  ASSETS—Net of accumulated amortization ofapproximately
                  $19,069 and $17,674 in 2006 and 2005, respectively
              
              
              3,286
              
              
              4,852OTHER
                  NONCURRENT ASSETS
              
              
              668
              
              
              207TOTAL
                  ASSETS
              
              $
              52,489
              
              $
              64,027**LIABILITIES
                  AND STOCKHOLDERS’ DEFICIT**CURRENT
                  LIABILITIESCurrent
                  portion of notes payable
              
              $
              2,000
              
              $
              4,721Promissory
                  notes payable
              
              
              94
              
              
              915Revolving
                  credit facility
              
              
              36,199
              
              
              36,251Accounts
                  payable
              
              
              10,819
              
              
              9,014Accrued
                  expenses
              
              
              5,550
              
              
              6,100Total
                  current liabilities
              
              
              54,662
              
              
              57,001NOTES
                  PAYABLE, NET OF DISCOUNT OF $2,372 in 2006
              
              
              5,129
              
              
              18,184OTHER
                  LONG-TERM LIABILITIES
              
              
              62
              
              
              135COMMITMENTS
                  AND CONTINGENCIESSTOCKHOLDERS’
                  DEFICIT:Series
                  A convertible preferred stock, $1,000 par value, 500,000 authorized
                  and
                  none outstanding
              
              
              -
              
              
              -Common
                  stock, $.001 par value, 200,000,000 shares authorized; 6,634,884
                  and
                  6,574,044 shares issued and outstanding for 2006 and 2005,
                  respectively
              
              
              66
              
              
              66Additional
                  paid in capital
              
              
              230,740
              
              
              227,336Accumulated
                  deficit
              
              
              (237,420
              )
              
              (238,131
              )Unearned
                  compensation
              
              
              (750
              )
              
              (564
              )Total
                  stockholders’ deficit
              
              
              (7,364
              )
              
              (11,293
              )TOTAL
                  LIABILITIES AND STOCKHOLDERS' DEFICIT
              
              $
              52,489
              
              $
              64,027
  See notes to condensed consolidated financial
        statements.
 1
  **FAMILYMEDS
                    GROUP, INC. AND SUBSIDIARIES****(formerly
                    DRUGMAX, INC.)****CONDENSED
                    CONSOLIDATED STATEMENTS OF OPERATIONS****THREE
                    AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2006 and OCTOBER 1,
                    2005****(in
                    thousands, except per share data)****(Unaudited)**
  **Three
                    Month Periods Ended**
                
                **Nine
                    Month Periods Ended****September
                    30,**
                  **2006**
                
                **October
                    1,**
                  **2005**
                
                **September
                    30,**
                  **2006**
                
                **October
                    1,**
                  **2005**NET
                    REVENUES
                
                $
                57,915
                
                $
                51,755
                
                $
                174,698
                
                $
                163,672COST
                    OF SALES
                
                
                46,532
                
                
                41,878
                
                
                140,527
                
                
                130,819Gross
                    margin
                
                
                11,383
                
                
                9,877
                
                
                34,171
                
                
                32,853SELLING,
                    GENERAL AND ADMINISTRATIVE EXPENSES
                
                
                12,760
                
                
                13,426
                
                
                40,201
                
                
                41,398GAIN
                    ON SALE OF PHARMACY ASSETS
                
                
                (839
                )
                
                -
                
                
                (839
                )
                
                -RESTRUCTURING
                    EXPENSE
                
                
                34
                
                
                -
                
                
                34
                
                
                -DEPRECIATION
                    AND AMORTIZATION EXPENSE
                
                
                951
                
                
                1,107
                
                
                2,678
                
                
                3,420OPERATING
                    LOSS
                
                
                (1,523
                )
                
                (4,656
                )
                
                (7,903
                )
                
                (11,965
                )OTHER
                    INCOME (EXPENSE):Gain
                    on extinguishment of debt
                
                
                -
                
                
                -
                
                
                13,086
                
                
                -Interest
                    expense
                
                
                (1,386
                )
                
                (1,757
                )
                
                (4,189
                )
                
                (3,939
                )Interest
                    income
                
                
                -
                
                
                3
                
                
                41
                
                
                18Other
                    income (expense)
                
                
                (18
                )
                
                68
                
                
                42
                
                
                354Total
                    other income (expense), net
                
                
                (1,404
                )
                
                (1,686
                )
                
                8,980
                
                
                (3,567
                )Income
                    (loss) from continuing operations
                
                
                (2,927
                )
                
                (6,342
                )
                
                1,077
                
                
                (15,532
                )Loss
                    from discontinued operations
                
                
                (144
                )
                
                (8,193
                )
                
                (366
                )
                
                (11,163
                )NET
                    INCOME (LOSS)
                
                
                (3,071
                )
                
                (14,535
                )
                
                711
                
                
                (26,695
                )Preferred
                    stock dividends
                
                
                -
                
                
                401
                
                
                -
                
                
                (1,854
                )NET
                    INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS
                
                $
                (3,071
                )
                $
                (14,134
                )
                $
                711
                
                $
                (28,549
                )BASIC
                    AND DILUTED INCOME (LOSS) PER COMMON SHARE:Income
                    (loss) from continuing operations available to common
                    shareholders
                
                
                (0.44
                )
                
                (2.96
                )
                
                0.16
                
                
                (8.76
                )Loss
                    from discontinued operations
                
                
                (0.02
                )
                
                (4.09
                )
                
                (0.05
                )
                
                (5.63
                )Net
                    income (loss) available to common shareholders
                
                $
                (0.46
                )
                $
                (7.05
                )
                $
                0.11
                
                $
                (14.39
                )WEIGHTED
                    AVERAGE SHARES OUTSTANDING:Basic
                    and diluted
                
                
                6,623
                
                
                2,005
                
                
                6,606
                
                
                1,984
  See notes to condensed consolidated financial
        statements.
 2
  **FAMILYMEDS
                    GROUP, INC. AND SUBSIDIARIES****(formerly
                    DRUGMAX, INC.)****CONDENSED
                    CONSOLIDATED STATEMENTS OF CASH FLOWS****NINE
                    MONTH PERIODS ENDED SEPTEMBER 30, 2006 and OCTOBER 1,
                    2005****(in
                    thousands)****(Unaudited)**
  **Nine
                    Month Periods Ended****September
                    30,**
                  **2006**
                
                **October
                    1,**
                  **2005**CASH
                    FLOWS FROM OPERATING ACTIVITIES:Net
                    income (loss)
                
                $
                711
                
                $
                (26,695
                )Adjustments
                    to reconcile net income (loss) to net cash used in operating
                    activities:Depreciation
                    and amortization
                
                
                2,678
                
                
                3,420Stock
                    compensation expense
                
                
                472
                
                
                5,074Noncash
                    interest expense
                
                
                989
                
                
                659Amortization
                    of deferred financing fees
                
                
                224
                
                
                187Provision
                    for (recoveries of) for doubtful accounts
                
                
                (8
                )
                
                120Gain
                    on extinguishment of debt
                
                
                (13,086
                )
                
                -(Gain)
                    loss on disposal of fixed assets and intangible assets
                
                
                (839
                )
                
                6Effect
                    of changes in operating assets and liabilities:Trade
                    receivables
                
                
                (1,774
                )
                
                2,851Inventories
                
                
                7,306
                
                
                2,783Prepaid
                    expenses and other current assets
                
                
                571
                
                
                356Accounts
                    payable
                
                
                955
                
                
                (334
                )Accrued
                    expenses
                
                
                (374
                )
                
                1,138Other
                
                
                (208
                )
                
                131Change
                    in assets held for sale
                
                
                -
                
                
                6,211Net
                    cash used in operating activities
                
                
                (2,383
                )
                
                (4,093
                )CASH
                    FLOWS FROM INVESTING ACTIVITIES:Purchases
                    of property and equipment
                
                
                (2,031
                )
                
                (1,451
                )Purchases
                    of pharmacy assets
                
                
                (244
                )
                
                -Proceeds
                    from sale of pharmacy assets
                
                
                850
                
                
                -Net
                    cash used in investing activities
                
                
                (1,425
                )
                
                (1,451
                )CASH
                    FLOWS FROM FINANCING ACTIVITIES:Proceeds
                    from (repayment of) revolving credit facility, net
                
                
                (52
                )
                
                5,694Repayment
                    of promissory notes payable
                
                
                (1,896
                )
                
                (1,219
                )Repayment
                    of obligations under capital leases
                
                
                -
                
                
                (30
                )Payment
                    of deferred financing fees
                
                
                (39
                )
                
                (435
                )Proceeds
                    from exercise of stock options
                
                
                9
                
                
                564Net
                    cash provided by (used in) financing activities
                
                
                (1,978
                )
                
                4,574NET
                    DECREASE IN CASH AND CASH EQUIVALENTS
                
                
                (5,786
                )
                
                (970
                )CASH
                    AND CASH EQUIVALENTS—Beginning of period
                
                
                6,681
                
                
                2,332CASH
                    AND CASH EQUIVALENTS—End of period
                
                $
                895
                
                $
                1,362SUPPLEMENTAL
                    DISCLOSURES OF CASH FLOW INFORMATION:Cash
                    paid for interest
                
                $
                2,564
                
                $
                3,280Noncash
                    transactions—Subordinated
                    Convertible Debenture interest payments made in common
                    stock
                
                $
                229
                
                $
                521Payment
                    of DrugMax Series A preferred stock dividends in common stock
                
                $
                -
                
                $
                294Conversion
                    of accounts payable to subordinated notes payable
                
                $
                -
                
                $
                23,000Retirement
                    of ABDC subordinated notes payable
                
                $
                23,089
                
                $
                -Issuance
                    of subordinated notes payable to Deerfield
                
                $
                10,000
                
                $
                -Capital
                    expenditures incurred but not yet paid
                
                $
                850
                
                $
                -
  See
          notes
          to condensed consolidated financial statements.
  3




**FAMILYMEDS
      GROUP** **,
      INC. AND SUBSIDIARIES**


**(formerly,
      Drugmax, Inc.)**


**Notes
      to (Unaudited) Condensed Consolidated Financial Statements**




**NOTE
      1 - BASIS OF PRESENTATION**




The
      accompanying unaudited condensed consolidated financial statements include
      the
      accounts of Familymeds Group, Inc., formerly known as DrugMax, Inc., and its
      wholly-owned subsidiaries (collectively referred to as the “Company” or
“Familymeds Group”). All intercompany accounts and transactions have been
      eliminated.




The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in conformity with generally accepted accounting principles for interim
      financial information and with the instructions to Form 10-Q and Article 10
      of
      Regulation S-X. Accordingly, they do not include all of the information and
      notes required by accounting principles generally accepted in the United States
      of America for complete financial statements. In the opinion of management,
      all
      adjustments (consisting of normal recurring items) considered necessary for
      a
      fair presentation have been included. Interim results are not necessarily
      indicative of the results that may be expected for a full year. These unaudited
      condensed consolidated statements should be read in conjunction with the audited
      consolidated financial statements and notes thereto included in our Annual
      Report on Form 10-K, as amended, for the fiscal year ended December 31, 2005
      filed with the United States Securities and Exchange Commission.





On
      June
      23, 2006, the Company’s shareholders approved a reverse stock split of up to
      one-for-ten of the Company’s authorized and outstanding common stock. The
      reverse stock split was effective with respect to shareholders of record at
      the
      opening of trading on August 16, 2006, and the Company’s common stock began
      trading as adjusted for the reverse stock split on that same day. As a result
      of
      the reverse stock split, each ten shares of common stock were combined into
      one
      share of common stock and the total number of shares outstanding were reduced
      from approximately 66 million shares to approximately 6.6 million
      shares. The Company has retroactively adjusted all share and per share
      information to reflect the reverse stock split in the accompanying unaudited
      condensed consolidated financial statements and notes.





The
      Company’s fiscal year 2006 begins on January 1, 2006 and ends on December 30,
      2006, which is the Saturday closest to December 31, 2006. The Company’s quarters
      end on the Saturday closest to March 31, June 30 and September 30. Each fiscal
      quarter is 13 weeks in length. The Company’s third quarter for fiscal year 2006
      ended on September 30, 2006.




**NOTE
      2 - BUSINESS AND GOING CONCERN**




On
      March
      19, 2004, Familymeds Group, Inc. (“FMG”) entered into an Agreement and Plan of
      Merger, which was amended on July 1, 2004 and on October 11, 2004 (as amended,
      the “Merger Agreement”), with DrugMax, Inc. (“DrugMax”). Under the terms of the
      Merger Agreement, on November 12, 2004, FMG merged into DrugMax, and DrugMax
      became the surviving corporation in the merger (the “Merger”). The Merger was
      treated as a purchase of DrugMax by FMG for accounting purposes.  On July
      10, 2006, the Company amended its Articles of Incorporation to change its name
      from DrugMax, Inc. to Familymeds Group, Inc. and changed its trading symbol
      from
      DMAX to FMRX.





***Business*** —
As
      of
      September 30, 2006, the Company operated 78 Company owned locations including
      75
      pharmacies, one home health center, one health and beauty location and one
      non-pharmacy mail order center, and franchised 7 pharmacies in 14 states, under
      the Familymeds Pharmacy, Arrow Pharmacy & Nutrition Center, and Worksite
      Pharmacy SM brand
      names.




4





The
      Company also operates a medical supply business primarily focused on
      the direct distribution of specialty pharmaceuticals to physicians, medical
      clinics and other health care providers.





***Going
      Concern*** —
The
      accompanying unaudited condensed consolidated financial statements have been
      prepared assuming that the Company will continue as a going concern. The report
      of independent registered public accounting firm for the Company’s December 31,
      2005 consolidated financial statements was modified with respect to
      uncertainties regarding the Company’s ability to continue as a going concern. As
      of December 31, 2005, the Company had a net stockholders' deficit of $11.3
      million and has incurred net losses of $54.9 million, $39.8 million and $12.2
      million for the years ended December 31, 2005, January 1, 2005 and December
      27,
      2003. As of September 30, 2006, the Company had a net stockholders’ deficit of
      $7.4 million. These matters raise substantial doubt about the Company's ability
      to continue as a going concern. During the fourth quarter of 2005, the Company
      completed certain transactions considered to be critical to achieving future
      growth and profitability. These include the sale of common stock for net
      proceeds of $47.4 million, the refinancing of the senior credit facility with
      a
      new $65.0 million facility, which allows for additional borrowing availability,
      and the sale and discontinuation of substantially all of the Company’s full-line
      wholesale drug distribution operations, which had incurred significant losses.
      Further, during the second quarter of 2006, the Company entered into a Note
      and
      Warrant Purchase Agreement and certain other agreements described below, each
      effective as of June 23, 2006, with Deerfield Special Situations Fund, L.P.
      (“Deerfield L.P.”) and Deerfield Special Situations Fund International, Limited
      (“Deerfield International”), pursuant to which Deerfield L.P. and Deerfield
      International (collectively, “Deerfield”) purchased two secured promissory notes
      in the aggregate principal amount of $10 million (one note in the principal
      amount of $3.32 million and the second note in the amount of $6.68 million
      collectively the “Notes”) and eight warrants to purchase an aggregate of 1.65
      million shares of Familymeds Group, Inc. common stock (the “Warrants”), for an
      aggregate purchase price of $10 million. The $10 million purchase price for
      the
      Notes and Warrants was used entirely for an early repayment, settlement and
      termination of approximately $23 million in outstanding subordinated debt and
      accrued unpaid interest with the Company’s former supplier AmerisourceBergen
      Drug Corporation (“ABDC”). Although no assurances may be made, management
      believes that these transactions as well as other organizational and operational
      changes will allow the Company to continue as a going concern.





**NOTE
      3 - PER SHARE INFORMATION**





The
      computations of basic and diluted net income (loss) per common share are based
      upon the weighted average number of common shares outstanding and potentially
      dilutive securities. Potentially dilutive securities include all-in-the money
      stock options and warrants.  Options and warrants to purchase 392,822 and
      4,405,599, respectively, shares of common stock were not included in the
      September 30, 2006 computations of diluted net income per common share because
      inclusion of such shares would have been anti-dilutive.  Options and
      warrants to purchase 325,390 and 550,922 shares of common stock were not
      included in the October 1, 2005 computations of diluted net loss per common
      share because inclusion of such shares would have been
      anti-dilutive.




**NOTE
      4 - STOCK BASED COMPENSATION**




In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS
      123(R), “Share-Based Payment (as amended).” SFAS No. 123(R) eliminates the
      alternative to use the intrinsic value method of accounting that was provided
      in
      SFAS No. 123, which generally resulted in no compensation expense recorded
      in
      the financial statements related to the issuance of equity awards to employees.
      SFAS No. 123(R) requires that the cost resulting from all share-based payment
      transactions be recognized in the financial statements. SFAS No. 123(R)
      establishes fair value as the measurement objective in accounting for
      share-based payment arrangements and requires all companies to apply a
      fair-value-based measurement method in accounting generally for all share-based
      payment transactions with employees.




On
      January 1, 2006, the Company adopted SFAS No. 123(R) using a modified
      prospective method resulting in the recognition of share-based compensation
      expense of $2.0 thousand, net of $0.0 related tax expense. Prior period amounts
      have not been restated. Under this application, the Company is required to
      record compensation expense for all awards granted after the date of adoption
      and for the unvested portion of previously granted awards that remain
      outstanding at the date of adoption.




5




Prior
      to
      the adoption of SFAS No. 123(R), the Company applied Accounting Principles
      Board
      (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related
      interpretations in accounting for our plans.




The
      following table details the effect on net loss and loss per common share had
      compensation expense for the employee share-based awards been recorded in the
      three and nine month periods ended October 1, 2005 based on the fair value
      method under SFAS No. 123 (in thousands, except per share data):


**Three
                  Months**
                **Ended**
                **October
                  1, 2005**
              
              
              **Nine
                  Months**
                **Ended**
                **October
                  1, 2005**Net
                  loss available to common
                shareholders,
                  as reported
              
              $
              (14,134
              )
              $
              (28,549
              )Add:
                  actual expense, as reported
              
              
              1,133
              
              
              5,074Less:
                  pro forma stock-based
                compensation
                  expense determined under
                fair
                  value method valuation for all
                awards
              
              
              (481
              )
              
              (1,423
              )Pro
                  forma net loss available to common
                stockholders
              
              $
              (13,482
              )
              $
              (24,898
              )


**Basic
                  and diluted net loss per common share:**Net
                  loss available to common
                stockholders,
                  as reported
              
              $
              (7.05
              )
              $
              (14.39
              )Pro
                  forma net loss available to common
                stockholders
              
              $
              (6.72
              )
              $
              (12.55
              )Shares
                  used in basic and diluted net
                loss
                  per common share
              
              
              2,005
              
              
              1,984





During
      the nine month period ended October 1, 2005, the Company granted 90,000 shares
      of restricted stock to directors. The restricted stock vests one third upon
      grant date, one third on the first anniversary, and one third on the second
      anniversary.





*Share
      Based Compensation Plans*




As
      of
      September 30, 2006, we have two share-based compensation plans, which are
      described below.




The
      DrugMax, Inc. 1999 Incentive and Non-Statutory Stock Option Plan permits the
      granting of stock options to purchase shares of common stock up to a total
      of
      6.0 million shares. The exercise price per share of common stock covered by
      an
      option may not be less than the par value per share on the date of grant, and
      in
      the case of an incentive stock option, the exercise price may not be less than
      the market value per share on the date of grant. The terms of any option grants
      are established by the Board of Directors and / or compensation committee,
      subject to the requirements of the plan, but, generally, these options vest
      over
      a three year period at a rate of 33% each year. The Plan will expire on August
      13, 2009. Options are issued to non-employee directors under this plan.




Each
      outside Director is issued an option to purchase 10,000 shares of common stock
      annually each year following his or her election to the Board of Directors.
      Each
      outside Director who serves as a member of a committee is issued an option
      to
      purchase 5,000 shares of the Company’s common stock annually. The chairperson of
      each committee, other than the Audit Committee, is issued an option to purchase
      an additional 5,000 shares of common stock annually. The chairperson of the
      Audit Committee and the Chairman of the Board shall receive an option to
      purchase 10,000 shares of the Company’s common stock annually. The foregoing
      options are granted under the Company’s 1999 Incentive and Non-Statutory Stock
      Option Plan. The exercise price for the options is determined as of the annual
      shareholders meeting of each year.




6




The
      DrugMax, Inc. 2003 Restricted Stock Plan permits the granting of shares of
      restricted common stock up to a total of 3.5 million shares. The Board of
      Directors determines the price, if any, on the date of grant. The Plan will
      expire on August 27, 2013. Restricted shares are issued to non-employee
      directors under this plan.





Upon
      election to the Board of Directors, each outside Director, receives an award
      of
      restricted stock in the amount of $50,000. Such shares vest 1/3 upon the date
      of
      grant and 1/3 on the first and second anniversary thereafter. Further, on each
      year following his or her election to the Board, each outside Director receives
      an award of restricted stock in the amount of $25,000. The foregoing shares
      are
      granted under the Company’s 2003 Restricted Stock Plan.




The
      Company uses the Black-Scholes option-pricing model to calculate the fair value
      of options. The key assumptions for this valuation method include the expected
      term of the option, stock price volatility, risk-free interest rate, dividend
      yield and exercise price. Many of these assumptions are judgmental and highly
      sensitive in the determination of compensation expense. Under the assumptions
      indicated below, the weighted-average fair value for each option granted during
      the three month period ended September 30, 2006 was $3.58 and the
      weighted-average fair value for each option granted during the three month
      period ended October 1, 2005 was $5.59. The table below indicates the key
      assumptions used in the option valuation calculations for options granted in
      the
      three month period ended September 30, 2006 and October 1, 2005 and a discussion
      of our methodology for developing each of the assumptions used in the valuation
      model:




**Three Months**
              **Ended**
              **September
                30,**
              **2006**
            
            
            **Three Months**
              **Ended**
              **October
                1,**
              **2005**Risk-free
                interest rate
            
            
            5.02
            %
            
            4.08-4.09
            %Expected
                life
            
            
            3
                years
            
            
            3
                yearsVolatility
            
            
            82
            %
            
            29-56
            %Dividend
                yield
            
            
            -
            %
            
            -
            %Fair
                value of each
              option
                granted
            
            $
            3.58
            
            $
            4.94-8.84




*Term* -
      This is the period of time over which the options granted are expected to remain
      outstanding. Options granted have a maximum term of ten years. An increase
      in
      the expected term will increase compensation expense.




*Volatility* -
      This is
      a measure of the amount by which a price has fluctuated or is expected to
      fluctuate. Volatilities are based on implied volatilities from traded options
      of
      the Company’s shares, historical volatility of the Company’s shares, and other
      factors, such as expected changes in volatility arising from planned changes
      in
      the Company’s business operations. An increase in the expected volatility will
      increase compensation expense.




*Risk-Free
      Interest Rate* -
      This is the U.S. Treasury rate on the date of the grant having a term equal
      to
      the expected term of the option. An increase in the risk-free interest rate
      will
      increase compensation expense.




7




*Dividend
      Yield* -
      We have never made any dividend payments and we have no plans to pay dividends
      in the foreseeable future. An increase in the dividend yield will decrease
      compensation expense.




The
      following table summarizes information about our stock option plans for the
      nine
      month period ended September 30, 2006.




**Number
                of**
              **Options**
            
            
            **Weighted**
              **Average**
              **Exercise
                Price**
            
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual
                life**
            
            
            **Weighted**
              **Average**
              **Fair
                Value**Balance,
                December 31, 2005
            
            
            377,084
            
            $
            17.66
            
            
            7.8
            
            
            24.36Granted
            
            
            75,125
            
            $
            7.67
            
            
            
            
            
            4.24Exercised
            
            
            (1,521
            )
            $
            5.70
            
            
            
            
            
            3.48Forfeited
            
            
            (57,866
            )
            $
            45.51
            
            
            
            
            
            4.14Options
                outstanding, September 30, 2006
            
            
            392,822
            
            $
            11.70
            
            
            7.9
            
            $
            18.26Options
                exercisable, September 30, 2006
            
            
            240,092
            
            $
            11.89
            
            
            7.4
            
            $
            26.37




As
      of
      September 30, 2006, there was $0.3 million of total unrecognized compensation
      cost related to stock options. These costs are expected to be recognized over
      a
      weighted average period of 1.4 years. The total fair value of stock awards
      granted was $5.0 thousand during the three month period ended September 30,
      2006. Cash received from stock option exercises for the nine month period ended
      September 30, 2006 was $9.0 thousand. The income tax benefits from share based
      arrangements totaled $0.0.




The
      following table summarizes information about restricted stock awards issued
      under the 2003 Restricted Stock Plan for the nine month period ended September
      30, 2006:




**Shares**
            
            **Weighted**
              **Average**
              **Grant-****Date**
              **Fair
                Value**Non
                Vested Balance at December 31, 2005
            
            
            44,403
            
            $
            15.65Granted
            
            
            33,436
            
            $
            6.58Vested
            
            
            (10,812
            )
            $
            13.09Non
                Vested Balance at September 30, 2006
            
            
            67,027
            
            $
            11.54




As
      of
      September 30, 2006, there was $0.4 million of total unrecognized compensation
      costs related to restricted stock awards. These costs are expected to be
      recognized over a weighted average period of 0.9 years. At September 30, 2006,
      an aggregate of 0.4 million shares of common stock remained available for future
      grants under our stock plans, which cover restricted stock awards and stock
      options. We issue shares to satisfy stock option exercises and restricted stock
      awards.




8


**NOTE
      5 -GOODWILL AND INTANGIBLE ASSETS**




The
      carrying value of goodwill and intangible assets is as follows (in thousands):




**September
                30,**
              **2006**
            
            **December
                31,**
              **2005****Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**
            
            **Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**Intangible
                assets
            
            $
            22,355
            
            $
            (19,069
            )
            $
            22,526
            
            $
            (17,674
            )Goodwill
            
            
            1,355
            
            
            -
            
            
            1,355
            
            
            —




The
      weighted average amortization period for intangible assets is approximately
      7.6
      years. Amortization expense related to intangible assets was approximately
      $0.4
      million and $0.7 million for the three month periods ended September 30, 2006
      and October 1, 2005, respectively. Amortization expense related to intangible
      assets was approximately $1.4 million and $2.1 million for the nine month
      periods ended September 30, 2006 and October 1, 2005, respectively.





Estimated
      future amortization expense for the remainder of 2006 and the succeeding four
      years is as follows (in thousands):




**Fiscal
                year ending**
            
            
            **Amount**2006
            
            $
            5082007
            
            
            8372008
            
            
            5512009
            
            
            2562010
            
            
            181




**NOTE
      6 —DEBT**




Debt
      at
      September 30, 2006 and December 31, 2005 consisted of the following (in
      thousands):




**September
                30,**
              **2006**
            
            **December****31,**
              **2005**Revolving
                credit facility
            
            $
            36,199
            
            $
            36,251Promissory
                notes payable
            
            
            94
            
            
            915Subordinated
                notes payable
            
            
            -
            
            
            22,905Secured
                promissory notes, current maturities
            
            
            2,000
            
            
            -Secured
                promissory notes, less debt discount of $2,372
            
            
            5,129
            
            
            -Total
            
            $
            43,422
            
            $
            60,071





On
      June
      29, 2006, the Company entered into a Note and Warrant Purchase Agreement and
      certain other agreements described below, each effective as of June 23, 2006,
      with Deerfield Special Situations Fund, L.P. (“Deerfield L.P.”) and Deerfield
      Special Situations Fund International, Limited (“Deerfield International”),
      pursuant to which Deerfield L.P. and Deerfield International (collectively,
      “Deerfield”) purchased two secured promissory notes in the aggregate principal
      amount of $10 million (one note in the principal amount of $3.32 million and
      the
      second note in the amount of $6.68 million collectively the “Notes”) and eight
      warrants to purchase an aggregate of 1.65 million shares of Familymeds Group,
      Inc. common stock (the “Warrants”), for an aggregate purchase price of $10
      million.





The
      $10
      million purchase price for the Notes and Warrants was used entirely for an
      early
      repayment, settlement and termination of approximately $23 million in
      outstanding subordinated debt and accrued unpaid interest with the Company’s
      former supplier AmerisourceBergen Drug Corporation (“ABDC”). The subordinated
      debt with ABDC consisted of a subordinated convertible debenture in the original
      principal amount of $11.5 million and a subordinated promissory note in the
      original principal amount of $11.5 million. Both original debt instruments
      were
      5-year agreements maturing in September 2010. In connection with the Deerfield
      transaction, the Company and ABDC entered into a payoff and mutual release
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10 million. Wells Fargo
      Retail Finance, LLC (“WFRF”), the Company’s senior lender, consented to the
      Company’s early repayment of the ABDC debt and waived any default under the
      Company’s credit facility with WFRF as a result of such repayment by entering
      into a Consent, Waiver and Second Amendment to such credit facility with the
      Company and its subsidiaries. The Company extinguished the ABDC Notes on June
      29, 2006 which resulted in a gain on the extinguishment of $13.1
      million.




9





Principal
      on each of the Notes is due and payable in successive quarterly installments
      each in the amount of $0.166 million and $0.334 million, respectively, beginning
      on September 1, 2006 and on each December 1, March 1, June 1 and September
      1
      thereafter and continuing until June 23, 2011, on which date all outstanding
      principal and accrued and unpaid interest is due. The Notes bear interest at
      a
      rate equal to 2.5% for the first year, 5.0% for the second year, 10.0% for
      the
      third year, 15.0% for the fourth year and 17.5% for the fifth year. The Notes
      may be prepaid by the Company at anytime without penalty. Interest expense
      has
      been estimated over the five year period to be approximately $1.8
      million (excludes the effect of amortization of the debt discount of $2.5
      million discussed below) and due to the increasing interest rate on this
      debt, the Company records the average quarterly interest expense and record
      a
      corresponding asset or liability for the difference not currently payable each
      quarter.




In
      lieu
      of making any interest payments in cash during the first and second year of
      the
      Notes, the Company may issue and deliver to Deerfield shares of common stock.
      Pursuant to an amendment in October 2006, such shares shall be issued annually
      and Deerfield shall not be able to transfer or sell such shares untill such
      time
      as the interest payment represented by those shares shall become due. During
      the
      fourth quarter of 2006, 58,878 shares of common stock were issued to Deerfield
      representing the first year's interest.




The
      Notes
      contain usual and customary events of default for notes of these dollar amounts
      and provide that, upon the occurrence of an event default, the entire
      outstanding principal balance and all interest accrued under each note shall
      immediately become due and payable without demand or notice to the Company.





The
      Notes
      are secured by subordinated security interests in substantially all of the
      assets of the Company and its subsidiaries, Familymeds, Inc. (“Familymeds”) and
      Valley Drug Company South (“Valley South”). These subordinated security
      interests are evidenced by three security agreements: (i) a Security Agreement
      between the Company and Deerfield L.P., as agent for Deerfield (the “Agent”),
      (ii) a Security Agreement between Familymeds and the Agent, and (iii) a Security
      Agreement between Valley South and the Agent (collectively, the “Security
      Agreements”). The Security Agreements are expressly subordinated to the prior
      lien rights of WFRF pursuant to the Company’s existing credit facility with
      WFRF. Both Familymeds and Valley South have entered into guaranty agreements
      pursuant to which they have guaranteed all of the obligations of the Company
      under the Notes.





In
      connection with the issuance of the Notes, 1.65 million of stock warrants were
      issued as follows: warrants for 0.30 million common shares were issued at an
      exercise price of $6.10 per share; warrants for 0.55 million common shares
      were
      issued at an exercise price of $7.50 per share; warrants for 0.55 million common
      shares were issued at an exercise price of $7.80 per share; and warrants for
      0.25 million common shares were issued at an exercise price of $9.20 per share.
      Proceeds from each warrant exercised by Deerfield will be used to equally repay
      the Notes and for the working capital needs of the Company. All of the Warrants
      are exercisable for a period of five years from the closing date.





In
      accordance with Accounting Principles Board (“APB”) Opinion No. 14 “Accounting
      for Convertible Debt and Debt Issued with Stock Purchase Warrants,” the Company
      allocated the proceeds received between the debt and the detachable warrants
      based upon the relative fair market values on the dates the proceeds were
      received. The net value allocated to the warrants was $2.5 million and was
      determined using the Black-Scholes option pricing formula. The $2.5 million
      has
      been recorded as debt discount and will be amortized over the life of the
      related debt using the effective interest method. The effective interest rate
      on
      the Notes, after giving effect to the amortization of the debt discount is
      approximately 17.0% annually.




10





**NOTE
      7 - INCOME TAXES**




The
      Company incurred a net loss and net income for the three and nine month periods
      ended September 30, 2006. No income tax expense had been recorded during the
      nine months ended September 30, 2006 due to the significant net operating losses
      available to the Company to offset such net income. The Company has established
      a valuation allowance on all of its deferred tax assets due to the uncertainty
      of their realization. The Company incurred a net loss for the three and nine
      month periods ended October 1, 2005.




**NOTE
      8 - DISCONTINUED OPERATIONS**




During
      fiscal year ended December 31, 2005, the Company operated two drug distribution
      facilities: Valley Drug Company (“Valley North”) and Valley Drug Company South.
      During the third quarter of 2005, the Company determined that it would sell
      certain assets of the drug distribution business and eliminate operations
      conducted out of the New Castle, Pennsylvania facility and the St. Rose,
      Louisiana facility related to the distribution to independent pharmacies.
      Accordingly, as of October 1, 2005, the Company considered substantially all
      of
      the full-line wholesale drug distribution as discontinued operations for
      financial statement presentation purposes. In December 2005, Rochester Drug
      Cooperative (“RDC”) acquired certain assets from the Company’s wholly-owned
      subsidiary, Valley Drug Company, including a customer list, furniture, fixtures
      and equipment located at the Company’s New Castle, Pennsylvania facility. In
      connection with the sale, RDC assumed certain property leases, customer and
      other miscellaneous contracts. The total purchase price for these select assets
      was $0.7 million, of which $0.4 million was received upon closing and $0.3
      million is required to be paid if and when the Pennsylvania Industrial
      Development Authority (“PIDA”) consents to a lease assignment of the New Castle
      facility to RDC.





Net
      revenues related to the discontinued operations were $0.0 million and $22.7
      million for the three month periods ended September 30, 2006 and October 1,
      2005, respectively, and $0.0 million and $80.1 million for the nine month
      periods ended September 30, 2006 and October 1, 2005, respectively.  The
      loss from discontinued operations was $0.1 million and $8.2 million and $0.4
      million and $11.2 million for the three and nine month periods ended September
      30, 2006 and October 1, 2005, respectively. During
      the third quarter 2006, we received notification of a tax assessment from a
      state tax authority relating to our discontinued operations.  We have
      accrued $0.2 million of estimated income taxes relating to this matter and
      is reflected as a component of discontinued operations.





**NOTE
      9- CONTINGENCIES**




As
      previously disclosed, the
      Company’s drug distribution operations operated out of two locations, one in New
      Castle, Pennsylvania and one in St. Rose, Louisiana.  The Pennsylvania
      operations were located at 209 Green Ridge Road, New Castle, Pennsylvania 16105,
      a facility consisting of approximately 45,000 square feet of office, warehouse,
      shipping and distribution space. Valley Drug Company( “Valley North”) leased
      this premises from Becan Development LLC (“Becan”), a company owned by a current
      director of the Company (Jugal Taneja) and certain former directors, officers
      and employees of the Company. The original lease (dated December 30, 2003)
      (the
“Original Lease”) provided for a term of 15 years, expiring December 30, 2018,
      and monthly lease payments of $17,000.  When the Original Lease was
      executed, Becan and Valley North entered into a Consent, Subordination and
      Assumption Agreement (the “Guarantee”) with the Pennsylvania Industrial
      Development Authority (“PIDA”) and Regional Industrial Development Corporation
      of Southwest Pennsylvania (“RIDC”) dated December 30, 2003, pursuant to which,
      among other things, Becan and Valley North, jointly and severally, assumed
      all
      obligations of RIDC to make payments and discharge all obligations expenses,
      costs and liabilities of RIDC in connection with the PIDA note (the “PIDA
      Note”). The PIDA Note is also secured by the Original Lease and the property.





In
      connection with the previously disclosed December 2005 sale of the business
      operated out of the Pennsylvania facility to Rochester Drug Cooperative (“RDC”)
      (the “Asset Sale”), Becan and Valley North agreed to shorten the lease to five
      years ending, December 2010, and to sublease the premises to RDC. It was the
      intent of the parties at that time to assign the lease to RDC upon the consent
      to such assignment by PIDA. RDC held back $0.3 million of the purchase price
      related to the Asset Sale pending receipt of PIDA’s
      consent.  PIDA recently agreed to consent to the assignment of
      the lease to RDC subject to the preparation of final documents, including
      documents evidencing the parties agreement to shorten the maturity of the PIDA
      Note to five years ending December 2010; but, during October 2006, RDC notified
      PIDA that it was withdrawing its application to PIDA and that it was no longer
      willing to assume the lease. Contemporaneously with its notice to PIDA, RDC
      notified the Company that it refused to pay the $0.3 million holdback to Valley
      because of the delays in obtaining the PIDA consent. RDC has signed a sublease
      for the property and remains legally responsible for the lease payments. In
      October 2006, the Company filed a demand for arbitration claiming RDC has acted
      in bad faith and demanding $0.3 million. Becan and its principals, including
      Mr.
      Taneja, indemnified Valley North and the Company against any claims or
      demands PIDA may bring against Valley or the Company in connection with the
      PIDA
      Note and will use their best efforts to have Valley released from all
      obligations under the PIDA Note.




11





As
      of
      September 30, 2006, the Company has not recorded any liabilities related to
      the
      Guarantee. However, should the Company be required to perform under the terms
      of
      the Guarantee, the Company would be required to pay all amounts owed under
      the
      PIDA Note, which as of September 30, 2006 was approximately $0.8 million. The
      Company believes it will not be required to perform under the terms of the
      Guarantee. Further any requirement to perform under the Guarantee would be
      mitigated by the indemnification by Becan and its principals. Additionally,
      management believes, the fair value of the Pennsylvania facility that could
      be realized upon the sale of the facility exceeds the amounts outstanding
      on the PIDA Note and the other loans related to the premises.





**NOTE
      10- NEW ACCOUNTING STANDARDS**





In
      June
      2006, the FASB issued Financial Accounting Standards Interpretation No. 48,
      “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) an interpretation of
      Financial Accounting Standards Statement No. 109, “Accounting for Income Taxes.”
FIN 48 prescribes a recognition threshold and measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. The interpretation requires that the
      Company recognize in the financial statements, the impact of a tax position,
      if
      that position is more likely than not of being sustained on audit, based on
      the
      technical merits of the position. FIN 48 also provides guidance on
      de-recognition, classification, interest and penalties, accounting in interim
      periods and disclosure. The provisions of FIN 48 are effective beginning January
      1, 2007 with the cumulative effect of the change in accounting principle
      recorded as an adjustment to the opening balance of retained earnings. The
      Company does not believe it will have a material impact on its financial
      position or results of operations as a full valuation allowance has been
      established.





In
      September 2006, the SEC issued Staff Accounting Bulletin, or SAB, No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements.* SAB No. 108
      provides guidance on how prior year misstatements should be taken into
      consideration when quantifying misstatements in current year financial
      statements for purposes of determining whether the current year’s financial
      statements are materially misstated. SAB No. 108 is effective for
      fiscal years ending on or after November 15, 2006. The Company is currently
      in the process of evaluating the impact of SAB No. 108 on our
      financial position and results of operations.








In
      September 2006, the Financial Accounting Standards Board, or FASB, issued
      SFAS No. 157, *Fair
      Value Measurements.* SFAS No. 157
      establishes a framework for measuring the fair value of assets and liabilities.
      This framework is intended to provide increased consistency in how fair value
      determinations are made under various existing accounting standards which
      permit, or in some cases require, estimates of fair market value.
      SFAS No. 157 is effective for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not yet issued
      financial statements for that fiscal year, including any financial statements
      for an interim period within that fiscal year. The Company is currently in
      the
      process of evaluating the impact of SFAS No. 157 on our financial
      position and results of operations.




12





**NOTE
      11- RESTRUCTURING EXPENSE**





During
      the three and nine month periods ended September 30, 2006, the Company
      recognized restructuring expense of $.03 million and $.03 million,
      respectively, all of which related to severance expenses for 33 terminated
      employees resulting from the Company’s July 2006 restructuring plan. All amounts
      have been paid during the three month period ended September 30,
      2006.





**NOTE
      12- SUBSEQUENT EVENT**





In
      October 2006, the operations known as Valley Medical Supply were relocated
      to
      the Company’s corporate location in Farmington, Connecticut and
      it is
      now doing business as Familymeds Medical Supply.




13


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




The
      following Management’s Discussion and Analysis of Financial Condition and
      Results of Operations should be read in conjunction with our unaudited condensed
      consolidated financial statements and the related notes found elsewhere in
      this
      Form 10-Q. This discussion, as well as the notes to our unaudited condensed
      consolidated financial statements, contain forward-looking statements based
      upon
      our current expectations that involve risks and uncertainties, such as our
      plans, objectives, expectations and intentions, as set forth under “Cautionary
      Statement Regarding Forward-Looking Statements.” Our actual results and the
      timing of events could differ materially from those anticipated in these
      forward-looking statements as a result of many factors.




***Cautionary
      Statement Concerning Forward-Looking Statements***




Certain
      oral statements made by management from time to time and certain statements
      contained in press releases and periodic reports issued by the Company,
      including those contained herein, that are not historical facts are
“forward-looking statements” within the meaning of the Private Securities
      Litigation Reform Act of 1995. Because such statements involve risks and
      uncertainties, actual results may differ materially from those expressed or
      implied by such forward-looking statements. Forward-looking statements, are
      statements regarding the intent, belief or current expectations, estimates
      or
      projections of the Company, its directors or its officers about the Company
      and
      the industry in which it operates, and include among other items, statements
      regarding (a) the Company’s strategies regarding growth and business expansion,
      including its strategy of building an integrated specialty drug distribution
      platform with multiple sales channels through both organic growth and
      acquisitions, (b) its financing needs and plans, including its need for
      additional capital related to its growth plans, and (c) trends affecting its
      financial condition or results of operations. Although the Company believes
      that
      its expectations are based on reasonable assumptions, it can give no assurance
      that the anticipated results will occur. When used in this report, the words
      “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,”
and similar expressions are generally intended to identify forward-looking
      statements.





Important
      factors that could cause the actual results to differ materially from those
      in
      the forward-looking statements include, among other items, (i) management’s
      ability to execute its strategy of growth and business expansion, (ii)
      management’s ability to secure additional financings, (iii) changes in the
      regulatory and general economic environment related to the health care and
      pharmaceutical industries, including possible changes in reimbursement for
      healthcare products and in manufacturers’ pricing or distribution policies, (iv)
      conditions in the capital markets or changes with regard to the Company's credit
      facilities, including interest rate increases, changes in the
      availability of capital and changes in the reserve under the Company's credit
      facility, (v) changes in the competitive marketplace that could affect the
      Company’s revenue and/or cost bases, such as increased competition, lack of
      qualified marketing, management or other personnel, and increased labor and
      inventory costs, and (vi) changes regarding the availability, supply chain
      and
      pricing of the products which the Company distributes, as well as the loss
      of
      one or more key suppliers for which alternative sources may not be available.





Further
      information relating to factors that could cause actual results to differ from
      those anticipated is included under the heading “Risk Factors” contained herein
      and in the Company’s Annual Report on Form 10-K, as amended, for the year ended
      December 31, 2005. The Company disclaims any intention or obligation to update
      or revise forward-looking statements, whether as a result of new information,
      future events or otherwise.





***Overview***





Familymeds
      Group, Inc. (“Familymeds Group,” the “Company,” or “we” and other similar
      pronouns) is a pharmacy and drug distribution provider formed by the merger
      on
      November 12, 2004 of DrugMax, Inc. and Familymeds Group, Inc. (“FMG”). The
      Company was formerly known as DrugMax, Inc. and on July 10, 2006, the Company
      amended its Articles of Incorporation to change its name from DrugMax, Inc.
      to
      Familymeds Group, Inc. and changed its trading symbol from DMAX to
      FMRX.




14





As
      of
      September 30, 2006, we operated 78 Company owned locations including 75
      pharmacies, one home health center, one health and beauty location and one
      non-pharmacy mail order center, and 7 franchised pharmacies in 14 states, under
      the Familymeds Pharmacy, Arrow Pharmacy & Nutrition Center, and Worksite
      Pharmacy SM brand
      names. We also operate a drug distribution business primarily focused on the
      direct distribution of specialty pharmaceuticals to physicians, medical clinics
      and other health care providers from our warehouse located in St. Rose,
      Louisiana known as Valley Medical Supply or VMS. On October 16, 2006, the
      operations known as Valley Medical Supply were relocated the Company’s corporate
      location in Farmington, Connecticut and are now doing business as Familymeds
      Medical Supply.




**Review
      of three month period ended September 30, 2006**





The
      Company’s strategy since the sale of substantially all of its full-line
      wholesale drug distribution business in December of 2005 has been to focus
      on
      its core business, which includes pharmacy operations, specialty sales,
      institutional sales, and direct distribution to physicians, medical clinics
      and
      other health care providers. During the three month period ended September
      30,
      2006, we have taken the following steps to improve our operating results and
      financial condition:


·
            Changed
                our corporate name to Familymeds Group, Inc., the recognized brand
                name of
                the Company's core pharmacy business. In conjunction with the name
                change,
                we began trading under our new Nasdaq stock symbol "FMRX."   The
                Company also performed
                areverse
                stock split of one-for-ten of the Company’s authorized and outstanding
                common stock on August 16, 2006. 
 ·
            Implemented
                expense control initiatives that included a workforce reduction of
                33
                employees at the Company headquarters in Farmington, Connecticut
                in July
                2006. The associated personnel reduction in headquarters expenses
                coupled
                with company-wide general and administrative expense reductions is
                expected to result in an estimated decrease in total selling, general
                and
                administrative costs of approximately 10%, or $2.8 million for the
                second
                half of fiscal 2006.  The Company expects these reductions will not
                have any significant impact on the Company's sales structure or customer
                operations. 
 ·
            Opened
                two new pharmacy locations: one in the Oklahoma areainside
                the Warren Medical Building on the campus of the St. Francis Hospital
                in
                Tulsa, Oklahoma in August 2006, anda
                long term care pharmacy located in Framingham, Massachusetts in September
                2006. 
 ·
            Agreed
                  to participate in two medication therapy management programs: the
                  Asthma
                  Intervention Program(TM), a pilot program and outcomes research
                  study
                  co-sponsored by the National Community Pharmacists Association
                  (NCPA),
                  Pharmacist e-Link and Medical Care and Outcomes, LLC., and a medication
                  therapy management program for qualifying patients who are enrolled
                  in the
                  Community Care Rx (CCRx) Medicare Part D plan.  ·
            Closed
                three under-performing locations and moved the assets from one pharmacy
                location to another existing location to reduce overall operating
                expense
                and to improve unit financial
                performance. 
 15




***Strategy***




Our
      primary strategy is to build an integrated specialty drug pharmacy platform
      with
      multiple sales channels including: clinic and apothecary pharmacies, Worksite
      Pharmacies SM ,
      institutional “closed door” type pharmacies, a central fill mail order based
      pharmacy and a pharmaceutical distribution center focused on medical specialty
      sales. We believe this can be accomplished through the present base of
      operations, through additional organic opening of new pharmacies and by
      acquiring pharmacies. We believe the integration of these types of locations
      will uniquely enable us to supply specialty drugs and other pharmaceuticals
      to
      patients, physicians and other healthcare providers.





Our
      strategy is to locate specialty clinic and apothecary pharmacy operations near
      or in medical facilities. The strategy is driven by the location concept whereby
      situating a clinical or specialty type pharmacy near the point of acute or
      chronic care provides us with a “first capture” opportunity to service patients
      when they visit their physicians. This also enables us to collaborate with
      the
      physician in the therapeutic regimen and may provide opportunities for generic
      drug sales or alternative pharmaceutical therapy, which generally provide us
      with higher profit margins. Many of these patients or special patient groups
      require central fill and or mail order follow-up care that can be provided
      through our “closed door” pharmacy or mail order center located in Connecticut.
      We also supply online web based access to all or most of our services and
      products through our nationally known website, www.familymeds.com.





We
      offer
      a comprehensive selection of branded and generic prescription and
      non-prescription pharmaceuticals, specialty injectables, generic biologics,
      compounded medicines, healthcare-related products and diagnostic products.
      These
      products are used for the treatment of acute or chronic medical conditions
      and
      may be purchased through our platforms. Also, we have recently placed
      significant emphasis on the injectable and orally administered specialty
      pharmaceuticals. We intend to increase pharmacy revenues through these
“Specialty Pharmaceuticals,” which generally are more expensive and provide a
      higher gross profit.





The
      Company’s strategy also includes selling specialty pharmaceuticals and
      healthcare products to physicians, home care providers and related healthcare
      providers including respiratory therapists and nurse practitioners that often
      re-administer these products to their patient immediately. We are executing
      this
      strategy by combining selling access through our existing physician
      relationships and medically based pharmacies with a sales force that actively
      pursues these practitioners as well as new potential practitioner customers.
      Our
      unique selling proposition to these practitioners is ease of obtaining product
      through same day delivery through our onsite pharmacies as well as our ability
      to supply the pharmaceutical to the physician already prepared and “ready to
      use.” As part of our service, we bill the physicians/patients payor/insurance
      carrier or Medicare under part B depending on the type of coverage each patient
      has. This strategy for distribution of pharmaceuticals will be ongoing and
      utilizes our wholesale authorized distribution agreements to obtain the drugs
      through the proper channel pricing and together with central and decentralized
      distribution to the practitioner customer depending on the customer
      needs.




The
      Company is also taking measures to reduce operating expenses by consolidating
      operations, and reducing corporate expenses.





***Pharmacy
      Operations*** ****





As
      of
      September 30, 2006, we operated 78 Company owned locations including 75
      pharmacies, one home health center, one health and beauty location and one
      non-pharmacy mail order center, in 14 states under the Familymeds Pharmacy,
      Arrow Pharmacy & Nutrition Center, and Worksite Pharmacy SM brand
      names. We have 43 pharmacies which are located at the point of care between
      physicians and patients, oftentimes inside medical office buildings or on a
      medical campus. The balance of our locations are usually nearby medical
      facilities though more retail accessible. The majority of our revenues from
      pharmacy operations come from the sale of prescription pharmaceuticals, which
      represented approximately 94.1% and 93.9% of our net revenues for the three
      and
      nine month periods ended September 30, 2006, respectively. Our corporate
      pharmacies provide services to approximately 400,000 acute or chronically ill
      patients each year, many with complex specialty and medical product needs.




16





We
      operate our pharmacies under the trade names Familymeds Pharmacy (“Familymeds”),
      Arrow Pharmacy and Nutrition Centers (“Arrow”) and Worksite Pharmacy SM .
      Familymeds is primarily used for pharmacies outside of New England. The
      Familymeds locations were primarily originated by acquiring the base pharmacy
      business from HMO’s, hospitals and regional independent operators. The locations
      are primarily clinic size with a small footprint, usually less than 1,500 sq.
      ft. The Arrow trade name is used in New England where most of the pharmacies
      were opened as a start-up or re-acquired from former Arrow franchise operators
      who opened these legacy pharmacy operations as start-ups. These locations are
      primarily apothecary size, approximately 2,000 sq. ft. and may be more visible
      as retail type locations, though primarily nearby hospitals or medical campus
      locations. Our locations in Michigan and certain locations elsewhere throughout
      our trading area may have a larger footprint to accommodate a comprehensive
      inventory of nutritional and home medical supplies.





By
      our
      estimates, we believe there are more than 5,000 locations nationwide at or
      near
      the point of care which may be available to open additional pharmacies. Because
      of our experience with operating pharmacies in similar locations, we believe
      we
      are uniquely positioned to target these sites and increase our core pharmacy
      market presence. We also believe that we can grow our pharmacy operations
      through selective acquisitions. By increasing our location count, through
      selective acquisitions or the opening of new pharmacies at or near the point
      of
      medical care, we believe we can increase our customer base, expand our
      geographic reach and improve profitability by leveraging our existing
      infrastructure. However, we will need to obtain financing, and there are no
      assurances we can do so.





Our
      strategy also includes offering our customers or patients multiple sales
      channels by which they can purchase our products. We offer them the opportunity
      to purchase a broad array of health-related products including a comprehensive
      selection of prescription medications, vitamins and nutritional supplements,
      home medical equipment, and health and beauty aids directly from our pharmacies,
      by mail order and via the Internet. Familymeds.com is the foundation of our
      Internet offering. This website is one of the few sites certified as a Verified
      Internet Pharmacy Provider Site (VIPPS) by the National Association of Boards
      of
      Pharmacy (NABP). The VIPPS program is a voluntary certification program designed
      to approve and identify online pharmacies that are appropriately licensed and
      prepared to practice Internet pharmacy. Familymeds.com is the non-prescription
      Internet commerce partner for select prescription benefit managers (PBMs)
      including Medco Health. We will continue to pursue opportunities to partner
      with
      managed care and others providers to increase our sales through our Internet
      sales channel.





***Worksite
      Pharmacy*** ***SM***





We
      operate Worksite Pharmacies SM (pharmacies
      that service a single, defined population) for large employers who are seeking
      to control overall employee prescription drug benefit expenditures while
      maintaining high employee satisfaction through improved accessibility. Our
      Worksite Pharmacies SM offer
      prescription services exclusively to the employer’s covered population. We can
      deliver these services at or near the employer’s work site by opening, staffing
      and managing a pharmacy. Our initial results have proven that this strategy
      reduces healthcare costs for the employer. Our research has shown that many
      employers, especially large Fortune 500 companies are seeking more aggressive
      methods to control healthcare expenditures, especially the pharmacy component
      of
      benefits. We have identified key large employers, those with over 2,000
      employees in a single location, to be target opportunities for this type of
      employer sponsored Worksite Pharmacy SM .
      Currently, we have a Worksite Pharmacy SM in
      the
      employee center of the Mohegan Sun Casino in Connecticut and Scotts Company
      L.L.C headquarters in Marysville, Ohio. Combined, these employers have more
      than
      14,000 employees and dependents as potential patients.




On
      November 9, 2006, we announced our third Worksite Pharmacy will open January
      2,
      2007 to exclusively service Toyota team members, participating on-site suppliers
      and their dependants. Under the contract with Toyota, Familymeds will operate
      a
      full service pharmacy at the site of Toyota's newly constructed plant in San
      Antonio. The plant will employ approximately 2,000 Toyota
      personnel.




17




Net
      revenues from Worksite Pharmacies SM increased by $0.8 million or 99.8% from $0.9 million for the three month period
      ended October 1, 2005 to $1.7 million for the three month period ended September
      30, 2006. Approximately $0.3 million, or 35.9% on a comparable same location
      basis, of the $0.8 million increase related to growth within our existing
      Worksite Pharmacy. The remaining $0.5 million of the $0.8 million increase
      related to the opening of a new Worksite Pharmacy effective at the beginning
      of
      the first quarter of 2006.





Net
      revenues from Worksite Pharmacies SM increased by $3.1 million or 123.6% from $2.5 million for the nine month period
      ended October 1, 2005 to $5.6 million for the nine month period ended September
      30, 2006. Approximately $0.8 million, or 31.8% on a comparable same location
      basis, of the $3.1 million increase related to growth within our existing
      Worksite pharmacy. The remaining $2.3 million of the $3.1 million increase
      related to the opening of a new Worksite Pharmacy effective at the beginning
      of
      the first quarter of 2006.





***Medical
      Supply***





In
      February 2006, we reopened and began providing distribution services from our
      St. Rose, Louisiana facility which had previously been closed due to Hurricane
      Katrina. We reconfigured and replenished the warehouse to facilitate the direct
      distribution of pharmaceuticals to physicians, medical clinics and other health
      care providers. In
      October 2006, the operations known as Valley Medical Supply were relocated
      to
      the Company’s corporate location in Farmington, Connecticut andit
      is now
      doing business as Familymeds Medical Supply.  This move is expected to
      reduce operating expenses.


Revenues
      from these operations for the three month period ended September 30, 2006 were
      $4.2 million compared to $0.6 million for the three month period ended October
      1, 2005, an increase of $3.6 million or 663.1%. Revenues from these operations
      for the nine month period ended September 30, 2006 were $9.3 million compared
      to
      $1.7 million for the nine month period ended October 1, 2005, an increase of
      $7.6 million or 432.0%. We expect the revenues attributable to this business
      to
      increase during the subsequent quarters in 2006.





***Patient
      Compliance***





We
      have
      developed programs designed to improve patient compliance and to reduce costs.
      For example, we have a prescription compliance program called Reliable Refill,
      a
      discount plan called Senior Save15. Reliable Refill is a compliance program
      that
      identifies prescriptions that are due to be filled and schedules them for
      filling before the patient has run out of the previous prescriptions. Our Senior
      Save15 program, introduced prior to the Medicare Modernization Act, is our
      own
      discount program that gives senior customers access to all of our prescription
      and over-the-counter products at discounted prices. These and other programs
      are
      designed to improve medication therapy management among patients with chronic
      therapeutic needs especially the elderly population. Our data warehouse allows
      us to identify and target patients with special needs.




***Technology
      Improvements and Electronic Prescription Solutions***





During
      the three month period ended September 30, 2006, we continued installing and
      upgrading our pharmacy management system and our home medical billing software.
      Upgrades include management of dispensing workflow, electronic signature
      capture, and improved data management. We believe the improvements to the
      pharmacy management system will provide value added services to our customers,
      increased billing capacity and better data management capabilities.





Additionally,
      we are implementing electronic prescription solutions to include the ability
      to
      accept delivery of prescriptions through electronic prescribing
      software technologies. Our pharmacies are able to accept receipt of
      electronic prescription orders and refill authorizations with secure, reliable
      transmission directly from physician practices.




18




***Medicare
      Part D***





Pharmacy
      sales trends are expected to continue to grow due, in part, to the Medicare
      Part
      D prescription drug benefit. As of January 1, 2006, Medicare beneficiaries
      have
      the opportunity to receive subsidized prescription drug coverage through the
      Medicare Part D program. The new drug benefit is delivered by competing plans,
      and our pharmacies have contracted with each of the major providers to ensure
      our customers can continue purchasing their prescriptions from our pharmacies.
      While the new Medicare drug benefit is entirely voluntary, we believe a
      significant portion of the Medicare population will enjoy this new benefit.
      During the three month period ended September 30, 2006, net revenues from
      prescriptions filled under Medicare Part D plans substantially increased
      compared to the three month periods ended April 1, 2006 and July 1, 2006. For
      the three month periods ended April 1, 2006, July 1, 2006 and September 30,
      2006, Medicare Part D prescriptions represented 14.8%, 19.8% and 21.2% of total
      prescription sales, respectively. The gross margin from this business is less
      than what the traditional prescription drug plans provide and the accounts
      receivable days outstanding is more than what the traditional prescription
      drug
      plans.




While
      the
      percentage of prescriptions filled through a Medicare Part D plan has continued
      to increase through September 30, 2006, Medicare Part D plans do not provide
      coverage for annual drug costs of the beneficiary between $2,250 and $5,100
      (sometimes referred to as the “donut hole”). As seniors enter the donut hole, it
      is unclear what effect, if any, this will have on our revenues or results of
      operations. We expect, however, that any negative impact the donut hole may
      have
      on our operating results will be offset, in part, by the effects of secondary
      coverage such as Medicaid and other third party providers.





***Supply
      Chain Management***





During
      the three month period ended April 2, 2005, the Company’s primary supplier,
      AmerisourceBergen Drug Corporation, supplied pharmaceuticals and related
      products directly to our pharmacy and non-pharmacy locations on a 5 day per
      week
      basis. Beginning in the second quarter of 2005, the Company began purchasing
      its
      products from D&K Healthcare Resources. Under the terms of this agreement,
      D&K delivered products directly to our distribution center in St. Rose,
      Louisiana. The products were then distributed to our locations from our
      full-line wholesale drug distribution facility located in St. Rose, Louisiana
      based upon the specific needs of the location twice per week.





Because
      of higher purchasing costs due to our inability to buy on a more credit worthy
      basis during fiscal year ended December 31, 2005, the Company began to
      experience a decrease in its ability to supply products to its customers and
      a
      decline in our gross margin, resulting in the Company amending its agreement
      with D&K (which was assumed by McKesson Corporation in August of 2005).
      Pursuant to the amended agreement, in February 2006, McKesson began supplying
      products directly to our locations on a 5 day per week basis. As a result,
      we
      believe our ability to manage our supply chain has improved.





The
      amended agreement requires us to purchase primarily all of our products for
      sale
      in our pharmacies from McKesson. It contains certain volume requirements and
      has
      an initial term of two years, through December 2006, and renews automatically
      for successive one-year periods unless either party provides the other party
      a
      written non-renewal notice. On October 16, 2006, McKesson provided notice that
      they wished to negotiate a new agreement to begin December 27, 2006 upon
      expiration of the existing agreement. The terms of the new agreement, including
      payment terms and pricing, are expected to be similar to the existing terms
      but
      the contract will be more in line with a standard McKesson contract rather
      than
      the current D&K contract. While, we believe that if we were unable to
      purchase products directly from McKesson we could secure the same products
      through other sources, including other distributors or directly from the
      manufacturers, there is a risk that our costs would increase and our supply
      could be interrupted affecting our net revenues if our primary supplier
      agreement were to be terminated.




19





***Discontinued
      Operations***





During
      fiscal year ended December 31, 2005, the Company operated two drug distribution
      facilities: Valley Drug Company and Valley Drug Company South. During the third
      quarter of 2005, the Company determined that it would sell certain assets of
      the
      drug distribution business and eliminate operations conducted out of the New
      Castle, Pennsylvania facility and the St. Rose, Louisiana facility related
      to
      the distribution to independent pharmacies. Accordingly, as of October 1, 2005,
      the Company considered substantially all of the wholesale distribution business
      as discontinued operations for financial statement presentation purposes. In
      December 2005, Rochester Drug Cooperative (“RDC”) acquired certain assets from
      the Company’s wholly-owned subsidiary, Valley Drug Company, including a customer
      list, furniture, fixtures and equipment located at the Company’s New Castle,
      Pennsylvania facility. In connection with the sale, RDC assumed certain property
      leases, customer and other miscellaneous contracts. The total purchase price
      for
      these select assets was $0.7 million, of which $0.4 million was received upon
      closing and $0.3 million is required to be paid if and when the Pennsylvania
      Industrial Development Authority (“PIDA”) consents to a lease assignment of the
      New Castle facility to RDC. The Company leased this premises from Becan
      Development LLC (“Becan”), a company owned by a current director of the Company
      (Jugal Taneja) and certain former directors, officers and employees of the
      Company.


The
        original
        lease (dated December 30, 2003) (the “Original Lease”) provided for a term of 15
        years, expiring December 30, 2018, and monthly lease payments of $17,000. 
When the Original Lease was executed, Becan and Valley North entered into
        a
        Consent, Subordination and Assumption Agreement (the “Guarantee”) with the
        Pennsylvania Industrial Development Authority (“PIDA”) and Regional Industrial
        Development Corporation of Southwest Pennsylvania (“RIDC”) dated December 30,
        2003, pursuant to which, among other things, Becan and Valley Drug Company
        (Valley North”), jointly and severally, assumed all obligations of RIDC to make
        payments and discharge all obligations expenses, costs and liabilities of
        RIDC
        in connection with the PIDA note (the “PIDA Note”).  The PIDA Note is also
        secured by the Original Lease and the property.
  In
        connection
        with the previously disclosed December 2005 sale of the business operated
        out of
        the Pennsylvania facility to Rochester Drug Cooperative (“RDC”) (the “Asset
        Sale”), Becan and Valley North agreed to shorten the lease to five years ending,
        December 2010, and to sublease the premises to RDC. It was the intent of
        the
        parties at that time to assign the lease to RDC upon the consent to such
        assignment by PIDA.  RDC held back $0.3 million of the purchase price
        related to the Asset Sale pending receipt of PIDA’s consent. Recently, PIDA
        agreed to consent to the assignment of the lease to RDC subject to the
        preparation of final documents, including documents evidencing the parties
        agreement to shorten the maturity of the PIDA Note to five years ending December
        2010; but, during October 2006, RDC notified PIDA that it was withdrawing
        its
        application to PIDA and that it was no longer willing to assume the
        lease.   Contemporaneously with its notice to PIDA, RDC notified the
        Company that it refused to pay the $0.3 million holdback to Valley because
        of
        the delays in obtaining the PIDA consent.  RDC has signed a sublease for
        the property and remains legally responsible for the lease payments.  In
        October 2006, the Company filed a demand for arbitration claiming RDC has
        acted
        in bad faith and demanding $0.3 million. Becan and its principals, including
        Mr.
        Taneja, indemnified Valley North and the Company against any claims or
        demands PIDA may bring against Valley or the Company in connection with the
        PIDA
        Note and will use their best efforts to have Valley released from all
        obligations under the PIDA Note.





In
      connection with the sale of these assets, the Company transferred a portion
      of
      the New Castle, Pennsylvania pharmaceutical inventory to the Company’s retail
      pharmacies as well as a portion to its St. Rose, Louisiana facility for
      continued distribution to the Company’s retail pharmacies and for use in the
      Valley Medical Supply operations. In October 2006, these operations were
      relocated to the corporate location in Farmington, Connecticut and are now
      doing
      business under the name Familymeds Medical Supply.




Net
      revenues related to the discontinued operations were $0.0 million and $22.7
      million for the three month period ended September 30, 2006 and October 1,
      2005,
      respectively and $0.0 million and $80.1million for the nine month period ended
      September 30, 2006 and October 1, 2005, respectively.  The loss from
      discontinued operations was $0.1 million and $8.2 million and $0.4 million
      and
      $11.2 million for the three and nine month periods ended September 30, 2006
      and
      October 1, 2005, respectively. During the third quarter 2006, we received
      notification of a tax assessment from a state tax authority relating to our
      discontinued operations.  We have accrued $0.2 million of estimated
      income taxes relating to this matter and is reflected as a component
      of discontinued operations.




20




**Comparison
      of Operating Results for the three and nine month periods ended September 30,
      2006 and October 1, 2005.**





We
      refer
      to prescription products as Rx products and to the remaining products, such
      as
      over-the-counter medications, home medical equipment and home health appliances,
      as non-Rx products. While non-Rx reflects a smaller percentage of our overall
      revenues, the gross margin for non-Rx products is higher. The Rx portion of
      the
      pharmacy business is dependent upon a number of third party payors that pay
      a
      portion or all of the Rx cost on behalf of the customers, “Third Party
      Customers.” Prescriptions generated by Third Party Customers represented
      approximately 93.3% and 93.8% and 93.5% and 94.0%, respectively Rx revenues
      for
      the three and nine month periods ended September 30, 2006 and October 1, 2005,
      respectively.





For
      financial statement presentation purposes, the Company has
      reported substantially all of the full-line wholesale drug distribution as
      discontinued operations.




***Net
      Revenues***




Net
      revenue performance is detailed below:


**Three
                  Months****Ended**
              
              **Nine
                  Months****Ended****September
                      30,**
                    **2006**
              ****
              **October
                      1,**
                    **2005**
              ****
              **September
                      30,**
                    **2006**
              ****
              **October
                      1,**
                    **2005**Net
                  Rx and non-Rx revenues (in millions) (1)
              
              $
              53.7
              
              $
              51.2
              
              $
              165.4
              
              $
              161.9Valley
                  Medical Supply
              
              
              4.2
              
              
              0.6
              
              
              9.3
              
              
              1.8Total
                  net revenues (in millions)
              
              $
              57.9
              
              $
              51.8
              
              $
              174.7
              
              $
              163.7Rx
                  % of location net revenues
              
              
              94.1
              %
              
              94.2
              %
              
              93.9
              %
              
              94.1
              %Third
                  party % of Rx net revenues
              
              
              93.3
              %
              
              93.8
              %
              
              93.5
              %
              
              94.0
              %Number
                  of Company locations
              
              
              78
              
              
              77
              
              
              78
              
              
              77Averagelocation
                  net revenue per location (in millions)
              
              $
              0.7
              
              $
              0.7
              
              $
              2.1
              
              $
              2.1




*(1) 
                Net revenues are net of contractual
                allowances.*




**Three Months**
              **Ended**
              **September
                30,**
              **2006**
              **versus**
              **October
                1, 2005**
            
            **Nine Months**
              **Ended**
              **September
                30,**
              **2006**
              **versus**
              **October
                1, 2005**Net
                revenues increases (decreases) are as follows (in
                millions):Net
                effect of location openings/closings(1)
            
            $
            0.6
            
            $
            2.3Rx
                revenues (2)
            
            
            2.0
            
            
            1.6Non-Rx
                revenues
            
            
            -
            
            
            (0.4
            )Valley
                Medical Supply(3)
            
            
            3.6
            
            
            7.5Net
                increase
            
            $
            6.2
            
            $
            11.0




*(1)*
            *The
                net effect of location openings/closing represents the revenues of
                locations that were not open during the full periods
                compared.**(2)*
            *Represents
                the net impact of price increases for brand name prescription products
                offset by an increase in the number of prescriptions filled for lower
                priced generic prescription products.**(3)*
            *Represents
                Valley Medical Supply revenues related to direct distribution to
                physicians, medical clinics and other health care
                providers.**In October 2006, this operation was moved to Farmington, Connecticut
                and
                is now doing business as Familymeds Medical
                Supply.*





21




***Gross
      Margin***





Gross
      margin was $11.4 million or 19.7% for the three month period ended September
      30,
      2006. This compares to $9.9 million or 19.1% for the three month period ended
      October 1, 2005. Gross margin was $34.2 million or 19.6% for the nine month
      period ended September 30, 2006 compared to $32.9 million or 20.1% for the
      nine
      month period ended October 1, 2005. The decrease reflects the adverse effect
      of
      the efforts of managed care organizations, pharmacy benefit managers and other
      third party payors to reduce their prescription costs, as well as the impact
      of
      Medicare Part D. In recent years, our industry has undergone significant changes
      driven by various efforts to reduce costs. As employers and managed care
      organizations continue to focus on the costs of branded and specialty
      pharmaceuticals, we expect there will continue to be negative pressure on gross
      margins. In addition, gross margin percentage is expected to be negatively
      impacted because of the addition of Medicare Part D and other efforts by third
      party payors to reduce reimbursement rates. The Company, like several others
      in
      the pharmacy industry, continues to experience a significant negative impact
      on
      gross margins due to the increasing number of prescriptions filled under
      Medicare Part D. For the three and nine month periods ended September 30, 2006,
      Medicare Part D prescriptions represented 21.2% and 18.6% of total prescription
      sales, respectively. Information that helps explain our gross margin trend
      is
      detailed below:





**Three Months**
              **Ended**
              **September
                30,**
              **2006**
              **Versus**
              **October
                1, 2005**
            
            **Nine Months**
              **Ended**
              **September
                30,**
              **2006**
              **versus**
              **October
                1, 2005**Gross
                margin increases (decreases) are as follows (in millions):Net
                effect of location openings/closings
            
            $
            -
            
            $
            0.2Rx
                gross margin
            
            
            1.2
            
            
            0.7Non-Rx
                gross margin
            
            
            (0.1
            )
            
            (0.3
            )Valley
                Medical Supply
            
            
            0.4
            
            
            0.7Net
                increase (decrease)
            
            $
            1.5
            
            $
            1.3




22




***Operating
      Expenses, Net***




Operating
      expenses include selling, general and administrative (“SG&A”) expenses,
      depreciation and amortization expense. Total operating expenses were $12.9
      million or 22.3% of net revenues for the three month period ended September
      30,
      2006. This compared to $14.5 million or 28.1% of net revenues for the three
      month period ended October 1, 2005. Total operating expenses were $42.1 million
      or 24.1% of net revenues for the nine month period ended September 30, 2006.
      This compared to $44.8 million or 27.4% of net revenues for the nine month
      period ended October 1, 2005. Information that helps explain our operating
      expense trend is detailed below:




**Three Months**
              **Ended**
              **September
                30,**
              **2006**
              **versus**
              **October
                1,****2005**
            
            **Nine Months**
              **Ended**
              **September
                30,**
              **2006**
              **versus**
              **October
                1, 2005**Operating
                expenses increases (decreases) are as follows (in
                millions):Selling,
                general and administrative expenses (1)
            
            $
            (0.6
            )
            $
            (1.2
            )Gain
                on sale of pharmacy assets (2)
            
            
            (0.8
            )
            
            (0.8
            )Depreciation
                and amortization (3)
            
            
            (0.2
            )
            
            (0.7
            )Net
                decrease
            
            $
            (1.6
            )
            $
            (2.7
            )




(1)
              The
                  decrease in selling, general and administrative expenses during
                  the three
                  month period ended September 30, 2006 over the period ended October
                  1,
                  2005 is primarily due to decreases in stock compensation expense
                  of $1.0
                  million and marketing expenses of $0.2 million offset by increases
                  in
                  expenses related to Valley Medical Supply of $0.3 million and payroll
                  and
                  benefits of $0.3 million,. The decrease in selling, general and
                  administrative expenses during the nine month period ended September
                  30,
                  2006 over the period ended October 1, 2005 is primarily due to
                  decreases
                  in stock compensation expense of $4.6 million offset by increases
                  in
                  expenses related to Valley Medical Supply of $0.9 million, payroll
                  and
                  benefits of $1.5 million, temporary labor of $0.5 million, recruiting
                  costs of $0.3 million and insurance costs of $0.2 million.In
                  October 2006, these operations were moved to Farmington, Connecticut
                  and
                  are now doing business as Familymeds Medical
                  Supply.


(2)
              The
                  gain on the sale of pharmacy assets represents the sale of certain
                  prescription assets from the closed pharmacy
                  locations.
  (3)
              The
                  decrease in depreciation and amortization is primarily due to fully
                  amortized prescription
                  files.




***Other
      Income (Expense), Net***





Other
      income (expense), net for the three and nine month periods ended September
      30,
      2006 included a gain on the extinguishment of the debt of $13.1 million. We
      extinguished this debt on June 23, 2006. There was no amounts related to the
      gain on extinguishment of this debt for the three and nine month periods ended
      October 1, 2005.





***Interest
      Expense***




Interest
      expense was $1.4 million for the three month period ended September 30, 2006
      versus $1.8 million for the three month period ended October 1, 2005. The
      decrease was due to a lower outstanding debt balance after the debt
      restructuring that took place at the end of the second quarter of 2006 partially
      offset by a $0.2 million of additional interest representing financing costs
      incurred for due diligence for potential investors that ultimately did not
      result in a financing transaction. Interest expense was $4.2 million for the
      nine month period ended September 30, 2006 versus $3.9 million for the nine
      month period ended October 1, 2005, respectively. The increase is mainly due
      to
      the financing costs referred to above. Higher interest paid in the first half
      of
      2006 due to higher interest rates on outstanding indebtedness with variable
      rates was largely offset by lower interest rates and debt balances in the third
      quarter due to the debt restructuring.





***Income
      Taxes***




No
      income
      taxes have been recorded in any period presented due to the uncertainty of
      realization of any related deferred tax assets.




***Net
      Income (Loss)***




Net
      loss
      for the three month period ended September 30, 2006 was $3.1 million versus
      a
      net loss of $14.5 million for the three month period ended October 1,
      2005.  Net income for the nine month period ended September 30, 2006 was
      $0.7 million versus a net loss of $26.7 million for the nine month period ended
      October 1, 2005.  Factors impacting these results are discussed above.




23





***Inflation
      and Seasonality***




Management
      believes that inflation had no material effect on the operations or our
      financial condition for the three and nine month periods ended September 30,
      2006 and October 1, 2005. Historically,
      our third quarter business has been affected by seasonality and has been lower
      than our other three fiscal quarters’ business due to the effect of reduced
      patient visits and doctor referrals during typical summer vacation
      months.





**LIQUIDITY
      AND CAPITAL RESOURCES**




We
      have
      financed our operations and have met our capital requirements primarily through
      private issuances of equity securities, convertible notes, bank borrowings,
      trade creditors and cash generated from operations.  Our principal sources
      of liquidity as of September 30, 2006, consisted of cash and cash equivalents
      of
      approximately $0.9 million along with approximately $2.0 million in availability
      under our $65.0 million revolving credit facility.





Provided
      that we can continue to successfully execute our growth strategies and reduce
      overhead expenses, we believe that our existing cash and cash equivalents and
      revolving credit facility will be sufficient to fund operating losses, capital
      expenditures, and debt service and to provide adequate working capital
      for the next twelve months based on our current terms with our suppliers.
      However, there can be no assurance that events in the future, including without
      limitation any changed terms imposed upon us by our suppliers or any increase
      in
      our reserves imposed under our credit facility will not require us to seek
      additional capital and, if so required, that capital will be available on terms
      favorable or acceptable to us, if at all.





**Credit
      Facility**





On
      October 12, 2005, the Company entered into a Loan and Security Agreement with
      Wells Fargo Retail Finance, LLC (“WFRF”), pursuant to which WFRF will provide
      the Company with a senior secured revolving credit facility up to $65.0 million
      (the “New Credit Facility”). On that same date the Company terminated its $65.0
      million Amended and Restated Credit Agreement with General Electric Capital
      Corporation (“GECC”) and in connection therewith repaid all outstanding amounts
      due under the credit facility to GECC along with a $0.5 million termination
      fee.
      The $65.0 million of maximum availability under the New Credit Facility is
      reduced by a $7.0 million reserve. Available credit is based on eligible
      receivables, inventory and prescription files, as defined in and determined
      pursuant to the agreement, and may be subject to reserves as determined by
      the
      lender from time to time. Interest on the revolving line of credit is calculated
      at the prime index rate plus an applicable prime margin (as defined in the
      agreement), unless the Company or the lender chooses to convert the loan to
      a
      LIBOR-based loan. In each case, interest is adjusted quarterly. The applicable
      prime index margin as of September 30, 2006 was 8.25%. As of September 30,
      2006, the interest rate, including applicable margin, used to calculate
      accrued interest was 8.50%. Interest is payable monthly.





The
      New
      Credit Facility includes usual and customary events of default (subject to
      applicable grace periods) for facilities of this nature and provides that,
      upon
      the occurrence of an event of default, payment of all amounts payable under
      the
      New Credit Facility may be accelerated and/or the lenders’ commitments may be
      terminated. In addition, upon the occurrence of certain insolvency or bankruptcy
      related events of default, all amounts payable under the New Credit Facility
      shall automatically become immediately due and payable, and the lenders’
commitments shall automatically terminate.





The
      New
      Credit Facility includes an early termination fee of $0.7 million if paid in
      full before October 12, 2008. The New Credit Facility is secured by
      substantially all assets of the Company. As of September 30, 2006, $36.2 million
      was outstanding on the revolving line of credit and $2.0 million was available
      for additional borrowings, based on eligible receivables, inventory and
      prescription files.


24




**Retired
      Subordinated Note and Convertible Debenture**





On
      March
      22, 2005, we converted $23.0 million in accounts payable owed to
      AmerisourceBergen Drug Corporation (“ABDC”) (after having repaid $6.0 million on
      March 23, 2005 in connection with the closing of the new vendor supply
      agreement) into (a) a subordinated convertible debenture in the original
      principal amount of $11.5 million (the “Subordinated Convertible Debenture”) and
      (b) a subordinated promissory note in the original principal amount of $11.5
      million (the “Subordinated Note”).





As
      further described below, on June 29, 2006, the Company and ABDC entered into
      an
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10 million.




**Note
      and Warrant Purchase Agreement**





On
      June
      29, 2006, we entered into a Note and Warrant Purchase Agreement and certain
      other agreements, each effective as of June 23, 2006, with Deerfield Special
      Situations Fund, L.P. (“Deerfield L.P.”) and Deerfield Special Situations Fund
      International, Limited (“Deerfield International”), pursuant to which Deerfield
      L.P. and Deerfield International (collectively, “Deerfield”) purchased two
      secured promissory notes in the aggregate principal amount of $10 million (one
      note in the principal amount of $3.32 million and the second note in the amount
      of $6.68 million collectively the “Notes”) and eight warrants to purchase an
      aggregate of 1.65 million shares of Familymeds Group, Inc. common stock (the
      “Warrants”), for an aggregate purchase price of $10 million.





The
      $10
      million purchase price for the Notes and Warrants was used entirely for an
      early
      repayment, settlement and termination of approximately $23 million in
      outstanding subordinated debt with Familymeds Group’s former supplier
      AmerisourceBergen Drug Corporation (“ABDC”). The subordinated debt with ABDC
      consisted of a subordinated convertible debenture in the original principal
      amount of $11.5 million and a subordinated promissory note in the original
      principal amount of $11.5 million. Both original debt instruments were 5-year
      agreements maturing in September 2010. In connection with the Deerfield
      transaction, Familymeds Group and ABDC entered into a payoff and mutual release
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10 million. Wells Fargo
      Retail Finance, LLC (“WFRF”), the Company’s senior lender, consented to
      Familymeds Group’s early repayment of the ABDC debt and waived any default under
      Familymeds Group’s credit facility with WFRF as a result of such repayment by
      entering into an amendment to such credit facility with Familymeds Group and
      its
      subsidiaries.





Principal
      on each of the Notes is due and payable in successive quarterly installments
      each in the amount of $0.166 million and $0.334 million, respectively, beginning
      on September 1, 2006 and on each December 1, March 1, June 1 and September
      1
      thereafter and continuing until June 23, 2011, on which date all outstanding
      principal and accrued and unpaid interest is due. The Notes bear interest at
      a
      rate equal to 2.5% for the first year, 5.0% for the second year, 10.0% for
      the
      third year, 15.0% for the fourth year and 17.5% for the fifth year. The Notes
      may be prepaid by the Company at anytime without penalty. Interest expense
      has
      been estimated over the five year period to be approximately $1.8
      million (excludes the effect of amortization of the debt discount of $2.5
      million discussed below) and due to the increasing interest rate on this
      debt, the Company records the average quarterly interest expense and record
      a
      corresponding asset or liability for the difference not currently payable each
      quarter.





In
        lieu of
        making any interest payments in cash during the first and second year of
        the
        Notes, the Company may issue and deliver to Deerfield shares of common
        stock.  Pursuant to an amendment in October 2006, such shares shall be
        issued annually and Deerfield shall not be able to transfer or sell such
        shares
        until such time as the interest payment represented by those shares shall
        become
        due.  During the fourth quarter of 2006, 58,878 shares of common stock were
        issued to Deerfield representing the first year’s interest.


25





The
      Notes
      contain usual and customary events of default for notes of these dollar amounts
      and provide that, upon the occurrence of an event default, the entire
      outstanding principal balance and all interest accrued under each note shall
      immediately become due and payable without demand or notice to the Company.




The
      Notes
      are secured by subordinated security interests in substantially all of the
      assets of the Company and its subsidiaries, Familymeds, Inc. (“Familymeds”) and
      Valley Drug Company South (“Valley South”). These subordinated security
      interests are evidenced by three security agreements: (i) a Security Agreement
      between the Company and Deerfield L.P., as agent for Deerfield (the “Agent”),
      (ii) a Security Agreement between Familymeds and the Agent, and (iii) a Security
      Agreement between Valley South and the Agent (collectively, the “Security
      Agreements”). The Security Agreements are expressly subordinated to the prior
      lien rights of WFRF pursuant to the Company’s existing credit facility with
      WFRF. Both Familymeds and Valley South have entered into guaranty agreements
      pursuant to which they have guaranteed all of the obligations of the Company
      under the Notes.





In
      connection with the issuance of these Notes, 1.65 million of stock warrants
      were
      issued as follows: warrants for 0.30 million common shares were issued at an
      exercise price of $6.10 per share; warrants for 0.55 million common shares
      were
      issued at an exercise price of $7.50 per share; warrants for 0.55 million common
      shares were issued at an exercise price of $7.80 per share; and warrants for
      0.25 million common shares were issued at an exercise price of $9.20 per share.
      Proceeds from each warrant exercised by Deerfield will be used to equally repay
      the Notes and for the working capital needs of the Company. All of the Warrants
      are exercisable for a period of five years from the closing date.





In
      accordance with Accounting Principles Board (“APB”) Opinion No. 14 “Accounting
      for Convertible Debt and Debt Issued with Stock Purchase Warrants,” the Company
      allocated the proceeds received between the debt and the detachable warrants
      based upon the relative fair market values on the dates the proceeds were
      received. The net value allocated to the warrants was $2.5 million and was
      determined using the Black-Scholes option pricing formula. The $2.5 million
      has
      been recorded as debt discount and will be amortized over the life of the
      related debt using the effective interest method. The effective interest rate
      on
      the Notes, after giving effect to the amortization of the debt discount is
      approximately 17.0% annually.





**New
      Accounting Standards**





In
      June
      2006, the FASB issued Financial Accounting Standards Interpretation No. 48,
      “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) an interpretation of
      Financial Accounting Standards Statement No. 109, “Accounting for Income Taxes.”
FIN 48 prescribes a recognition threshold and measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. The interpretation requires that the
      Company recognize in the financial statements, the impact of a tax position,
      if
      that position is more likely than not of being sustained on audit, based on
      the
      technical merits of the position. FIN 48 also provides guidance on
      de-recognition, classification, interest and penalties, accounting in interim
      periods and disclosure. The provisions of FIN 48 are effective beginning January
      1, 2007 with the cumulative effect of the change in accounting principle
      recorded as an adjustment to the opening balance of retained earnings. We do
      not
      believe it will have a material impact on its financial position or results
      of
      operations as a full valuation allowance has been established.




In
      September 2006, the SEC issued Staff Accounting Bulletin, or SAB, No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements.* SAB No. 108
      provides guidance on how prior year misstatements should be taken into
      consideration when quantifying misstatements in current year financial
      statements for purposes of determining whether the current year’s financial
      statements are materially misstated. SAB No. 108 is effective for
      fiscal years ending on or after November 15, 2006. We are currently in the
      process of evaluating the impact of SAB No. 108 on our financial
      position and results of operations.




26








In
      September 2006, the Financial Accounting Standards Board, or FASB, issued
      SFAS No. 157, *Fair
      Value Measurements.* SFAS No. 157
      establishes a framework for measuring the fair value of assets and liabilities.
      This framework is intended to provide increased consistency in how fair value
      determinations are made under various existing accounting standards which
      permit, or in some cases require, estimates of fair market value.
      SFAS No. 157 is effective for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not yet issued
      financial statements for that fiscal year, including any financial statements
      for an interim period within that fiscal year. We are currently in the process
      of evaluating the impact of SFAS No. 157 on our financial position and
      results of operations.





**Operating,
      Investing and Financing Activities**




***Cash
      Inflows and Outflows***




During
      the nine month period ended September 30, 2006, the net decrease in cash and
      cash equivalents was $5.8 million compared to a net decrease of $1.0 million
      during the nine month period ended October 1, 2005. As reported on our condensed
      consolidated statements of cash flows, our change in cash and cash equivalents
      during the nine month period ended September 30, 2006 and October 1, 2005 is
      summarized as follows:




**Nine
                month period ended****Dollars
                in millions**
            
            
            **September
                30,**
              **2006**
            
            
            **October
                1,**
              **2005**Net
                cash used by operating activities
            
            $
            (2.4
            )
            $
            (4.1
            )Net
                cash used by investing activities
            
            
            (1.4
            )
            
            (1.5
            )Net
                cash (used in)
              provided
                by financing activities
            
            
            (2.0
            )
            
            4.6Change
                in cash and cash equivalents
            
            $
            (5.8
            )
            $
            (1.0
            )




27




Details
      of our cash inflows and outflows are as follows during the nine month period
      ended September 30, 2006:




*Operating
      Activities:* During
      the nine month period ended September 30, 2006, we used $2.4 million in cash
      and
      cash equivalents in operating activities as compared with $4.1 million used
      during the same prior year period. For the nine month period ended September
      30,
      2006, this was comprised primarily of net income of $0.7 million and an increase
      in working capital of $6.5 million, the net change in operating assets and
      liabilities reflected on our condensed consolidated statements of cash flows,
      partially offset by non-cash charges totaling $9.6 million. For the nine month
      period ended October 1, 2005, the use of cash consisted primarily of a net
      loss
      of $26.7 million offset by an increase in working capital of $13.1 million,
      the
      net change in operating assets and liabilities reflected on our condensed
      consolidated statements of cash flows, and by non-cash items of $9.5 million.
      Components of our significant non-cash adjustments for the nine month period
      ended September 30, 2006 are as follows:




**Non-cash
                Adjustments**
            
            
            **Nine month
                period ended**
              **September
                30 ,**
              **2006**
              **(amounts in**
              **thousands)**
            
            
            **Explanation
                of Non-cash Activity**Depreciation
                and amortization
            
            $
            2,678
            
            
            Consists
                of depreciation of property and equipment as well as amortization
                of
                intangibles.Non
                cash interest expense
            
            
            989
            
            
            Interest
                expense related to ABDC notes payable in common stock along with
                deemed
                shortfall paymentsGain
                on extinguishment of debt
            
            
            (13,086
            )
            
            We
                retired the outstanding ABDC notes amounting to $23 million and issued
                a
                $10 million Note due to Deerfield that was used to retire the ABDC
                notes.Other
                non-cash items, net
            
            
            (166
            )
            
            Other
                non-cash items include items such as adjustments to deferred financing
                fees, adjustments to our allowance for doubtful accounts and non-cash
                stock-based compensation.Total
                non-cash adjustments to net income
            
            $
            (9,585
            )




*Investing
      Activities:* Cash
      used by investing activities was $1.4 million for the nine month period ended
      September 30, 2006, as compared with $1.5 million used in investing activities
      in the nine month period ended October 1, 2005. Specific investing activity
      during the nine month periods ended September 30, 2006 and October 1, 2005
      was
      as follows:


·
            During
                the nine month period ended September 30, 2006, we invested approximately
                $2.0 million in pharmacy software, leasehold improvements, land and
                computer hardware. We incurred capital expenditures of $0.9 million
                which
                we have not paid for as of September 30, 2006.


·
            During
                the first nine months of 2006, we used cash of approximately $0.2
                million
                to acquire the assets of an oncology based pharmacy located in central
                Florida. 
 ·
            During
                the first nine months of 2006, we received cash of approximately
                $0.9
                million from the sale of certain prescription assets from closed
                pharmacy
                locations.




*Financing
      Activities:* Net
      cash
      provided by (used in) financing activities was $(2.0) million during the nine
      month period ended September 30, 2006, as compared with $4.6 million used in
      financing activities in the nine month period ended October 1, 2005. Specific
      financing activity during the nine month periods ended September 30, 2006 and
      October 1, 2005 was as follows:


·
            During
                the nine month period ended September 30, 2006, our revolving credit
                facility to fund our operations, acquire pharmacy assets and to purchase
                capital expenditures remained flat. This compares to $5.7 million
                in net
                proceeds in the same period of
                2005.


·
            During
                the nine month period ended September 30, 2006, we made scheduled
                debt
                repayments of $1.9 million under our outstanding subordinated notes.
                This
                compares to $1.2 million for scheduled debt repayments in the same
                period
                of 2005.  28
  ·
            During
                the first nine months of 2006, we also received proceeds of approximately
                $0.009 million from the issuance of common stock under our employee
                stock
                plans. This compares to $0.5 million for proceeds related to employee
                stock option exercises in the same period of
                2005.


***Off-Balance
      Sheet Arrangements***





We
      do not
      make use of any off-balance sheet arrangements that currently have or that
      we
      expect are reasonably likely to have a material effect on our financial
      condition, results of operations or cash flows. We utilize operating leases
      for
      substantially all of our locations. We do not use special-purpose entities
      in
      any of our leasing arrangements.





***Critical
      Accounting Policies and Estimates***




Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (“MD&A”) contains a discussion of the Company’s condensed unaudited
      consolidated financial statements, that have been prepared in accordance with
      accounting principles generally accepted in the United States. The preparation
      of these financial statements requires us to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities and the disclosure of
      contingent assets and liabilities at the date of the financial statements and
      the reported amounts of revenues and expenses during the reporting periods.
      On
      an on-going basis, we evaluate estimates and judgments, including the most
      significant judgments and estimates. We based our estimates and judgments on
      historical experience and on various other facts that are believed to be
      reasonable under the circumstances, the results of which form the basis for
      making judgments about the carrying values of assets and liabilities that are
      not readily apparent from other sources. Actual results may differ from these
      estimates under different assumptions or conditions. Our critical accounting
      policies include: assessing merger goodwill and identifiable intangible assets
      for impairment, assessing other long-lived assets for impairment, evaluating
      the
      adequacy of the allowance for doubtful accounts, and estimating for inventory
      loss reserves.





**Goodwill
      and Identifiable Intangible Assets**




Useful
      lives for identifiable intangibles are determined based on the expected future
      period of benefit of the asset, the assessment of which considers various
      characteristics of the asset, including historical cash flows. After goodwill
      is
      initially recorded, annual impairment tests are required, or more frequently
      if
      impairment indicators are present. The amount of goodwill cannot exceed the
      excess of the fair value of the related reportable unit (which is based, in
      part, on the Company’s stock price) over the fair value of reporting unit’s
      identifiable assets and liabilities. Continued downward movement in the
      Company’s common stock price could have a material effect on the fair value of
      goodwill in future measurement periods. As of September 30, 2006, goodwill
      was
      $1.4 million.




**Impairment
      of Other Long-lived Assets**





The
      Company reviews other long-lived assets, including property, equipment and
      prescription file intangible assets, to be held and used for impairment whenever
      events or changes in circumstances indicate that the carrying amount of an
      asset
      may not be recoverable. If the sum of the undiscounted expected future cash
      flows is less than the carrying amount of the related assets, the Company
      recognizes an impairment loss. Impairment losses are measured as the amount
      by
      which the carrying amount of the assets, including prescription file intangible
      assets, exceeds the future cash flows for the assets. For purposes of
      recognizing and measuring impairment of other long-lived assets, the Company
      evaluates assets at the location level for pharmacy operations.





Our
      impairment loss calculations contain uncertainty since we must use judgment
      to
      estimate future revenues, profitability and cash flows. When preparing these
      estimates, we consider historical results and current operating trends and
      our
      consolidated revenues, profitability and cash flow results and forecasts. These
      estimates can be affected by a number of factors including, but not limited
      to,
      general economic conditions, the cost of real estate, the continued efforts
      of
      third party customers to reduce their prescription drug costs, regulatory
      changes the continued efforts of competitors to gain market share and consumer
      spending patterns. If these projections change in the future, we may be required
      to write-down our long-lived assets. Long-lived assets evaluated for impairment
      include property and equipment as well as intangible assets, which as of
      September 30, 2006 and December 31, 2005 were approximately $9.8
      million.




29





**Trade
      Receivables**





At
      September 30, 2006 and December 31, 2005, trade receivables reflected
      approximately $17.4 million and $15.7 million, respectively, of amounts due
      from
      various insurance companies, governmental agencies and individual customers.
      Of
      these amounts, there was approximately $2.8 million and $2.8 million reserved
      as
      of September 30, 2006 and December 31, 2005, respectively, for a balance of
      net
      trade receivables of $14.6 million and $12.9 million, respectively. We use
      historical experience, market trends and other analytical data to estimate
      our
      allowance for doubtful accounts. Based upon these factors, the reserve at
      September 30, 2006 is considered adequate. Although we believe that the reserve
      estimate is reasonable, actual results could differ from our estimate, and
      such
      differences could be material. If the estimate is too low, we may incur higher
      bad debt expenses in the future resulting in lower net income or higher net
      losses. If the estimate is too high, we may experience lower bad debt expense
      in
      the future resulting in higher net income or lower net losses.





**Inventories**





Inventories
      consist of pharmaceuticals and other retail merchandise owned by us. Inventories
      are stated at the lower of cost (first-in, first-out method for pharmaceutical
      inventory and retail method for retail merchandise inventory) or market.
      Physical inventory counts are taken on a regular basis in each location to
      ensure that the amounts reflected in the unaudited condensed consolidated
      financial statements are properly stated. We use historical data to estimate
      our
      inventory loss reserves and we have not made any material changes in the
      accounting methodology used to establish our inventory loss reserves during
      the
      past three years. If the estimate of inventory losses is too low we may incur
      higher cost of sales in the future resulting in lower net income or higher
      net
      losses. If the estimate of inventory losses incurred is too high, we may
      experience lower cost of sales in the future resulting in higher net income
      or
      lower net losses. Inventories as of September 30, 2006 and December 31, 2005
      were approximately $23.6 million and $30.6 million, respectively, net of
      approximately $2.0 million and $2.1 million of inventory loss reserves,
      respectively.





**Item
      3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**




As
      of
      September 30, 2006, $36.2 million and $9.5 million were outstanding on our
      revolving credit facility and Deerfield Notes, respectively. These borrowings
      are at a variable rate of interest. Assuming $45.7 million was outstanding
      for a
      full year, a 1% change in interest rates would change our interest expense
      by
      $0.5 million annually.





We
      do not
      currently utilize derivative financial instruments to address market
      risk.





**Item
      4. CONTROLS AND PROCEDURES.**





We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in our Exchange Act reports is recorded,
      processed, summarized and reported within the time periods specified in the
      SEC’s rules and forms, and that such information is accumulated and communicated
      to our management, including our Chief Executive Officer and Chief Financial
      Officer, as appropriate, to allow timely decisions regarding required
      disclosure.




30





**Conclusion
      Regarding the Effectiveness of Disclosure Controls and
      Procedures.** We
      carried out an evaluation, under the supervision and with the participation
      of
      our Chief Executive Officer and Chief Financial Officer, of the effectiveness
      of
      the design and operation of our disclosure controls and procedures as of the
      end
      of the period covered by this report pursuant to Exchange Act Rule 13a-15.
      Our
      disclosure controls and procedures include, without limitation, controls and
      procedures designed to ensure that information required to be disclosed by
      us in
      reports that we file or submit pursuant to the Securities Exchange Act of 1934,
      as amended, are accumulated and communicated to our management, including our
      Chief Executive Officer and Chief Financial Officer, as appropriate to allow
      timely decisions regarding required disclosure.  Based on this evaluation,
      our Chief Executive Officer and Chief Financial Officer concluded that our
      disclosure controls and procedures were effective as of the end of the period
      covered by this report.  In designing and evaluating the disclosure
      controls and procedures, management recognized that any controls and procedures,
      no matter how well designed and operated, can provide only reasonable assurance
      of achieving the desired control objectives, and in reaching a reasonable level
      of assurance, management necessarily was required to apply its judgment in
      evaluating the cost-benefit relationship of possible controls and procedures.





**Changes
      in Internal Control Over Financial Reporting.** There
      has been no change in our internal control over financial reporting during
      the
      third quarter of 2006 that has materially affected, or is reasonably likely
      to
      materially affect, our internal control over financial reporting.





**PART
      II - OTHER INFORMATION**




**Item
      1. LEGAL PROCEEDINGS.**




There
      has
      been no significant change in the status of the legal matters described in
      the
      Company’s fiscal 2005 Form 10-K, as amended.





**Item
      1A. RISK FACTORS.**





There
      following risk factors should be considered in addition to the Risk Factors
      described in the Company’s fiscal 2005 Form 10-K, as amended.





**We
      have received a non-compliance letter from Nasdaq.**




On
      October 6, 2006, the Company received a Nasdaq Staff Determination Letter,
      indicating that the Company has failed to comply with the minimum $35,000,000
      market value of publicly held shares requirement for continued listing set
      forth
      in Marketplace Rule 4310(c)(2)(B)(ii) and that its securities are, therefore,
      subject to delisting from The Nasdaq Capital Market unless the Company requests
      a hearing and appeals the determination. The Company has requested a hearing
      before a NASDAQ Listing Qualifications Panel to review the above Nasdaq staff
      determination. The hearing request will stay the suspension of the Company's
      securities on The Nasdaq Capital Market until the Panel issues its decision
      following the hearing. There can be no assurance the Panel will grant the
      Company’s request for continued listing.





**Our
      business could be adversely affected if relations with our primary supplier
      are
      terminated; substantially all of our supplier agreements are terminable at
      will.**




Beginning
      in the second quarter of 2005, the Company began purchasing its products from
      D&K Healthcare Resources. In December 2005, the Company amended its
      agreement with D&K (which was assumed by McKesson Corporation in August of
      2005). The amended agreement requires us to purchase primarily all of our
      products for sale in our pharmacies from McKesson. It contains certain volume
      requirements and has an initial term of two years, through December 2006, and
      renews automatically for successive one-year periods unless either party
      provides the other party a written non-renewal notice. On October 16, 2006,
      McKesson provided notice that they wished to negotiate a new agreement to begin
      December 27, 2006 upon expiration of the existing agreement. The terms of the
      new agreement, including payment terms and pricing, are expected to be similar
      to the existing terms but the contract will be more in line with a standard
      McKesson contract rather than the current D&K contract. While, we believe
      that if we were unable to purchase products directly from McKesson we could
      secure the same products through other sources, including other distributors
      or
      directly from the manufacturers, there is a risk that our costs would increase
      and our supply could be interrupted affecting our net revenues if our primary
      supplier agreement were to be terminated.




31




**Item
      2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**





None.





**Item
      3. DEFAULT UPON SENIOR SECURITIES.**




None.





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




None.




**Item
      5. OTHER INFORMATION.**




None.




**Item
      6. EXHIBITS**





31.1
            Certification
                of Principal Executive Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002. *31.2
            Certification
                of Principal Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002. *32.1
            Certification
                Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002. *32.2
            Certification
                Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002. *10.1
            First
                Amendment to Deerfield Promissory Note and Investor Rights Agreement
                dated
                as of October 11, 2006.*







*
            
            Filed
                herewith.1
            
            Incorporated
                by reference to Amendment No. 1 to Form S-3 filed on October 18,
                2006.




32





**SIGNATURES**




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




**Familymeds
                Group, Inc.**Date:
                November 14, 2006
            By:
            */s/
                Edgardo A. Mercadante*Edgardo
                  A. Mercadante
                President,
                  Chief Executive Officer and Chairman of the Board
                (Principal
                  Executive Officer)


Date: November
                14, 2006
            By:
            */s/
                James A. Bologa*James
                  A. Bologa
                Senior
                  Vice President, Chief Financial Officer and Treasurer
                (Principal
                  Financial and Accounting
                  Officer)




33