**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 **JULY
      1, 2006**




OR





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




FOR
      THE
      TRANSITION PERIOD FROMTO








**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)**





**DrugMax,
      Inc.**


**(Former
      name, former address and former fiscal year if changed since last report)**






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




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
      August 3, 2006, there were 66,351,423 shares of common stock, par value $0.001
      per share, outstanding.





**FAMILYMEDS
      GROUP, INC. AND SUBSIDIARIES**


**FORM
      10-Q**


**FOR
      THE THREE AND SIX MONTH PERIODS ENDED JULY 1, 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 SubsidiariesCondensed
                Consolidated Balance Sheets as of July 1, 2006 (unaudited) and December
                31, 2005
            1Condensed
                Consolidated Statements of Operations Three and Six Month
                Periods Ended July 1, 2006 and July 2, 2005 (unaudited)
            2Condensed
                Consolidated Statements of Cash Flows Three and Six Month Periods
                Ended
                July 1, 2006 and July 2, 2005 (unaudited)
            3Notes
                to Condensed Consolidated Financial Statements
            4Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            12Item
                3. Quantitative and Qualitative Disclosures About Market Risk
            26Item
                4. Controls and Procedures
            26**PART
                II -****OTHER
                INFORMATION**Item
                1. Legal Proceedings
            27Item
                1A. Risk Factors
            27Item
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds
            27Item
                3. Default upon Senior Securities
            27Item
                4. Submission of Matters to a Vote of Security Holders
            28Item
                5. Other Information
            29Item
                6. Exhibits
            29**SIGNATURES**
            30




i








**PART
      I - FINANCIAL INFORMATION**




**Item
      1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**




**FAMILYMEDS
                  GROUP, INC. AND SUBSIDIARIES****(formerly
                  DRUGMAX, INC.)****CONSENSED
                  CONSOLIDATED BALANCE SHEETS****JULY
                  1, 2006 AND DECEMBER 31, 2005****(in
                  thousands, except share data)****(Unaudited)****ASSETS**
              
              **July
                  1, 2006**
              
              **December
                  31, 2005**CURRENT
                  ASSETS:Cash
                  and cash equivalents
              
              $
              3,038
              
              $
              6,681Trade
                  receivables, net of allowance for doubtful accounts of
                  approximately$2,490
                  and $2,777 in 2006 and 2005, respectively
              
              
              15,495
              
              
              12,855Inventories
              
              
              27,543
              
              
              30,631Prepaid
                  expenses and other current assets
              
              
              1,590
              
              
              2,487Total
                  current assets
              
              
              47,666
              
              
              52,654PROPERTY
                  AND EQUIPMENT—Net of accumulated depreciation and
                  amortizationof
                  approximately $13,878 and $13,080 in 2006 and 2005,
                  respectively
              
              
              6,886
              
              
              4,959GOODWILL
              
              
              1,355
              
              
              1,355INTANGIBLE
                  ASSETS—Net of accumulated amortization ofapproximately
                  $18,728 and $17,674 in 2006 and 2005, respectively
              
              
              3,820
              
              
              4,852OTHER
                  NONCURRENT ASSETS
              
              
              727
              
              
              207TOTAL
                  ASSETS
              
              $
              60,454
              
              $
              64,027**LIABILITIES
                  AND STOCKHOLDERS’ DEFICIT**CURRENT
                  LIABILITIESRevolving
                  credit facility
              
              $
              38,239
              
              $
              36,251Promissory
                  notes payable
              
              
              281
              
              
              915Accounts
                  payable
              
              
              13,279
              
              
              9,014Accrued
                  expenses
              
              
              5,550
              
              
              6,100Current
                  portion of notes payable
              
              
              2,000
              
              
              4,721Total
                  current liabilities
              
              
              59,349
              
              
              57,001NOTES
                  PAYABLE, NET OF DISCOUNT OF $2,497 in 2006
              
              
              5,503
              
              
              18,184OTHER
                  LONG-TERM LIABILITIES
              
              
              66
              
              
              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; 66,117,050
                  and
                  65,740,436 shares issued and outstanding for 2006 and 2005,
                  respectively
              
              
              66
              
              
              66Additional
                  paid in capital
              
              
              230,542
              
              
              227,336Accumulated
                  deficit
              
              
              (234,349
              )
              
              (238,131
              )Unearned
                  compensation
              
              
              (723
              )
              
              (564
              )Total
                  stockholders’ deficit
              
              
              (4,464
              )
              
              (11,293
              )TOTAL
                  LIABILITIES AND STOCKHOLDERS' DEFICIT
              
              $
              60,454
              
              $
              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 SIX MONTH PERIODS ENDED JULY 1, 2006 and JULY 2,
                  2005****(in
                  thousands, except per share data)****(Unaudited)****Three
                  Month Periods Ended**
              
              **Six
                  Month Periods Ended****July
                  1, 2006**
              
              **July
                  2, 2005**
              
              **July
                  1, 2006**
              
              **July
                  2, 2005**NET
                  REVENUES
              
              $
              60,743
              
              $
              54,716
              
              $
              116,783
              
              $
              111,917COST
                  OF SALES
              
              
              48,870
              
              
              43,683
              
              
              93,995
              
              
              88,941Gross
                  margin
              
              
              11,873
              
              
              11,033
              
              
              22,788
              
              
              22,976SELLING,
                  GENERAL AND ADMINISTRATIVE EXPENSES
              
              
              14,454
              
              
              14,030
              
              
              27,441
              
              
              27,973DEPRECIATION
                  AND AMORTIZATION EXPENSE
              
              
              889
              
              
              1,110
              
              
              1,727
              
              
              2,312OPERATING
                  LOSS
              
              
              (3,470
              )
              
              (4,107
              )
              
              (6,380
              )
              
              (7,309
              )OTHER
                  INCOME (EXPENSE):Gain
                  on extinguishment of debt
              
              
              13,086
              
              
              -
              
              
              13,086
              
              
              -Interest
                  expense
              
              
              (1,407
              )
              
              (1,419
              )
              
              (2,803
              )
              
              (2,182
              )Interest
                  income
              
              
              31
              
              
              5
              
              
              41
              
              
              15Other
                  income
              
              
              1
              
              
              100
              
              
              60
              
              
              285Total
                  other income (expense), net
              
              
              11,711
              
              
              (1,314
              )
              
              10,384
              
              
              (1,882
              )Income
                  (loss) from continuing operations
              
              
              8,241
              
              
              (5,421
              )
              
              4,004
              
              
              (9,191
              )Loss
                  from discontinued operations
              
              
              (403
              )
              
              (1,744
              )
              
              (222
              )
              
              (2,970
              )NET
                  INCOME (LOSS)
              
              
              7,838
              
              
              (7,165
              )
              
              3,782
              
              
              (12,161
              )Preferred
                  stock dividends
              
              
              -
              
              
              (1,623
              )
              
              -
              
              
              (2,254
              )NET
                  INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS
              
              $
              7,838
              
              $
              (8,788
              )
              $
              3,782
              
              $
              (14,415
              )BASIC
                  INCOME (LOSS) PER COMMON SHARE:Income
                  (loss) from continuing operations available to common
                  shareholders
              
              $
              0.12
              
              $
              (0.35
              )
              $
              0.06
              
              $
              (0.58
              )Loss
                  from discontinued operations
              
              $
              (0.00
              )
              
              (0.09
              )
              $
              (0.00
              )
              
              (0.15
              )Net
                  income (loss) available to common shareholders
              
              $
              0.12
              
              $
              (0.44
              )
              $
              0.06
              
              $
              (0.73
              )FULLY
                  DILUTED INCOME (LOSS) PER COMMON SHARE:Income
                  (loss) from continuing operations available to common
                  shareholders
              
              $
              0.12
              
              $
              (0.35
              )
              $
              0.06
              
              $
              (0.58
              )Loss
                  from discontinued operations
              
              $
              (0.00
              )
              
              (0.09
              )
              $
              (0.00
              )
              
              (0.15
              )Net
                  income (loss) available to common shareholders
              
              $
              0.12
              
              $
              (0.44
              )
              $
              0.06
              
              $
              (0.73
              )WEIGHTED
                  AVERAGE SHARES OUTSTANDING:Basic
              
              
              66,062
              
              
              19,918
              
              
              65,968
              
              
              19,754Fully
                  diluted
              
              
              66,330
              
              
              19,918
              
              
              66,102
              
              
              19,754See
                  notes to condensed consolidated financial statements.





2


**FAMILYMEDS
                  GROUP, INC. AND SUBSIDIARIES****(formerly
                  DRUGMAX, INC.)****CONDENSED
                  CONSOLIDATED STATEMENTS OF CASH FLOWS****SIX
                  MONTH PERIODS ENDED JULY 1, 2006 and JULY 2,
                  2005****(in
                  thousands)****(Unaudited)****Six
                  Month Periods Ended****July
                  1, 2006**
              
              **July
                  2, 2005**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  income (loss)
              
              $
              3,782
              
              $
              (12,161
              )Adjustments
                  to reconcile net income (loss) to net cash used in operating
                  activities:Depreciation
                  and amortization
              
              
              1,727
              
              
              2,412Stock
                  compensation expense
              
              
              301
              
              
              3,941Noncash
                  interest expense
              
              
              848
              
              
              354Amortization
                  of deferred financing fees
              
              
              124
              
              
              153Provision
                  (recoveries) for doubtful accounts
              
              
              (2
              )
              
              34Gain
                  on extinguishment of debt
              
              
              (13,086
              )
              
              -Loss
                  on disposal of fixed assets and intangible assets
              
              
              -
              
              
              9Effect
                  of changes in operating assets and liabilities:Trade
                  receivables
              
              
              (2,638
              )
              
              2,275Inventories
              
              
              3,332
              
              
              (3,409
              )Prepaid
                  expenses and other current assets
              
              
              518
              
              
              334Accounts
                  payable
              
              
              3,304
              
              
              (2,992
              )Accrued
                  expenses
              
              
              (374
              )
              
              (193
              )Other
              
              
              (248
              )
              
              27Net
                  cash used in operating activities
              
              
              (2,412
              )
              
              (9,216
              )CASH
                  FLOWS FROM INVESTING ACTIVITIES:Purchases
                  of property and equipment
              
              
              (1,754
              )
              
              (1,092
              )Purchases
                  of pharmacy assets
              
              
              (244
              )
              
              -Net
                  cash used in investing activities
              
              
              (1,998
              )
              
              (1,092
              )CASH
                  FLOWS FROM FINANCING ACTIVITIES:Proceeds
                  from revolving credit facility, net
              
              
              1,988
              
              
              9,793Repayment
                  of promissory notes payable
              
              
              (1,209
              )
              
              (702
              )Repayment
                  of obligations under capital leases
              
              
              -
              
              
              (22
              )Payment
                  of deferred financing fees
              
              
              (21
              )
              
              (434
              )Proceeds
                  from exercise of stock options
              
              
              9
              
              
              547Net
                  cash provided by financing activities
              
              
              767
              
              
              9,182NET
                  DECREASE IN CASH AND CASH EQUIVALENTS
              
              
              (3,643
              )
              
              (1,126
              )CASH
                  AND CASH EQUIVALENTS—Beginning of period
              
              
              6,681
              
              
              2,332-
              
              
              -CASH
                  AND CASH EQUIVALENTS—End of period
              
              $
              3,038
              
              $
              1,206SUPPLEMENTAL
                  DISCLOSURES OF CASH FLOW INFORMATION:Cash
                  paid for interest
              
              $
              1,736
              
              $
              1,828Noncash
                  transactions—Subordinated
                  Convertible Debenture interest payments made in common
                  stock
              
              $
              229
              
              $
              -Payment
                  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 paid
              
              $
              961
              
              
              -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
      footnotes required by accounting principles generally accepted in the United
      States of America for complete financial statements. In the opinion of
      management, all adjustments (consisting of normal recurring items) considered
      necessary for a fair presentation have been included. Interim results are not
      necessarily indicative of the results that may be expected for a full year.
      These 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.




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 second quarter for fiscal year 2006
      ended on July 1, 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
      July 1, 2006, the Company operated 79 Company owned locations including 76
      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.





The
      Company also operates a wholesale drug distribution business primarily focused
      on the direct distribution of specialty pharmaceuticals to physicians, medical
      clinics and other health care providers from its warehouse located in St. Rose,
      Louisiana known as Valley Medical Supply.





***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 July 1, 2006, the Company had a net stockholders deficit of $4.0
      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.
      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.


4








**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 249,090 and
      285,717, respectively, shares of common stock were included in the July 1,
      2006
      computations of diluted net income per common share.  Options and warrants
      to purchase 3,253,901 and 5,408,967 shares of common stock were not included
      in
      the July 2, 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, we adopted SFAS No. 123(R) using a modified prospective method
      resulting in the recognition of share-based compensation expense of $0.002
      million, net of zero related tax expense. Prior period amounts have not been
      restated. Under this application, we are 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.




Prior
      to
      the adoption of SFAS No. 123(R), we 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 six month periods ended July 2, 2005 based on the fair value method
      under SFAS No. 123 (in thousands, except per share data):





**Three
                Months Ended**
              **July
                2,**
              **2005**
            
            **Six
                Months Ended**
              **July
                2,**
              **2005**Net
                loss available to common
              shareholders,
                as reported
            
            $
            (8,788
            )
            $
            (14,415
            )Add:
                actual expense, as reported
            
            
            2,001
            
            
            3,941Less:
                pro forma stock-based
              compensation
                expense determined under
              fair
                value method valuation for all
              awards
            
            
            (1,367
            )
            
            (2,719
            )Pro
                forma net loss available to common
              stockholders
            
            $
            (8,154
            )
            $
            (13,193
            )





5





**Basic
                and diluted net loss per common share:**Net
                loss available to common
              stockholders,
                as reported
            
            $
            (0.44
            )
            $
            (0.73
            )Pro
                forma net loss available to common
              stockholders
            
            $
            (0.41
            )
            $
            (0.67
            )Shares
                used in basic and diluted net
              loss
                per common share
            
            
            19,918
            
            
            19,754








During
      the six month period ended July 2, 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
      July 1, 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 shall be 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 shall
      be
      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,
      shall be 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 shall
      be
      determined as of the annual shareholders meeting of each year.




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 shall determine 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 shall
      receive an award of restricted stock in the amount of $25,000. The foregoing
      shares are granted under the Company’s 2003 Restricted Stock Plan.




We
      use
      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,
      exercise price, and forfeiture rate. 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 of the three month
      period ended July 1, 2006 stock option grants was $0.44 and the weighted-average
      fair value of the three month period ended July 2, 2005 stock option grants
      was
      $0.58. The table below indicates the key assumptions used in the option
      valuation calculations for options granted in the three month period ended
      July
      1, 2006 and July 2, 2005 and a discussion of our methodology for developing
      each
      of the assumptions used in the valuation model:


6







**Three Months Ended**
              **July
                1,**
              **2006**
            
            **Three Months Ended**
              **July
                2,**
              **2005**Risk-free
                interest rate
            
            
            4.94-4.97
            %
            
            3.42-3.55
            %Expected
                life
            
            
            3
                years
            
            
            3
                yearsVolatility
            
            
            80.00
            %
            
            35-27
            %Dividend
                yield
            
            
            —
            %
            
            —
            %Weighted
                average fair value of each
              option
                granted
            
            $
            0.36-$0.43
            
            $
            0.58-$0.89




*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.




*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.




*Forfeiture
      Rate* -
      This is the estimated percentage of options granted that are expected to be
      forfeited or canceled before becoming fully vested. An increase in the
      forfeiture rate will decrease compensation expense.





The
      following table summarizes information about our stock option plans for the
      six
      months ended July 1, 2006.




**Number
                of Options**
            
            **Weighted**
              **Average**
              **Exercise
                Price**
            
            **Weighted**
              **Average**
              **Remaining**
              **Contractual
                life**
            
            **Weighted**
              **Average**
              **Fair
                Value**Balance,
                December 31, 2005
            
            
            3,770,760
            
            $
            1.77
            
            
            7.8
            
            
            2.44Granted
            
            
            616,250
            
            $
            0.80
            
            
            
            
            
            0.44Exercised
            
            
            (15,195
            )
            $
            0.57
            
            
            
            
            
            3.48Forfeited
            
            
            (539,176
            )
            $
            4.76
            
            
            
            
            
            4.14Options
                outstanding, July 1, 2006
            
            
            3,832,639
            
            $
            1.19
            
            
            8.5
            
            $
            1.87Options
                exercisable, July 1, 2006
            
            
            2,951,744
            
            $
            2.35
            
            
            7.2
            
            $
            3.34




7





As
      of
      July 1, 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 1.0 years. The total fair value of stock options
      exercised was $0.05 million and the total fair value of stock awards granted
      was
      $0.3 million during the three month period ended July 1, 2006. Cash received
      from stock option exercises for the three and six month periods ended July
      1,
      2006 was $0.003 million and $0.009 million, respectively. The income tax
      benefits from share based arrangements totaled zero.




The
      following table summarizes information about restricted stock awards issued
      under the 2003 Restricted Stock Plan for the six month period ended July 1,
      2006:




**Shares**
            
            **Weighted**
              **Average
                Grant-**
              **Date
                Fair Value**Non
                Vested Balance at December 31, 2005
            
            
            444,030
            
            $
            1.57Granted
            
            
            100,000
            
            $
            0.70Vested
            
            
            (30,000
            )
            $
            3.05Non
                Vested Balance at July 1, 2006
            
            
            514,030
            
            $
            1.31




As
      of
      July 1, 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 1.7 years. At July 1, 2006, an aggregate
      of
      4.1 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.




**NOTE
      5 -GOODWILL AND INTANGIBLE ASSETS**




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




**July
                1,**
              **2006**
            
            **December
                31,**
              **2005****Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**
            
            **Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**Intangible
                assets
            
            $
            22,548
            
            $
            (18,728
            )
            $
            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
      $0.5
      million and $0.7 million for the three month period ended July 1, 2006 and
      July
      2, 2005, respectively. Amortization expense related to intangible assets was
      approximately $1.1 million and $1.4 million for the six month period ended
      July
      1, 2006 and July 2, 2005, respectively.


8







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




**Fiscal
                year ending**
            
            **Amount**2006
            
            $
            7822007
            
            
            7932008
            
            
            5072009
            
            
            2122010
            
            
            137




**NOTE
      6 —DEBT**




Debt
      at
      July 1, 2006 and December 31, 2005 consisted of the following (in thousands):




**July
                1, 2006**
            
            **December 31, 2005**Revolving
                credit facility
            
            $
            38,239
            
            $
            36,251Promissory
                notes payable
            
            
            281
            
            
            915Subordinated
                notes payable
            
            
            -
            
            
            22,905Secured
                promissory notes, current maturities
            
            
            2,000Secured
                promissory notes, less debt discount of $2,497
            
            
            5,503
            
            
            -Total
            
            $
            46,023
            
            $
            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 16.5 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.





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 will record the average quarterly interest expense and record
      a corresponding asset or liability for the difference not currently payable
      each
      quarter in cash.


9


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.




They
      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, 16.5 million of stock warrants
      were
      issued as follows: warrants for 3.0 million common shares were issued at an
      exercise price of $0.61 per share; warrants for 5.5 million common shares were
      issued at an exercise price of $0.75 per share; warrants for 5.5 million common
      shares were issued at an exercise price of $0.78 per share; and warrants for
      2.5
      million common shares were issued at an exercise price of $0.92 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. The Company
      has entered into an Investor Rights Agreement with Deerfield, pursuant to which
      it has agreed to file a registration statement with respect to the resale of
      the
      shares of common stock issuable upon exercise of the Warrants within 60 days
      of
      the closing date, and to use its reasonable best efforts to cause such
      registration statement to be declared effective by the SEC as promptly as
      possible after the filing of such registration statement.





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.




In
      addition, the Company extinguished the ABDC Notes on June 23, 2006 which
      resulted in a gain on the extinguishment of $13.1 million.




**NOTE
      7 - INCOME TAXES**




The
      Company incurred net income for the three and six month periods ended July
      1,
      2006. No income tax expense had been recorded in these periods due to the
      significant net operating losses available to the Company to offset such net
      income. The Company has established a valuation allowance on substantially
      all
      of its deferred tax assets due to the uncertainty of their realization. The
      Company incurred a net loss for the three and six month periods ended July
      2,
      2005.




**NOTE
      8 - 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 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. The Company expects payment
      of the $0.3 million during the third quarter of 2006.


10








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.




Net
      revenues related to the discontinued operations were $0.0 million and $27.3
      million for the three month period ended July 1, 2006 and July 2, 2005,
      respectively, and $0.0 million and $57.4 million for the six month period ended
      July 1, 2006 and July 2, 2005, respectively.  The loss from discontinued
      operations was $0.4 million and $1.7 million and $0.2 million and $3.0 million
      for the three and six month periods ended July 1, 2006 and July 2, 2005,
      respectively.





**NOTE
      9- CONTINGENCIES**




There
      have been no significant changes in the status of the legal matters described
      in
      the Company’s fiscal 2005 Annual Report on Form 10-K, as amended.




**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.




**NOTE
      11- SUBSEQUENT EVENTS**





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.





On
      August
      14, 2006, the Company entered into a new employment agreement with James E.
      Searson, Senior Vice President and Chief Operations Officer. The initial term
      of
      Mr. Searson’s agreement terminates on May 2, 2008, and is subject to
      successive, automatic one-year renewals, unless one party notifies the other
      of
      its desire not to renew the agreement. The agreement provides a salary of
      $275,000, and for bonuses as determined by the board of directors. The agreement
      also contains standard termination provisions for disability, for cause, and
      for
      good reason, and it also contains confidentiality and non-competition provisions
      that prohibit Mr. Searson from disclosing certain information belonging to
      the Company and from competing against the Company. If the employment agreement
      is terminated other than for cause prior to May 2, 2008, the Company is required
      to continue to pay to Mr. Searson one year’s severance equal to the amount
      of the compensation to which he was entitled at the time of
      termination, subject to the terms of the agreement.


11


**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 identify and integrate new acquisitions, (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 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.


12








As
      of
      July 1, 2006, we operated 79 Company owned locations including 76 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.





**Review
      of three month period ended July 1, 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 July 1, 2006,
      we have taken the following steps to improve our operations:





·
            In
                April 2006, Familymeds.com, the Company’s online and mail-order provider,
                joined the HealthAllies discount program network. HealthAllies is
                part of
                the UnitedHealth Group family of companies and helps consumers reduce
                their out-of-pocket health care expenses by negotiating discounted
                rates
                on a variety of health-related services not traditionally covered
                by
                insurance.





·
            On
                April 17, 2006, the Company opened a closed door institutional pharmacy
                located in Farmington, Connecticut.·
            On
                June 23, 2006, the Company retired the subordinated debt payable
                to
                AmerisourceBergen Drug Corporation consisting 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. Familymeds and Amerisource agreed to settle and retire
                both
                of the existing debt instruments early for a lump sum payment of
                $10
                million. Funds for the repayment came from a $10 million subordinated
                secured debt private placement with investment funds managed by Deerfield
                Management Company L.P. and related warrant
                purchase.





·
            On
                March 20, 2006, the Company received notice from the Nasdaq Stock
                Market
                (“NASDAQ”) that for the past 30-consecutive business days, the bid price
                of our common stock has closed below the $1.00 per share minimum
                requirement for continued inclusion on the Nasdaq Capital Market
                under
                Marketplace Rule 4310(c)(4). In accordance with Marketplace Rule
                4310(c)(8)(D), we have been provided with 180-calendar days, or until
                September 18, 2006, to regain compliance with theminimum
                bid requirement.On
                June 23, 2006, the stockholders of the Company approved a proposal
                to
                empower the Board of Directors, in its discretion, to undertake a
                reverse
                stock split of Familymeds Group’s common stock at a ratio of between
                one-for-ten and one-for-two at any time on or prior March 31, 2007.
                We
                believe we can regain compliance with NASDAQ Market Place rules if
                we
                perform the reverse stock
                split.





***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.


13







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 who 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
      July 1, 2006, we operated 79 Company owned locations including 76 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 44 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 93.7% and 93.9% of our net revenues for the three
      and
      six month periods ended July 1, 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.


14







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.





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 online 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 and locate 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 Merryville, Ohio. Combined, these employers have more
      than
      14,000 employees and dependents as potential patients.





Net
      revenues from Worksite Pharmacies SM increased by $1.1 million or 122.2% from $0.9 million for the three month period
      ended July 2, 2005 to $2.0 million for the three month period ended July 1,
      2006. Approximately $0.3 million, or 27.3% on a comparable same location basis,
      of the $1.1 million increase related to growth within our existing Worksite
      pharmacy. The remaining $0.8 million of the $1.1 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 $2.2 million or 129.4% from $1.7 million for the six month period
      ended July 2, 2005 to $3.9 million for the six month period ended July 1, 2006.
      Approximately $0.5 million, or 29.4% on a comparable same location basis, of
      the
      $2.2 million increase related to growth within our existing Worksite pharmacy.
      The remaining $1.7 million of the $2.2 million increase related to the opening
      of a new Worksite Pharmacy effective at the beginning of the first quarter
      of
      2006.


15








***Valley
      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. These operations are known as Valley Medical
      Supply.





Revenues
      from these operations for the three month period ended July 1, 2006 were $4.2
      million compared to $0.8 million for the three month period ended July 2, 2005,
      an increase of $3.4 million or 425.0%. Revenues from these operations for the
      six month period ended July 1, 2006 were $5.1 million compared to $1.5 million
      for the six month period ended July 2, 2005, an increase of $3.6 million or
      240.0%.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.
      We have three major programs, a prescription compliance program called Reliable
      Refill, a discount plan called Senior Save15 and a telephony system designed
      to
      notify patients of recalls, provide refill reminders and notify our customers
      of
      other important information. 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. Our 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 July 1, 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.




***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 July 1, 2006, net revenues from
      prescriptions filled under Medicare Part D plans substantially increased
      compared to the three month period ended April 1, 2006 . For the three month
      periods ended April 1, 2006 and July 1, 2006 Medicare Part D prescriptions
      represented 14.8% and 19.8% ,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 July 1, 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.


16








***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. 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.





***Hurricane
      Katrina***




In
      September 2005, Hurricane Katrina resulted in the temporary closure of the
      warehouse facility located in St. Rose, Louisiana. The Company maintains
      insurance coverage, which provides for reimbursement from losses resulting
      from
      property damage, loss of product and losses from business interruption. The
      Company estimates approximately $0.2 million of inventory was damaged during
      the
      hurricane and that it incurred approximately $0.8 million of incremental costs
      related to closing the facility and relocating the inventory and operations
      to
      our New Castle facility. The Company has evaluated the extent of the loss from
      business interruption and is attempting to recover these costs through insurance
      claims. No amounts have been recorded related to amounts that may be received
      from insurance.




***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 expects payment of the $0.3 million
      during the third quarter of 2006.


17








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.




Net
      revenues related to the discontinued operations were $0.0 million and $27.3
      million for the three month period ended July 1, 2006 and July 2, 2005,
      respectively and $0.0 million and $57.4 million for the six month period ended
      July 1, 2006 and July 2, 2005, respectively.  The loss from discontinued
      operations was $0.4 million and $1.7 million and $0.2 million and $3.0 million
      for the three and six month periods ended July 1, 2006 and July 2, 2005,
      respectively.




**Comparison
      of Operating Results for the three and six month periods ended July 1, 2006
      and
      July 2, 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 93.7% and 94.2% and 93.6% and 94.0%, respectively Rx revenues
      for
      the three and six month periods ended July 1, 2006 and July 2, 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:


**ThreeMonthsEnded**
              
              **SixMonthsEnded****July1,**
              
              **July
                  2,**
              
              **July1,**
              
              **July
                  2,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Net
                  pharmacy revenues (in millions) (1)
              
              $
              56.5
              
              $
              53.9
              
              $
              111.7
              
              $
              110.4Valley
                  Medical Supply
              
              $
              4.2
              
              
              0.8
              
              
              5.1
              
              
              1.5Total
                  net revenues (in millions)
              
              $
              60.7
              
              $
              54.7
              
              $
              116.8
              
              $
              111.9Rx
                  % of location net revenues
              
              
              93.7
              %
              
              94.1
              %
              
              93.8
              %
              
              94.1
              %Third
                  party % of Rx net revenues
              
              
              93.7
              %
              
              94.2
              %
              
              93.6
              %
              
              94.0
              %Number
                  of Company locations
              
              
              79
              
              
              77
              
              
              79
              
              
              77Average pharmacy
                  location net revenue per location (in millions)
              
              $
              0.7
              
              $
              0.7
              
              $
              1.4
              
              $
              1.4





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




**Three Months**
              **Ended July 1, 2006
                versus July 2, 2005**
            
            **Six Months Ended**
              **July 1, 2006 versus**
              **July 2, 2005**Net
                revenues increases (decreases) are as follows (in
                millions):Net
                effect of location openings/closings(1)
            
            $
            0.8
            
            $
            1.8Rx
                revenues (2)
            
            
            1.5
            
            
            (0.5
            )Non-Rx
                revenues
            
            
            0.3
            
            
            (0.0
            )Valley
                Medical Supply(3)
            
            
            3.4
            
            
            3.6Net
                increase
            
            $
            6.0
            
            $
            4.9






*(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.*





***Gross
      Margin***





Gross
      margin was $11.9 million or 19.6% for the three month period ended July 1,
      2006.
      This compares to $11.0 million or 20.1% for the three month period ended July
      2,
      2005. Gross margin was $22.8 million or 19.5% for the six month period ended
      July 1, 2006 compared to $23.0 million or 20.6% for the six month period ended
      July 2, 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. 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 recent 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 six month periods ended July
      1,
      2006 Medicare Part D prescriptions represented 19.8% and 17.3% of total
      prescription sales, respectively. Information that helps explain our gross
      margin trend is detailed below:





**Three Months**
              **Ended July 2, 2006**
              **versus
                July 2, 2005**
            
            **Six Months Ended**
              **July 1, 2006 versus**
              **July 2, 2005**Gross
                margin increases (decreases) are as follows (in millions):Net
                effect of location openings/closings
            
            $
            0.1
            
            $
            0.2Rx
                gross margin
            
            
            0.5
            
            
            (0.5
            )Non-Rx
                gross margin
            
            
            0.1
            
            
            (0.3
            )Valley
                Medical Supply
            
            
            0.2
            
            
            0.5Net
                increase (decrease)
            
            $
            0.9
            
            $
            (0.2
            )




18





***Operating
      Expenses***




Operating
      expenses include selling, general and administrative (“SG&A”) expenses,
      depreciation and amortization expense. Total operating expenses were $15.3
      million or 25.2% of net revenues for the three month period ended July 1, 2006.
      This compared to $15.1 million or 27.7% of net revenues for the three month
      period ended July 2, 2005. Total operating expenses were $29.2 million or 25.0%
      of net revenues for the six month period ended July 1, 2006. This compared
      to
      $30.3 million or 27.1% of net revenues for the six month period ended July
      2,
      2005. Information that helps explain our operating expense trend is detailed
      below:




**Three Months**
              **Ended July 1, 2006**
              **versus
                July 2, 2005**
            
            **Six Months Ended**
              **July 1, 2006 versus**
              **July 2, 2005**Operating
                expenses increases (decreases) are as follows (in
                millions):Selling,
                general and administrative expenses (1)
            
            $
            0.3
            
            $
            (0.6
            )Depreciation
                & amortization (2)
            
            
            (0.1
            )
            
            (0.6
            )Net
                increase (decrease)
            
            $
            0.2
            
            $
            (1.2
            )





*(1)*
            *The
                increase in selling, general and administrative expenses during the
                three
                month period ended July 1, 2006 over the period ended July 2, 2005
                is
                primarily due to increases in payroll and benefits of $0.9 million,
                temporary labor of $0.3 million, recruiting costs of $0.3 million,
                insurance of $0.1 million and expenses related to Valley Medical
                Supply of
                $0.5 million offset by a decrease in employee stock option expense
                of $1.8
                million. The decrease in selling, general and administrative expenses
                during the six month period ended July 1, 2006 over the same period
                ended
                July 2, 2005 is primarily due to a decrease in employee stock option
                expense of $3.7 million, partially offset by increases in payroll
                and
                benefits of $1.2 million, temporary labor of $0.4 million, recruiting
                of
                $0.4 million, insurance of $0.2 million and expenses related to Valley
                Medical Supply of $0.7 million.**(2)*
            *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 six month periods ended July 1, 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 six month periods ended
      July 2, 2005.





***Interest
      Expense, Net***




Interest
      expense was $1.4 million for the three month period ended July 1, 2006 versus
      $1.4 million for the three month period ended July 2, 2005.  There was no
      change in the amount of interest expense for the three month period ended July
      1, 2006 compared to the three month period ended July 2, 2005 as higher interest
      rates were offset by lower average outstanding balances.  Interest expense
      was $2.8 million for the six month period ended July 1, 2006 versus $2.2 million
      for the six month period ended July 2, 2005.  The increase for the six
      month period ended July 1, 2006 was due to higher interest rates on our
      outstanding indebtedness with variable rates.


19





***Income
      Taxes***




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




***Net
      Income (Loss)***




Net
      income for the three month period ended July 1, 2006 was $7.8 million versus
      a
      net loss of $7.1 million for the three month period ended July 2, 2005. 
Net income for the six month period ended July 1, 2006 was $3.8 million versus
      a
      net loss of $12.2 million for the six month period ended July 2, 2005.
 Factors impacting these results are discussed above.





***Inflation
      and Seasonality***




Management
      believes that inflation had no material effect on the operations or our
      financial condition for the three and six month periods ended July 1, 2006
      and
      July 2, 2005. Management does not believe that our business is materially
      impacted by seasonality; however, significant promotional activities can have
      a
      direct impact on net revenues for our distribution operations in any given
      quarter.




**LIQUIDITY
      AND CAPITAL RESOURCES**




At
      July
      1, 2006, we had a working capital deficit of $11.7 million. Our working capital
      deficit is affected by our classification of our revolving credit facility
      as a
      current liability as required under EITF issue No. 95-22, “Balance Sheet
      Classification of Borrowings Outstanding under Revolving Credit Agreements
      That
      Include Both a Subjective Acceleration Clause and a Lock Box Arrangement.” Our
      revolving credit facility has a contractual life until October 12, 2010. If
      this
      liability was classified as a long term liability our working capital deficit
      would be improved by approximately $38.2 million resulting in working capital
      of
      $26.5 million.




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 July 1, 2006, consisted of cash and cash equivalents of
      approximately $3.0 million along with approximately $2.6 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, debt service and 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 reserve
      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
      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. While the credit facility currently does
      not
      require compliance with financial covenants, the Company has the ability to
      reduce this reserve by $3.5 million by agreeing to implement one or more
      financial covenants. 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 July 1, 2006 was 8.25%. As of July 1, 2006, the interest rate,
      including applicable margin, used to calculate accrued interest was 8.5%.
      Interest is payable monthly.


20








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 July 1, 2006, $38.2 million
      was
      outstanding on the line and $2.6 million was available for additional
      borrowings, based on eligible receivables, inventory and prescription
      files.




**Retired
      Subordinated Note and Convertible Debenture**





On
      March
      22, 2005, we c onverted
      $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.




The
      Subordinated Convertible Debenture and Subordinated Note were guaranteed by
      Familymeds Group and certain of Familymeds Group’s subsidiaries, including
      Valley Drug Company, Valley Drug Company South, Familymeds, Inc. and Familymeds
      Holdings, Inc. pursuant to Continuing Guaranty Agreements dated as of March
      21,
      2005. We also entered into a subordinated security agreement dated as of March
      21, 2005, pursuant to which we agreed that upon the occurrence of certain
      defaults and the passage of applicable cure periods we shall be deemed at that
      point to have granted to ABDC a springing lien upon and a security interest
      in
      substantially all of our assets to secure the Subordinated Convertible Debenture
      and the Subordinated Note.





Pursuant
      to the Subordinated Note, principal was due and payable in 20 successive
      quarterly installments each in the amount of $0.6 million through September
      1,
      2010, on which date all outstanding amounts are required to be paid. The
      Subordinated Note interest was a variable rate equal to the prime rate plus
      2.0%
      per annum. The interest rate adjusted on each quarterly payment date based
      upon
      the prime rate in effect on each such quarterly payment date; provided that
      in
      no event would the interest rate in effect be less than 5.0% per annum or
      greater than 10% per annum. Interest accrued on the unpaid principal balance
      of
      the Subordinated Note is due and payable on each quarterly payment date and
      interest payments commenced on June 1, 2005. Interest of $0.3 million was
      expensed during the three month period ended July 1, 2006.





Pursuant
      to the Subordinated Convertible Debenture, principal was due and payable in
      19
      successive quarterly installments each in the amount of $0.6 million commencing
      on March 1, 2006 and continuing until August 15, 2010, on which date all
      outstanding amounts were required to be paid. Quarterly principal payments
      were
      paid in shares of common stock in an amount equal to $0.6 million divided by
      $3.4416 (the “Issue Price”). The Subordinated Convertible Debenture interest
      rate was adjusted on each quarterly payment date and was equal to (a) 10%,
      if
      the quarterly interest payment is made in common stock or (b) the prime rate
      on
      the date the quarterly interest payment is due plus 1% per annum, if the
      quarterly interest payment was made in cash; provided that in no event would
      the
      interest rate in effect be less than 5.0% per annum or greater than 10% per
      annum.


21








**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 16.5 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 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, the
      Company will record the average interest expense and record a corresponding
      asset or liability for the difference not currently payable each quarter in
      cash.




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.




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.
      They
      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.


22







In
      connection with the issuance of these Notes, 16.5 million of stock warrants
      were
      issued as follows: warrants for 3.0 million common shares were issued at an
      exercise price of $0.61 per share; warrants for 5.5 million common shares were
      issued at an exercise price of $0.75 per share; warrants for 5.5 million common
      shares were issued at an exercise price of $0.78 per share; and warrants for
      2.5
      million common shares were issued at an exercise price of $0.92 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. The Company
      has entered into an Investor Rights Agreement with Deerfield, pursuant to which
      it has agreed to file a registration statement with respect to the resale of
      the
      shares of common stock issuable upon exercise of the Warrants within 60 days
      of
      the closing date, and to use its reasonable best efforts to cause such
      registration statement to be declared effective by the SEC as promptly as
      possible after the filing of such registration statement.








**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.




**Operating,
      Investing and Financing Activities** ****




***Cash
      Inflows and Outflows***




During
      the six month period ended July 1, 2006, the net decrease in cash and cash
      equivalents was $3.6 million compared to a net decrease of $1.1 million during
      the six month period ended July 2, 2005. As reported on our condensed
      consolidated statements of cash flows, our change in cash and cash equivalents
      during the six month period ended July 1, 2006 and July 2, 2005 is summarized
      as
      follows:




**Six
                month period ended****Tabular
                dollars in thousands**
            
            **July
                1, 2006**
            
            
            **July
                2, 2005**Net
                cash used by operating activities
            
            $
            (2,412
            )
            
            $
            (9,216
            )Net
                cash used by investing activities
            
            
            (1,998
            )
            
            
            (1,092
            )Net
                cash provided by financing activities
            
            
            767
            
            
            
            9,182Change
                in cash and cash equivalents
            
            $
            (3,643
            )
            
            $
            (1,126)




Details
      of our cash inflows and outflows are as follows during the six month period
      ended July 1, 2006:




*Operating
      Activities:* During
      the six month period ended July 1, 2006, we used $2.4 million in cash and
      cash equivalents in operating activities as compared with $9.2 million used
      during the same prior year period. For the six month period ended July 1, 2006,
      this was comprised primarily of net income of $3.8 million and an increase
      in
      working capital of $3.9 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 $(10.1) million. For the six
      month
      period ended July 2, 2005, the use of cash consisted primarily of a net loss
      of
      $12.2 million and a decrease in working capital of $4.0 million, the net change
      in operating assets and liabilities reflected on our condensed consolidated
      statements of cash flows, partially offset by non-cash items of $6.9 million.
      Components of our significant non-cash adjustments for the six month period
      ended July 1, 2006 are as follows:




23


**Non-cash
                Adjustments**
            
            **Six month
                period ended**
              **July
                1 , 2006**
              **(amounts in thousands)**
            
            
            **Explanation
                of Non-cash Activity**Depreciation
                and amortization
            
            $
            1,727
            
            
            Consists
                of depreciation of property and equipment as well as amortization
                of
                intangibles.Non
                cash interest expense
            
            
            848
            
            
            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
            
            
            395
            
            
            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
            
            $
            (10,116
            )




*Investing
      Activities:* Cash
      used by investing activities was $2.0 million for the six month period ended
      July 1, 2006, as compared with $1.1 million used in investing activities in
      the
      six month period ended July 2, 2005. Specific investing activity during the
      six
      month periods ended July 1, 2006 and July 2, 2005 was as follows:




•
            
            During
                the six month period ended July 1, 2006, we invested approximately
                $1.8
                million in pharmacy software, leasehold improvements, land and computer
                hardware. We incurred capital expenditures of $1.0 million which
                we have
                not paid for as of July 1, 2006.




•
            
            During
                the first six months of 2006, we used cash of approximately $0.2
                million
                to acquire the assets of an oncology based pharmacy located in central
                Florida.






*Financing
      Activities:* Net
      cash
      provided by financing activities was $0.8 million during the six month period
      ended July 1, 2006, as compared with $9.2 million used in financing activities
      in the six month period ended July 2, 2005. Specific financing activity during
      the six month periods ended July 1, 2006 and July 2, 2005 was as follows:




•
            
            During
                the six month period ended July 1, 2006, we received net proceeds
                of $2.0
                million under our revolving credit facility to fund our operations,
                acquire pharmacy assets and to purchase capital expenditures. This
                compares to $9.9 million in the same period of
                2005.




•
            
            During
                the six month period ended July 1, 2006, we made scheduled debt repayments
                of $1.2 million under our outstanding subordinated notes. This compares
                to
                $0.7 million for scheduled debt repayments in the same period of
                2005.




•
            
            During
                the first six 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.







24










***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 on
      the
      Company’s stock price) over the fair value of reporting units 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 July 1, 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.


25




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 July
      1,
      2006 and December 31, 2005 were approximately $10.7 million and $9.8 million,
      respectively.





**Trade
      Receivables**





At
      July
      1, 2006 and December 31, 2005, trade receivables reflected approximately $18.0
      million and $15.7 million, respectively, of amounts due from various insurance
      companies, governmental agencies and individual customers. Of these amounts,
      there was approximately $2.5 million and $2.8 million reserved as of July 1,
      2006 and December 31, 2005, respectively, for a balance of net trade receivables
      of $15.5 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 July 1, 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 July 1, 2006 and December 31, 2005 were
      approximately $27.5 million and $30.6 million, respectively, net of
      approximately $2.1 million and $2.1 million of inventory loss reserves,
      respectively.





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




As
      of
      July 1, 2006, $38.2 million and $10.0 million were outstanding on our revolving
      credit facility and Deerfield Notes, respectively. These borrowings are at
      a
      variable rate of interest. Assuming $48.2 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.


26




**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
      second 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
      have been no material changes to the Risk Factors described in the Company’s
      fiscal 2005 Form 10-K, as amended.





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





On
      June
      29, 2006, Familymeds Group, Inc. 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 16.5 million shares
      of Familymeds Group, Inc. common stock (the “Warrants”), for an aggregate
      purchase price of $10 million.





Warrants
      for 3.0 million common shares were issued at an exercise price of $0.61 per
      share; warrants for 5.5 million common shares were issued at an exercise price
      of $0.75 per share; warrants for 5.5 million common shares were issued at an
      exercise price of $0.78 per share; and warrants for 2.5 million common shares
      were issued at an exercise price of $0.92 per share. All of the Warrants are
      exercisable for a period of five years from the closing date. Familymeds Group,
      Inc. has entered into an Investor Rights Agreement with Deerfield, pursuant
      to
      which it has agreed to file a registration statement with respect to the resale
      of the shares of common stock issuable upon exercise of the Warrants within
      60
      days of the closing date, and to use its reasonable best efforts to cause such
      registration statement to be declared effective by the SEC as promptly as
      possible after the filing of such registration statement.








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




None.


27





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




The
      stockholders of the Company voted on 4 items at the annual meeting of
      stockholders held on June 23, 2006:






1.
            To
                elect directors to serve until the annual meeting in 2007 and until
                their
                successors are elected and qualified or until their earlier resignation,
                removal from office or death;




2.
            To
                ratify the appointment of Deloitte & Touche LLP as the Company’s
                independent registered public accounting firm for the current fiscal
                year;





3.
            To
                approve an amendment to the Company’s Certificate of Incorporation to
                change the name of the Company to Familymeds Group, Inc.,
                and




4.
            To
                approve a proposal to empower the Board of Directors, in its discretion,
                to undertake a reverse stock split of Familymeds Group’s common stock at a
                ratio of between one-for-ten and one-for-two at any time on or prior
                March
                31, 2007 (the “Reverse Stock Split”), or not to complete the Reverse Stock
                Split.







The
      nominees for directors were elected based upon the following votes:




**Nominee**
            
            **Votes
                For**
            
            **Votes
                Withheld**Dr.
                Philip P. Gerbino
            
            
            42,879,309
            
            
            156,472Peter
                J. Grua
            
            
            42,879,101
            
            
            156,680Mark
                T. Majeske
            
            
            42,929,309
            
            
            106,472Edgardo
                A. Mercadante
            
            
            42,878,893
            
            
            156,888James
                E. Searson
            
            
            42,929,309
            
            
            106,472Dr.
                Rakesh K. Sharma
            
            
            42,738,377
            
            
            297,404Jugal
                K. Taneja
            
            
            42,788,077
            
            
            247,704Laura
                L. Witt
            
            
            42,851,101
            
            
            184,680




The
      proposal to ratify the appointment of Deloitte & Touche LLP as
      independent registered public accounting firm for 2006 received the following
      votes:




•
            41,924,883
            Votes
                for approval•
            1,093,305
            Votes
                against•
            17,593
            Abstentions


There
      were no broker non-votes for this item.






The
      proposal to amend the Company's Certificate of Incorporation to change the
      name
      of the Company to Familymeds Group, Inc. received the following
      votes:




•
            42,963,241
            Votes
                for approval•
            41,593
            Votes
                against•
            30,947
            Abstentions


There
      were no broker non-votes for this item.






The
      proposal to empower the Board of Directors, in its discretion, to undertake
      a
      reverse stock split of Familymeds Group’s common stock at a ratio of between
      one-for-ten and one-for-two at any time on or prior March 31, 2007 (the “Reverse
      Stock Split”), or not to complete the Reverse Stock Split; received the
      following votes:




28




•
            41,794,400
            Votes
                for approval•
            1,214,259
            Votes
                against•
            27,122
            Abstentions


There
      were no broker non-votes for this item.






**Item
      5. OTHER INFORMATION.**




None.




**Item
      6. EXHIBITS**





10.1
            Employment
                Agreement by and between DrugMax, Inc. and James E. Searson dated
                August
                14, 2006.*10.2
            Note
                and Warrant Purchase Agreement by and among Familymeds Group, Inc.
                (formerly known as DrugMax, Inc.) and Deerfield Special Situations
                Fund,
                L.P. and Deerfield Special Situations Fund International, Limited
                dated as
                of June 23, 2006. *10.3
            Form
                of Common Stock Purchase Warrant issued in connection with Note and
                Purchase Warrant Agreement dated as of June 23, 2006. *10.4
            Investor
                Rights Agreement executed in connection with Note and Purchase Warrant
                Agreement dated as of June 23, 2006. *10.5
            Security
                Agreement by and among Familymeds Group, Inc. (formerly known as
                DrugMax,
                Inc.) and Deerfield Special Situations Fund, L.P. and Deerfield Special
                Situations Fund International, Limited dated as of June 23, 2006.
                *10.6
            Form
                of Secured Promissory Note issued in connection with Note and Warrant
                Purchase Agreement dated as of June 23, 2006.
                *




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.
                  *





*
            Filed
                herewith.










29


**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: August
                15, 2006
            By:
            */s/
                Edgardo A. Mercadante*Edgardo
                A. Mercadante
              President,
                Chief Executive Officer and Chairman of the Board(Principal
                Executive Officer)




Date: August
                15, 2006
            By:
            */s/
                James A. Bologa*James
                A. Bologa
              Senior
                Vice President, Chief Financial Officer and Treasurer(Principal
                Financial and Accounting Officer)










30