|
|

UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

---

FORM 10-Q

(Mark One)

|    |                                                                                              |                                              
|--- | -------------------------------------------------------------------------------------------- | ---------------------------------------------
|[X] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
|   
|    |                                                                                              | For the quarterly period ended March 31, 2008

|     |                                                                                               |                                                         
|---- | --------------------------------------------------------------------------------------------- | --------------------------------------------------------
|[  ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
|    
|     |                                                                                               | For the transition period from ___________ to __________
|    
|     |                                                                                               | Commission file number 1-31070                          

Derma Sciences, Inc.(Exact name of small business issuer as specified in its charter)

|Pennsylvania                                                        | 23-2328753                               
|------------------------------------------------------------------- | -----------------------------------------
|(State or other jurisdiction of
     incorporation or organization) | (I.R.S. Employer Identification
     No.)

214 Carnegie Center, Suite 300Princeton, New Jersey
08540(Address of principal executive
offices)

(609) 514-4744(Issuer's telephone number)

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.þYes   oNo

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

| |                                                                                          |                                       |                               | 
| | ---------------------------------------------------------------------------------------- | ------------------------------------- | ----------------------------- | 
| | Large accelerated filer
          o                                                      |                                       | Accelerated filer
          o | 
| | Non-accelerated filer
          o  (Do not check if a
        smaller reporting company) | Smaller reporting company
          þ |                              

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

Indicate the number of shares of each of the issuer's classes of
common equity, as of the latest practicable date.

|                   |        |                                       
|------------------ | ------ | --------------------------------------
|Date: May 14, 2008 | Class: | Common Stock, par value $.01 per share
|                   |        | Shares Outstanding: 40,140,743        

|
|

Part I

DERMA SCIENCES, INC.

FORM 10-Q

INDEX

|                               |         |                                                                                                                        |   
|------------------------------ | ------- | ---------------------------------------------------------------------------------------------------------------------- | --
|Description                    | Page   
|Part I  Financial Information
|                               | Item 1. | Financial Statements                                                                                                   |   
|                               |         | Condensed Consolidated Balance
     Sheets - March 31, 2008 (Unaudited) andDecember 31, 2007                           | 3 
|                              
|                               |         | Condensed Consolidated Statements of
     Operations  Three months endedMarch 31, 2008 and March 31, 2007 (Unaudited) | 4 
|                              
|                               |         | Condensed Consolidated Statements of
     Cash Flows  Three months endedMarch 31, 2008 and March 31, 2007 (Unaudited) | 5 
|                              
|                               |         | Notes to Condensed Consolidated Financial
     Statements (Unaudited)                                                  | 6 
|                              
|                               | Item 2. | Management's Discussion and
     Analysis of Financial Condition and Results of Operations                             | 17
|                              
|                               | Item 4. | Controls and
     Procedures                                                                                           | 28
|                              
|Part II - Other Information   
|                              
|                               | Item 6. | Exhibits                                                                                                               | 29

Forward Looking Statements

This document includes certain
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements are based on managements current
expectations and are subject to uncertainty and changes in circumstances. Actual results
may differ materially from these expectations due to changes in political, economic,
business, competitive, market and regulatory factors.

1

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Index

Part I  Financial
Information

Item 1. FINANCIAL
STATEMENTS

2

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                 |  |                |              |                |  
|---------------------------------------------------------------- |  | -------------- | ------------ | -------------- | -
|Condensed Consolidated Balance Sheets                           
|                                                                
|                                                                 |  | March 31,      |             
|ASSETS                                                           |  | 2008           | December 31,
|                                                                 |  | (Unaudited)    | 2007        
|                                                                
|Current Assets                                                   |  |                |              |                |  
|Cash and cash equivalents                                        |  | $      711,662 |              | $      577,096 |  
|Accounts receivable, net                                         |  | 3,740,527      |              | 3,667,119      |  
|Inventories                                                      |  | 10,563,538     |              | 9,935,977      |  
|Prepaid expenses and other current assets                        |  | 684,186        |              | 1,210,135      |  
|                                                                
|Total current assets                                             |  | 15,699,913     |              | 15,390,327     |  
|Equipment and improvements, net                                  |  | 4,781,801      |              | 4,909,049      |  
|Goodwill                                                         |  | 9,407,404      |              | 9,524,305      |  
|Other intangible assets, net                                     |  | 5,249,006      |              | 5,537,653      |  
|Other assets, net                                                |  | 754,733        |              | 509,507        |  
|                                                                
|Total Assets                                                     |  | $ 35,892,857   |              | $ 35,870,841   |  
|                                                                
|LIABILITIES AND SHAREHOLDERS' EQUITY                             | 
|                                                                
|Current Liabilities                                              | 
|Line of credit borrowings                                        |  | 5,202,382      |              | 1,219,197      |  
|Current maturities of long-term debt                             |  | 1,324,639      |              | 1,288,532      |  
|Accounts payable                                                 |  | 3,030,715      |              | 4,092,278      |  
|Accrued expenses and other current liabilities                   |  | 2,197,694      |              | 3,421,282      |  
|                                                                
|Total current liabilities                                        |  | 11,755,430     |              | 10,021,289     |  
|Long-term debt                                                   |  | 5,032,193      |              | 5,292,136      |  
|Other long-term liabilities                                      |  | 81,837         |              | 82,402         |  
|Deferred tax liability                                           |  | 319,503        |              | 420,059        |  
|                                                                
|Total Liabilities                                                |  | 17,188,963     |              | 15,815,886     |  
|                                                                
|Shareholders' Equity                                             | 
|Convertible preferred stock, $.01 par value; 11,750,000 shares   | 
|authorized; issued and outstanding: 2,280,407 shares             | 
|(liquidation preference of $4,210,231 at March 31, 2008)         |  | 22,804         |              | 22,804         |  
|Common stock, $.01 par value, 150,000,000 authorized; issued and | 
|outstanding: 34,040,743 shares at March 31, 2008 and 33,829,755  | 
|shares at December 31, 2007                                      |  | 340,407        |              | 338,298        |  
|Common stock subscribed                                          |  | 61,000         |              |               |  
|Additional paid-in capital                                       |  | 39,467,291     |              | 33,540,952     |  
|Common stock subscriptions receivable                            |  | (5,700,822     | )            |               |  
|Accumulated other comprehensive income                          | 
|cumulative translation adjustments                               |  | 1,624,888      |              | 1,854,787      |  
|Accumulated deficit                                              |  | (17,111,674    | )            | (15,701,886    | )
|                                                                
|Total Shareholders' Equity                                       |  | 18,703,894     |              | 20,054,955     |  
|                                                                
|Total Liabilities and Shareholders' Equity                       |  | $ 35,892,857   |              | $ 35,870,841   |  
|                                                                

See accompanying consolidated notes.

3

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                                   |  |                              |      |                 |  
|------------------------------------------------------------------ |  | ---------------------------- | ---- | --------------- | -
|Condensed Consolidated Statements of Operations (Unaudited)        | 
|                                                                   |  | Three months ended March 31,
|                                                                   |  | 2008                         | 2007
|                                                                  
|Net Sales                                                          |  | $ 11,724,822                 |      | $   7,965,797   |  
|Cost of sales                                                      |  | 8,516,164                    |      | 5,161,369       |  
|                                                                  
|Gross Profit                                                       |  | 3,208,658                    |      | 2,804,428       |  
|                                                                  
|Operating expenses                                                 | 
|Selling, general and administrative                                |  | 4,386,866                    |      | 2,668,154       |  
|Research and development                                           |  | 48,108                       |      | 125,000         |  
|                                                                  
|Total operating expenses                                           |  | 4,434,974                    |      | 2,793,154       |  
|                                                                  
|Operating (loss) income                                            |  | (1,226,316                   | )    | 11,274          |  
|                                                                  
|Other expense, net:                                                | 
|Interest expense                                                   |  | 264,915                      |      | 50,246          |  
|Other expense, net                                                 |  | 8,614                        |      | 26,557          |  
|                                                                  
|Total other expense, net                                           |  | 273,529                      |      | 76,803          |  
|                                                                  
|Loss before (benefit) provision for income taxes                   |  | (1,499,845                   | )    | (65,529         | )
|(Benefit) provision for income taxes                               |  | (90,057                      | )    | 73,424          |  
|                                                                  
|Net Loss                                                           |  | $ (1,409,788                 | )    | $    (138,953   | )
|                                                                  
|Loss per common share - basic and diluted                          |  | $          (0.04             | )    | $         (0.01 | )
|                                                                  
|Shares used in computing loss per common share - basic and diluted |  | 34,038,207                   |      | 25,246,596      |  
|                                                                  

See accompanying consolidated notes.

4

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Index

DERMA SCIENCES, INC. AND
SUBSIDIARIES

|                                                            |  |                              |      |               |  
|----------------------------------------------------------- |  | ---------------------------- | ---- | ------------- | -
|Condensed Consolidated Statements of Cash Flows (Unaudited) | 
|                                                            |  | Three months ended March 31,
|                                                            |  | 2008                         | 2007
|                                                           
|Operating Activities                                        |  |                              |      |               |  
|Net loss                                                    |  | $ (1,409,788                 | )    | $  (138,953   | )
|Adjustments to reconcile net loss to net                    | 
|cash (used in) provided by operating activities:            | 
|Depreciation of equipment and improvements                  |  | 230,840                      |      | 171,305       |  
|Amortization of intangible assets                           |  | 288,647                      |      | 137,038       |  
|Amortization of deferred financing costs                    |  | 21,709                       |      | 15,393        |  
|Recovery of bad debts                                       |  | (3,000                       | )    | (8,609        | )
|Allowance for sales adjustments                             |  | 207,702                      |      | 588,157       |  
|Provision for inventory obsolescence                        |  | 22,629                       |      | 35,718        |  
|Deferred rent expense                                       |  | (11,196                      | )    | (2,627        | )
|Compensation charge for employee stock options              |  | 187,344                      |      | 166,236       |  
|Compensation charge for restricted stock                    |  | 12,105                       |      | 12,105        |  
|Deferred income taxes                                       |  | (90,057                      | )    | 73,424        |  
|Changes in operating assets and liabilities:                | 
|Accounts receivable                                         |  | (279,947                     | )    | 842,494       |  
|Inventories                                                 |  | (633,841                     | )    | (1,335,955    | )
|Prepaid expenses and other current assets                   |  | 470,511                      |      | (90,169       | )
|Other assets                                                |  | (6,413                       | )    | 12,498        |  
|Accounts payable                                            |  | (996,996                     | )    | 268,271       |  
|Accrued expenses and other current liabilities              |  | (1,064,807                   | )    | (251,101      | )
|Other long-term liabilities                                 |  | 9,576                        |      |              |  
|                                                           
|Net cash (used in) provided by operating activities         |  | (3,044,982                   | )    | 495,225       |  
|                                                           
|Investing Activities                                        | 
|Costs of acquiring businesses                               |  | (104,426                     | )    |              |  
|Purchase of equipment and improvements                      |  | (134,428                     | )    | (124,376      | )
|                                                           
|Net cash used in investing activities                       |  | (238,854                     | )    | (124,376      | )
|                                                           
|Financing Activities                                        | 
|Net change in bank line of credit                           |  | 3,983,185                    |      |              |  
|Deferred financing costs                                    |  | (262,776                     | )    |              |  
|Long-term debt repayments                                   |  | (320,160                     | )    | (72,681       | )
|Proceeds from issuance of stock, net of costs               |  | 89,177                       |      |              |  
|                                                           
|Net cash provided by (used in) financing activities         |  | 3,489,426                    |      | (72,681       | )
|                                                           
|Effect of exchange rate changes on cash                     |  | (71,024                      | )    | 23,807        |  
|                                                           
|Net increase in cash and cash equivalents                   |  | 134,566                      |      | 321,975       |  
|Cash and cash equivalents                                   | 
|Beginning of period                                         |  | 577,096                      |      | 1,285,943     |  
|                                                           
|End of period                                               |  | $    711,662                 |      | $ 1,607,918   |  
|                                                           
|Supplemental disclosures of cash flow information:          | 
|Equipment obtained with capital lease                       |  | $      96,324                |      |              |  
|Cash paid during the period for:                            | 
|Interest                                                    |  | $    264,915                 |      | $      50,247 |  
|                                                           

See accompanying consolidated notes.

5

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

1.     Organization and
Summary of Significant Accounting Policies

Derma
Sciences, Inc. and its subsidiaries (the Company) is a full line provider of
wound care, wound closure and specialty securement devices and skin care products. The
Company markets its products principally through independent distributors servicing the
long-term care, home health and acute care markets in the United States, Canada and other
select international markets. The Companys U.S. distribution facility is located in
St. Louis, Missouri, while the Companys Canadian distribution facility is located in
Toronto. The Company has manufacturing facilities in Toronto, Canada and Nantong, China.
With the first aid division (FAD) acquisition, the Company temporarily
manufactures and distributes its adhesive strips and related first aid wound care products
at a Houston, Texas location.

Basis
of Presentation

The
accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of America
for interim financial information and with the instructions to Form 10-Q and Article 8 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 adjustments) considered necessary for a fair presentation have been
included. Operating results for the three months ended March 31, 2008, are not necessarily
indicative of the results that may be expected for the year ending December 31, 2008.
Information included in the condensed balance sheet as of December 31, 2007 has been
derived from the consolidated financial statements and footnotes thereto for the year
ended December 31, 2007, included in Form 10-KSB previously filed with the Securities and
Exchange Commission. For further information, refer to that Form 10-KSB.

Net
Loss per Share Net loss per common share  basic is computed by dividing net
loss by the weighted average number of common shares outstanding for the period. Net loss
per common share  diluted reflects the potential dilution of earnings by including
the effects of the assumed exercise, conversion or issuance of potentially issuable shares
of common stock (potentially dilutive securities), including those
attributable to stock options, warrants, convertible preferred stock and restricted common
stock in the weighted average number of common shares outstanding for a period, if
dilutive. The effects of the assumed exercise of warrants and stock options are determined
using the treasury stock method. Potentially dilutive securities have not been included in
the computation of diluted loss per share for the three months ended March 31, 2008 and
2007 as the effect would be anti-dilutive.

Potentially
dilutive shares excluded as a result of the effects being anti-dilutive are as follows:

|                          |  |                              |  |            | 
|------------------------- |  | ---------------------------- |  | ---------- | 
|                          |  | Three Months Ended March 31, | 
|                          |  | 2008                         |  | 2007       | 
|Excluded dilutive shares: |  |                              |  |            | 
|Preferred stock           |  | 2,280,407                    |  | 2,280,407  | 
|Restricted common stock   |  | 175,000                      |  | 175,000    | 
|Stock options             |  | 8,065,480                    |  | 6,545,280  | 
|Warrants                  |  | 8,212,759                    |  | 6,169,904  | 
|                         
|Total dilutive shares     |  | 18,733,646                   |  | 15,170,591 | 

Reclassifications Certain reclassifications have been made to prior period reported amounts to conform
with the 2008 presentation.

6

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

2.     Acquisitions

NutraMax
Acquisition

On
November 8, 2007, the Company acquired
the NutraMax Products, Inc., (NutraMax) first aid division (FAD)
for $13,000,000 cash and a $500,000 potential earn out bonus. The cash purchase price
consisted of $10,250,000 paid to NutraMax, $2,000,000 deposited in a supply agreement
escrow account and $750,000 deposited in an indemnification escrow account. The supply
agreement escrow funds are payable to NutraMax quarterly, in the amount of $500,000 plus
interest at 6% from the closing date, upon achievement of certain agreed-upon third party
supplier product cost and delivery performance objectives. The indemnification escrow
funds are being held for one year from the date of closing against any intervening
adjustments to the purchase price. If certain agreed-upon third party supplier product
cost and delivery performance objectives are met during the twelve month post closing
period, the Company will pay to NutraMax an additional $500,000 which will be recorded as
an addition to the purchase price. In addition, the Company incurred $842,091 of
capitalized transaction costs related to the acquisition. The purchased assets consist of
receivables, inventory, equipment, other amortizable intangibles and goodwill. To fund the
acquisition, the Company raised $5,610,915 (net of $389,079 in commission and other
offering expenses) from the private sale of 8,571,420 shares of common stock at a price of
$0.70 per share, together with 2,142,855 five-year warrants to purchase one share of
common stock at a price of $0.77 per share. In addition, the Company entered into a new
five-year credit and security agreement comprised of an $8,000,000 revolver and a
$6,000,000 term loan. At closing, the Company applied the entirety of the $6,000,000 term
loan and approximately $3,000,000 of the revolver in satisfaction of the Companys
obligations under the purchase agreement and related obligations.

The
FAD is a leading manufacturer and marketer of branded and private label adhesive strips
and related first aid products to the medical, industrial and retail markets. For its
latest fiscal year ended September 29, 2007, FAD reported audited sales of $16,688,000,
gross profit of $1,232,000 and a net loss of $880,000. The FADs product line will
serve to expand the Companys existing basic wound care line to new customers and
markets, especially the retail market where the Company did not have a presence. The
Company anticipates being able to leverage cross selling opportunities presented by the
purchase to grow sales. In addition, the Company expects to be able to significantly
reduce FAD product costs by completing the transfer of production of FAD products,
initiated by NutraMax, to lower cost suppliers.

The
acquisition has been accounted for as a purchase. Accordingly, the results of operations
of FAD have been included in the condensed consolidated financial statements commencing November 8,
2007. A preliminary allocation of the purchase price is outlined below:

| |                                                  |  |               |  
| | ------------------------------------------------ |  | ------------- | -
| | Purchase Price:                                  |  |               |  
|
| | Cash paid                                        |  | $ 13,000,000  |  
| | Transaction costs                                |  | 842,091       |  
|
| | Total                                            |  | $ 13,842,091  |  
|
| | Allocation of Purchase Price:                    | 
|
| | Trade receivables                                |  | $   2,075,320 |  
| | Inventory                                        |  | 2,533,240     |  
| | Equipment                                        |  | 300,000       |  
| | Goodwill                                         |  | 6,967,362     |  
| | Identifiable intangibles subject to amortization |  | 3,000,000     |  
| | Liabilities Assumed                              |  | (1,033,831    | )
|
| | Total                                            |  | $ 13,842,091  |  

7

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

The
allocation of the preliminary purchase price to the estimated fair values of the assets
acquired and liabilities assumed as reflected in the consolidated financial statements is
preliminary and subject to change based on finalization of the Companys valuation.
The Company is currently assessing the fair value of the identifiable tangible and
intangible assets acquired and liabilities assumed. It is expected that the current assets
and liabilities assumed will approximate the values assigned as of the date of the
acquisition. A valuation study is presently being conducted to establish the fair market
value of the equipment and the identifiable intangibles acquired. The intangible assets
acquired consist primarily of customer lists, trademarks, a supply agreement and a
non-compete agreement. Since the date of the acquisition, the estimated identifiable
intangibles have been amortized to general administrative expense assuming a useful life
of five years. The final purchase price allocation to reflect the fair values of the
assets acquired and liabilities assumed will be based on the final results of the
agreed-upon third party supplier, product cost and delivery performance objectives and the
outcome of the Companys valuation study. The final valuation is expected to be
completed in the second quarter of 2008.

The
Company has retained certain NutraMax personnel to perform sales and marketing,
manufacturing and distribution activities on a permanent and transitional basis.
Manufacturing activities are expected to continue in Houston on an as needed basis through
the third quarter 2008 to meet customer demand and build safety stock. Distribution
activities are expected to continue through the first quarter 2009, at which time the
Company will have determined how best to rationalize its U.S. distribution network. The
Company has entered into a six month lease for NutraMaxs former facility in Houston,
Texas. Under the terms of the lease, the Company will pay the landlord $18,750 per month
and will be responsible for utilities and ongoing normal repair and maintenance costs.
Under an agreement between the Company and NutraMax, NutraMax has agreed to reimburse the
Company for one-half of the utilities expense during the lease term and to pay for the
clean up and removal of any of its assets remaining in the facility at the end of the
Companys lease. The Company is presently looking for equivalent warehouse space in
Houston to be utilized through the first quarter 2009.

The
unaudited pro forma information below presents combined results of operations as if the
FAD acquisition had occurred at January 1, 2007 instead of November 8, 2007. The pro forma
information is based on historical results and is not necessarily indicative of the
results of operations of the combined entity had the acquisition occurred at the beginning
of the periods presented, nor is it necessarily indicative of future results.

|                           |                                   |               |  
|-------------------------- | --------------------------------- | ------------- | -
|                           | Three Months Ended March 31, 2007
|                          
|Revenues                   |                                   | $ 11,782,797  |  
|                          
|Net loss                   |                                   | $    (323,953 | )
|Net loss per common share: |                                   |              
|                          
|Basic and diluted          |                                   | $(0.01        | )

3.     Inventories

Inventories
include the following:

| |                     |  |               |  |                  | 
| | ------------------- |  | ------------- |  | ---------------- | 
| |                     |  | March 31,2008 |  | December 31,2007 | 
|
| | Finished goods      |  | $  7,046,651  |  | $6,660,454       | 
| | Work in process     |  | 478,487       |  | 180,823          | 
| | Packaging materials |  | 979,996       |  | 1,152,268        | 
| | Raw materials       |  | 2,058,404     |  | 1,942,432        | 
|
| | Total inventory     |  | $10,563,538   |  | $9,935,977       | 

8

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

4.     
U.S. Line of Credit

In
November, 2007, the Company entered into a new five-year revolving credit agreement
providing for maximum borrowings of $8,000,000 with its new U.S. lender. Advances under
the revolving credit agreement may be drawn, from time to time, up to the amount of 85% of
eligible receivables (as defined) and 60% of eligible inventory (as defined). Interest on
outstanding advances under the revolving credit agreement is payable at the LIBOR monthly
rate, plus 2.75%, (5.45% at March 31, 2008). In addition, the Company will pay a monthly
unused line fee of 0.5% per annum on the difference between the daily average amount of
advances outstanding under the agreement and $8,000,000 together with a monthly collateral
management fee of $2,000. Outstanding balances under the agreement are secured by all of
the Companys and its subsidiaries existing and after-acquired tangible and
intangible assets located in the United States and Canada. At March 31, 2008 the Company
had an outstanding balance of $5,202,382 under this agreement.

The
revolving credit agreement is subject to financial covenants which require maintaining
certain ratios of debt service coverage, fixed charge coverage, senior debt coverage and
total debt coverage as defined in the agreement. Additional covenants governing permitted
investments, indebtedness and liens, together with payments of dividends and protection of
collateral, are also included in the agreement. The revolving credit agreement contains a
subjective acceleration provision whereby the lender can declare a default upon a material
adverse change in the Companys business operations.

Effective
March 28, 2008, the Companys U.S. lender agreed to waive all prior financial and
reporting covenant defaults and amend the existing minimum EBITDA, fixed charge coverage,
senior debt coverage and total debt coverage covenants, to be measured on a quarterly
basis, to allow the Company to implement its growth strategy. Amendment of the covenants
was predicated upon the Companys commitment to raise a minimum of $3,000,000 by May
1, 2008 from the sale of equity and agreement to limit its maximum revolver borrowing to
the lesser of (a) the revolver loan commitment ($8,000,000) or (b) the borrowing base (as
defined), less $1,500,000. Not less than $3,000,000 of the equity infusion must be used
to pay down the existing revolver balance which amount will be credited as a component of
EBITDA for covenant compliance purposes. The Company incurred fees of $250,000 associated
with the granting of the covenant amendment, together with estimated related expenses of $10,829 which are included as
additions to deferred financing costs. The equity infusion requirement (see Note 11) has
been met.

5.     Long-Term Debt

U.S.
Term Loan

In
November, 2007, the Company entered into a five-year $6,000,000 term loan agreement with
its new U.S. lender. Interest on the term loan is payable at the LIBOR monthly rate plus
4.25%, (6.95% at March 31, 2008). Monthly payments of principal in the amount of $100,000
together with interest are due under the agreement. The agreement is secured by all of the
Companys and its subsidiaries existing and after-acquired tangible and
intangible assets located in the United States and Canada.

The
term loan agreement is subject to financial covenants which require maintaining certain
ratios of debt service coverage, fixed charge coverage, senior debt coverage and total
debt coverage as defined in the agreement. Additional covenants governing permitted
investments, indebtedness and liens, together with payments of dividends and protection of
collateral, are also included in the agreement. The term loan agreement contains a
subjective acceleration provision whereby the lender can declare a default upon a material
adverse change in the Companys business operations.

Effective
March 28, 2008, the foregoing financial covenants were amended as described in the third
paragraph under the heading U.S. Line of Credit (see Note 4).

9

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

Long-term
debt includes the following:

| |                           |  |               |  |                  | 
| | ------------------------- |  | ------------- |  | ---------------- | 
| |                           |  | March 31,2008 |  | December 31,2007 | 
|
| | U.S. term loan            |  | $5,600,000    |  | $5,900,000       | 
| | Promissory note           |  | 500,000       |  | 500,000          | 
| | Capital lease obligations |  | 256,832       |  | 180,668          | 
|
| | Total debt                |  | 6,356,832     |  | 6,580,668        | 
|
| | Less: current maturities  |  | 1,324,639     |  | 1,288,532        | 
|
| | Long-term debt            |  | $5,032,193    |  | $5,292,136       | 

Promissory
Note

In
connection with the acquisition of Western Medical in April 2006, a portion of the
purchase price was paid via a three-year unsecured promissory note issued to the seller.
The principal amount of the promissory note, together with simple interest of 12%, is
payable in 11 quarterly installments of interest only in the amount of $15,000 and a final
payment of accrued interest of $15,000 and the principal balance of $500,000 on April 18,
2009. The promissory note may be prepaid in part or in full at any time without penalty.

Capital
Lease Obligations

The
Company has three capital lease obligations for certain office furniture and distribution
equipment totaling $256,832 as of March 31, 2008. The capital lease obligations bear
interest at annual rates ranging from 6.8% to 9.6% with the longest lease term expiring in
February, 2011.

6.     Shareholders
Equity

Preferred
Stock

There
are 150,003 shares of series A convertible preferred stock outstanding at March 31, 2008.
The series A preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference of $4.00 per share, votes as a class
on matters affecting the series A preferred stock and maintains voting rights identical to
the common stock on all other matters.

There
are 440,003 shares of series B convertible preferred stock outstanding at March 31, 2008.
The series B preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference of $6.00 per share, votes as a class
on matters affecting the series B preferred stock and maintains voting rights identical to
the common stock on all other matters.

There
are 619,055 shares of series C convertible preferred stock outstanding at March 31, 2008.
The series C preferred stock is convertible into common stock on a one-for-one basis,
bears no dividend, maintains a liquidation preference averaging $0.70 per share, votes as
a class on matters affecting the series C preferred stock and maintains voting rights
identical to the common stock on all other matters.

There
are 1,071,346 shares of series D convertible preferred stock outstanding at March 31,
2008. The series D preferred stock is convertible into common stock on a one-for-one
basis, bears no dividend, maintains a liquidation preference averaging $0.50 per share,
votes as a class on matters affecting the series D preferred stock and maintains voting
rights identical to the common stock on all other matters.

10

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

Common
Stock

On
March 31, 2008, the Company received executed stock purchase agreements (SPAs)
totaling $6,100,000 from the private sale of 6,100,000 shares of common stock at a price
of $1.00 per share, together with 3,050,000 five-year warrants to purchase one share of
common stock at a price of $1.20 per share. In addition, the placement agent for the
shares sold received 142,500 five-year warrants to purchase one share of common stock at
$1.20 per share. The Company closed on the SPAs and received $5,700,822 (net of $399,178
in commission and other offering expenses) on April 2, 2008 (see Note 11). The proceeds
will be used to meet the minimum equity infusion requirements associated with the
Companys amended bank covenants and to support the Companys strategic growth
initiatives.

In
January, 2008 the Company issued 210,988 shares of common stock as follows: (a) 100,000
shares in consideration of $105,000 upon exercise of series G warrants, (b) 19,800 shares
in consideration of $12,375 upon exercise of stock options, and (c) 91,188 shares upon
cashless exercise of stock options.

On
December 28, 2007 the Company amended its articles of incorporation to increase the number
of authorized shares of common stock from 50,000,000 to 150,000,000.

In
November, 2007 the Company raised $5,610,915 (net of $389,079 in commission and other
offering expenses) from the private sale to two institutional investors of 8,571,420
shares of the Companys common stock at the price of $0.70 per share, together with
2,142,855 five-year warrants to purchase one share of common stock at the price of $0.77.
The funds were used for the acquisition of FAD.

In
accordance with the series F warrant agreement, effective January 4, 2007, the warrant holders
effected a cashless exercise of all issued and outstanding series F warrants comprising
1,309,441 warrants with an exercise price of $0.57 per warrant. Based on the thirty day
trailing average closing price of $0.78 per share, the warrants had a calculated value of
$0.21 each ($0.78  $0.57), or $274,983 in the aggregate, and were exchanged for
352,175 shares of common stock.

Stock
Purchase Warrants

At
March 31, 2008, the Company had warrants outstanding to purchase 8,212,759 shares of the
Companys common stock as outlined below:

| |        |  |                   |  |                |  |                   |  | 
| | ------ |  | ----------------- |  | -------------- |  | ----------------- |  | 
| | Series |  | Number ofWarrants |  | Exercise Price |  | Expiration Date   |  | 
|
| | G      |  | 2,660,000         |  | $1.05          |  | December 31, 2008 |  | 
| | H      |  | 2,655,098         |  | $1.00          |  | April 30, 2011    |  | 
| | I      |  | 754,806           |  | $0.72          |  | April 30, 2011    |  | 
| | J      |  | 2,142,855         |  | $0.77          |  | May 31, 2013      |  | 
|
| | Total  |  | 8,212,759         |  |               

Stock
Options

The
Company has a stock option plan under which options to purchase a maximum of 10,000,000
shares of common stock may be issued. The plan permits the granting of both incentive
stock options and nonqualified stock options to employees and directors of the Company
and certain outside consultants and advisors to the Company. The option exercise price
may not be less than the fair market value of the stock on the date of the grant of the
option. The duration of each option may not exceed 10 years from the date of grant. Under
the plan, service based options to purchase 50,000 and 730,000 shares of common stock
were granted to officers, directors, agents and employees for the three months ended
March 31, 2008 and 2007, respectively, with exercise prices ranging from $0.80 to $1.11
per share. For the three months ended March 31, 2008, 10,000 plan options were forfeited.
As of

11

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

March 31, 2008, options to purchase
5,994,625 shares of the Companys common stock were issued and outstanding under the
plan. During the three months ended March 31, 2008, 198,000 plan options were exercised.

The
Company has previously granted nonqualified stock options to officers, directors, agents
and employees outside of the stock option plan (non-plan options). All
non-plan options were granted at the fair market value at the date of grant. As of March
31, 2008, non-plan options to purchase 2,070,855 shares of the Companys common stock
were issued and outstanding. During the three months ended March 31, 2007, 23,000 non-plan
options expired.

For
the three months ended March 31, 2008 and 2007 the fair value of each service based option
award was estimated at the date of grant using the Black-Scholes option pricing model. The
weighted-average assumptions for the three months ended March 31, 2008 and 2007 were as
follows:

|                             |  |       |  |       | 
|---------------------------- |  | ----- |  | ----- | 
|                             |  | 2008  |  | 2007  | 
|                            
|Risk-free interest rate      |  | 2.14% |  | 4.72% | 
|Volatility factor            |  | 162%  |  | 118%  | 
|Dividend yield               |  | 0%    |  | 0%    | 
|Expected option life (years) |  | 6.25  |  | 6.25  | 
|Contractual life (years)     |  | 10    |  | 10    | 

In
both 2008 and 2007, the risk-free rate utilized represents the U.S. Treasury yield curve
rate which approximates the risk-free rate for the expected option life at the time of
grant. In 2008 and 2007, the volatility factor was calculated based on the seventy-five
month-end closing prices of the Companys common stock preceding the month of stock
option grant. The Company uses a seventy-five month volatility period to coincide with
the expected stock option life. Based on guidance from Staff Accounting Bulletin 107 and
110, a stock option life of 6.25 years was utilized under the simplified method. The
dividend yield is 0% since the Company does not anticipate paying dividends in the near
future. Based on the Companys historical experience of options that expire or are
cancelled before becoming fully vested, the Company assumed an annualized forfeiture rate
of 1.0% for all options. Under the true-up provision of SFAS 123R, the Company will
record additional expense if the actual forfeiture rate is lower than estimated, and will
record a recovery of prior expense if the actual forfeiture rate is higher than
estimated.

A
summary of the Companys stock option activity and related information for the three
months ended March 31, 2008 and 2007 follows:

|                        |  |           |   |                               |  |           |   |                               | 
|----------------------- |  | --------- | - | ----------------------------- |  | --------- | - | ----------------------------- | 
|                        |  | 2008      |   | 2007                          | 
|                       
|                        |  | Options   |   | WeightedAverageExercise Price |  | Options   |   | WeightedAverageExercise Price | 
|                       
|Outstanding  January 1 |  | 8,223,480 |   | $0.78                         |  | 5,838,280 |   | $0.94                         | 
|Granted                 |  | 50,000    |   | $1.11                         |  | 730,000   |   | $0.80                         | 
|Forfeited               |  | (10,000   | ) | $1.22                         |  | (23,000   | ) | $11.67                        | 
|Exercised               |  | (198,000  | ) | $0.62                         |  | -         |   | -                             | 
|                       
|Outstanding  March 31  |  | 8,065,480 |   | $0.79                         |  | 6,545,280 |   | $0.88                         | 
|                       
|Exercisable at March 31 |  | 6,081,730 |   | $0.83                         |  | 5,730,280 |   | $0.90                         | 

The
weighted average fair value per share of options granted during the three months ended
March 31, 2008 and 2007 was $1.02 and $0.70, respectively.

12

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|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

For
the three months ended March 31, 2008 and 2007, no income tax benefit was recognized
related to stock option activity.

During
the three months ended March 31, 2008 and 2007, stock option compensation expense was
recorded using the fair value method under SFAS 123R as follows:

|                                             |  |          |  |           | 
|-------------------------------------------- |  | -------- |  | --------- | 
|                                             |  | 2008     |  | 2007      | 
|                                            
|Cost of sales                                |  | $  9,855 |  | $  16,364 | 
|Selling, general and administrative expenses |  | 177,489  |  | 149,872   | 
|                                            
|Total stock option compensation expense      |  | $187,344 |  | $166,236  | 

As
of March 31, 2008, there was $914,643 of unrecognized compensation cost related to
nonvested service based awards and $370,563 related to nonvested market based awards
granted under the plan. That cost is expected to be recognized over the options
remaining weighted average vesting period of 2.03 years for service based options and 1.75
years for market based options.

Restricted
Common Stock

On
May 11, 2006, the Company adopted a restricted common stock plan and reserved 2,500,000
shares of common stock for issuance.

On
May 12, 2006, 175,000 shares of restricted common stock were granted to non-employee
members of the Companys board of directors and will vest three years from the date
of the grant. The fair market value at the date of grant, determined by the quoted market
price, was $145,250 or $0.83 per share. The fair market value of the grant is being
recognized to compensation expense over the three-year service period. For the three
months ended March 31, 2008 and 2007, $12,105 for each period was recorded in operating
expenses for these grants.

Shares
Reserved for Future Issuance

At
March 31, 2008, the Company had reserved the following shares of common stock for future
issuance:

|                                                 |  |            | 
|------------------------------------------------ |  | ---------- | 
|Convertible preferred shares (series A - D)      |  | 2,280,407  | 
|Common stock options available for grant         |  | 4,005,375  | 
|Common stock options outstanding                 |  | 8,065,480  | 
|Common stock warrants outstanding (series G - J) |  | 8,212,759  | 
|Restricted common stock available for grant      |  | 2,325,000  | 
|Restricted common stock grants                   |  | 175,000    | 
|                                                
|Total common stock shares reserved               |  | 25,064,021 | 

13

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

7.     Comprehensive (Loss)
Income

The
Companys comprehensive (loss) income was as follows:

|                                        |  |                             |   |           |  
|--------------------------------------- |  | --------------------------- | - | --------- | -
|                                        |  | Three Months EndedMarch 31, |  
|                                        |  | 2008                        |   | 2007      |  
|                                       
|Net loss as reported                    |  | $(1,409,788                 | ) | $(138,953 | )
|Other comprehensive income (loss):      | 
|Foreign currency translation adjustment |  | (229,899                    | ) | 58,540    |  
|                                       
|Comprehensive loss                      |  | $(1,639,687                 | ) | $(80,413  | )

8.     Operating Segments

The Company
consists of three operating segments: wound care, wound closure and specialty securement
devices and skin care. Products in the wound care segment consist of basic and advanced
dressings, adhesive strips, ointments and sprays. Wound closure and specialty securement
device products include wound closure strips, nasal tube fasteners and a variety of
catheter fasteners. The skin care segment consists of bath sponges, antibacterial skin
cleansers, hair and body soaps, lotions and moisturizers.

Products
in all three operating segments are marketed to long-term care facilities, hospitals,
physicians, clinics, home health care agencies and other healthcare institutions. Basic
and advanced wound care products are manufactured both internally and outsourced, while
the manufacture of skin care products is completely outsourced. Wound closure-specialty
securement devices are significantly manufactured in-house. Internally, the segments are
managed at the gross profit level. The aggregation or allocation of other costs by segment
is not practical.

Segment
sales, gross profit and other related information for 2008 and 2007 are as follows:

|               |  |                                   |   |                                          |  |           |  |              |   |                  |  
|-------------- |  | --------------------------------- | - | ---------------------------------------- |  | --------- |  | ------------ | - | ---------------- | -
|               |  | Three Months Ended March 31, 2008 |   |                                          |  |          
|              
|               |  | Wound Care                        |   | Wound Closure-SpecialtySecurementDevices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $ 11,118,926                      |   | $ 433,948                                |  | $ 171,948 |  | -            |   | $ 11,724,822     |  
|              
|Gross profit   |  | 2,913,582                         |   | 245,694                                  |  | 49,382    |  | -            |   | 3,208,658        |  
|Total expenses |  | -                                 |   | -                                        |  | -         |  | $ (4,618,446 | ) | (4,618,446       | )
|              
|Net loss       |  | $ (1,409,788                      | )

14

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

|               |  |                                   |   |                                          |  |           |  |              |   |                  |  
|-------------- |  | --------------------------------- | - | ---------------------------------------- |  | --------- |  | ------------ | - | ---------------- | -
|               |  | Three Months Ended March 31, 2007 |   |                                          |  |          
|              
|               |  | Wound Care                        |   | Wound Closure-SpecialtySecurementDevices |  | Skin Care |  | Other Costs  |   | Total    Company |  
|              
|Net sales      |  | $   7,076,239                     |   | $ 672,186                                |  | $ 217,372 |  | -            |   | $   7,965,797    |  
|              
|Gross profit   |  | 2,401,842                         |   | 375,939                                  |  | 26,647    |  | -            |   | 2,804,428        |  
|Total expenses |  | -                                 |   | -                                        |  | -         |  | $ (2,943,381 | ) | (2,943,381       | )
|              
|Net loss       |  | $    (138,953                     | )

The
following table presents net sales by geographic region.

|              |  |                             |   |      |  
|------------- |  | --------------------------- | - | ---- | -
|              |  | Three Months EndedMarch 31, |  
|              |  | 2008                        |   | 2007 |  
|             
|United States |  | 59                          | % | 57   | %
|Canada        |  | 36                          | % | 39   | %
|Other         |  | 5                           | % | 4    | %

For the
three months ended March 31, 2008, the Company has a major U.S. customer comprising 12% of
U.S. sales and 10% of U.S. operations trade accounts receivable at March 31, 2008. The
Companys wholly owned Canadian subsidiary sells to one customer who serves as its
exclusive third party distributor and comprises 100% of Canada operations trade accounts
receivable at March 31, 2008.

9.     Income Taxes

The
Company recorded a $90,057 foreign income tax benefit for the three months ended March 31,
2008, based on the operating results of the Companys wholly owned Canadian
subsidiary. No benefit was realized for the Companys net loss from U.S. operations
in the three months ended March 31, 2008 due to uncertainties surrounding the
Companys ability to utilize the net operating loss carry forwards. The Company
recorded a $73,424 deferred tax provision in the first quarter 2007 related to its
Canadian subsidiarys operating results.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred assets, a full valuation allowance has been provided. The
Companys wholly owned Canadian subsidiary, based on recent operating profitability
and the prospect of future profitable operations, realized its net operating loss carry
forward and deferred tax assets and liabilities.

10.    Commitments

Clinical
Services Agreement

In
January 2008, the Company entered into an agreement with a clinical services company to
provide phase II clinical studies for the angiotensin analog technology compound licensed
in November 2007.

Costs
under the agreement include services fees of approximately $23,000 per month from
February 2008 to January 2010 and reimbursement of sterile manufacturing, toxicology and
statistician support services estimated in the amount of $470,000. The foregoing costs
represent an estimate of the Companys costs under the agreement; however, actual
costs could exceed these estimates. In addition, the clinical services company is the
recipient of a

15

---



|                                                                     
|---------------------------------------------------------------------
|Index                                                                
|DERMA SCIENCES, INC. AND
     SUBSIDIARIES                           
|Notes To Condensed
     Consolidated Financial Statements (Unaudited)

grant issued by the National
Institute of Health and will use the proceeds of the grant of approximately $1,575,000 to
cover certain other clinical testing costs (including patient care, toxicology studies
and certain other costs). The Company is responsible for these other costs to the extent
that they exceed the amount of the grant. If the amount under the grant is reduced by
more than 10%, Derma Sciences may terminate the agreement. In addition, the agreement may
be terminated upon termination of the angiotensin analog technology compound license
agreement.

11.    Subsequent Event

On
April 2, 2008, the Company closed on the SPAs (see Note 6) and received $5,700,822 (net of
$399,178 in commission and other offering expenses). The proceeds will be used to meet the
minimum equity infusion requirements associated with the Companys amended bank
covenants and in support of the Companys strategic growth initiatives.

16

---



Index

|Item 2. |  | MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF OPERATION
|------- |  | --------------------------------------------------------------------------------

Quarter Ended March 31, 2008
Compared to Quarter Ended March 31, 2007

Overview of Consolidated
Operating Results

The
2008 and 2007 operating results include Derma Sciences, Inc. and its subsidiaries. The
results of operations of the first aid division (FAD) have been included in
the consolidated results of operations commencing November 8, 2007. Unless otherwise
indicated by the context, the terms U.S. operations and Canadian operations are used
throughout this discussion in reference to the Companys U.S. operations and the
operations of Derma Sciences Canada Inc., respectively.

The
following table highlights the quarter ended March 31, 2008 versus 2007 operating results:

|                                     |  |                         |   |               |   |             |   |         | 
|------------------------------------ |  | ----------------------- | - | ------------- | - | ----------- | - | ------- | 
|                                     |  | Quarter Ended March 31, |  
|                                     |  | 2008                    |   | 2007          |   | Variance    |  
|                                    
|Gross Sales                          |  | $ 14,263,197            |   | $ 10,179,980  |   | $ 4,083,217 |   | 40.1%   | 
|Sales adjustments                    |  | (2,538,375              | ) | (2,214,183    | ) | (324,192    | ) | 14.6%   | 
|                                    
|Net sales                            |  | 11,724,822              |   | 7,965,797     |   | 3,759,025   |   | 47.2%   | 
|Cost of sales                        |  | 8,516,164               |   | 5,161,369     |   | 3,354,795   |   | 65.0%   | 
|                                    
|Gross profit                         |  | 3,208,658               |   | 2,804,428     |   | 404,230     |   | 14.4%   | 
|                                    
|Operating expenses                   |  | 4,434,974               |   | 2,793,154     |   | 1,641,820   |   | 58.8%   | 
|Interest expense                     |  | 264,915                 |   | 50,246        |   | 214,669     |   | 427.2%  | 
|Other expense, net                   |  | 8,614                   |   | 26,557        |   | (17,943     | ) | (67.6%) | 
|                                    
|Total expenses                       |  | 4,708,503               |   | 2,869,957     |   | 1,838,546   |   | 64.1%   | 
|                                    
|Loss before income taxes             |  | (1,499,845              | ) | (65,529       | ) | (1,434,316  | ) |        | 
|                                    
|(Benefit) provision for income taxes |  | (90,057                 | ) | 73,424        |   | 163,481     |   |        | 
|                                    
|Net loss                             |  | $(1,409,788             | ) | $    (138,953 | ) | $(1,270,835 | ) |        | 

Gross to Net Sales
Adjustments

Gross
sales are adjusted for trade rebates, distribution fees (in Canada), sales incentives,
Medicaid rebates, returns and allowances and cash discounts to derive net sales. Trade
rebates are trued-up monthly based upon an analysis of historical sales subject to rebate
and actual rebates received from distributors. The normal rebate cycle is one month.
Non-exclusive distributors generally carry one months inventory. The Companys
exclusive distributor in Canada normally carries three to four months inventory. As
distributor inventory is depleted via sales, it is replenished via purchases from the
Company. Rebates are processed and submitted for credit on a timely basis consistent with
distributor sales. If the normal rebate cycle were one-half month less than estimated at
March 31, 2008, the trade rebate reserve would be overstated by approximately $280,000. If
the normal rebate cycle were one month greater than estimated at March 31, 2008, the trade
rebate reserve would be understated by approximately $560,000. To minimize its cash
outflow invested in rebates, distributors generally strive to optimize the rebate credit
submission process.

Given
the nature of the Companys products and business, there is no external information
available to further validate the reasonableness of the trade rebate accrual balance.
Historical trends of sales subject to rebate and rebates received are evaluated monthly,
by distributor, on a 3 month, 6 month and 12 month rolling basis to update the continued reasonableness
of the assumptions used to quantify the trade rebate accrual balance.

17

---



Index

Deviations in the
trends resulting, among other causes, from distributors not submitting their rebates on a
timely basis are analyzed and factored in determining the required accrual balance.

The
Company currently pays its exclusive Canadian distributor a fixed fee of 10% on net sales
subject to the fee (as defined) for distribution services in Canada. The distribution fee
is accrued each month based on net sales to the distributor times the ratio of estimated
percentage of distribution fee expense to net sales based on past history. The percentage
of distributor fee expense to net sales is re-evaluated quarterly for reasonableness.

Sales
incentives are credits granted to specific customers based upon attainment of
pre-determined sales objectives. The agreements are generally for a period of one year.

Medicaid
rebates are accrued monthly based upon recent historical activity and reconciled quarterly
based upon receipt of rebate reports from participating state agencies. Returns and
allowances and cash discounts are accrued monthly based on recent historical activity.

Gross
to net sales adjustments comprise the following:

|                       |  |                         |   |               |  
|---------------------- |  | ----------------------- | - | ------------- | -
|                       |  | Quarter Ended March 31, |  
|                       |  | 2008                    |   | 2007          |  
|                      
|Gross Sales            |  | $ 14,263,197            |   | $ 10,179,980  |  
|                      
|Trade rebates          |  | (1,921,525              | ) | (1,754,282    | )
|Distribution fees      |  | (286,022                | ) | (289,138      | )
|Sales incentives       |  | (43,352                 | ) | (57,168       | )
|Medicaid rebates       |  | (3,000                  | ) | (1,515        | )
|Returns and allowances |  | (155,430                | ) | (43,517       | )
|Cash discounts         |  | (129,046                | ) | (68,563       | )
|                      
|Total adjustments      |  | (2,538,375              | ) | (2,214,183    | )
|                      
|Net sales              |  | $ 11,724,822            |   | $   7,965,797 |  

Trade rebates
increased in 2008 versus 2007 due to higher rebate intensive Canadian sales coupled with
an increase in the overall rebate percentage due to renewal of buying group contracts at
lower selling prices and continuing growth of rebate intensive U.S. private label sales.
The slight decrease in distribution fee expense is attributable to a portion of the 2008
sales that were not subject to the distribution fee. Excluding these sales, the fee was
commensurate with the increase in Canadian net sales upon which it is based. The decrease
in sales incentive expense principally relates to timing and the discontinuation of
several incentive programs in 2008. Sales returns and allowances increased in 2008
due principally to the addition of the FAD sales and a higher level of FAD returns
associated with the integration of this business. An instance of returned private label
products also contributed. Cash discounts increased commensurate with the sales increase
and as a result of a slight increase in the percentage of cash discounts to sales. A
larger portion of the sales growth continues to come from customers that have historically
taken advantage of the Companys discount terms (including FAD customers).

Rebate Reserve Roll
Forward

A
roll forward of the trade rebate accruals at March 31, 2008 and 2007 is outlined below:

|                              |  |                         |   |             |  
|----------------------------- |  | ----------------------- | - | ----------- | -
|                              |  | Quarter Ended March 31, |  
|                              |  | 2008                    |   | 2007        |  
|                             
|Beginning balance  January 1 |  | $ 2,404,861             |   | $ 1,817,558 |  
|Rebates paid                  |  | (1,591,259              | ) | (1,204,036  | )
|Rebates accrued               |  | 1,921,525               |   | 1,754,282   |  
|                             
|Ending balance  March 31     |  | $ 2,735,127             |   | $ 2,367,804 |  

18

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Index

The
$330,266 increase in the 2008 trade rebate reserve ending balance reflects an increase in
the Canadian rebate reserve due to higher sales, an increase in the overall rebate
percentage due to renewal of buying group contracts at lower selling prices coupled with a
slight increase in the exclusive distributors inventory level. Continued growth of
the rebate laden U.S. private label business and an increase in non-private label U.S.
rebate laden sales also contributed. There has been no other discernable change in the
nature of the Companys business as it relates to the accrual and subsequent payment
of rebates.

Net Sales and Gross Margin

The
following table highlights 2008 versus 2007 net sales and gross profit:

|               |  |                         |  |            |  |             |  |       | 
|-------------- |  | ----------------------- |  | ---------- |  | ----------- |  | ----- | 
|               |  | Quarter Ended March 31, | 
|               |  | 2008                    |  | 2007       |  | Variance    | 
|              
|Net Sales      |  | $11,724,822             |  | $7,965,797 |  | $3,759,025  |  | 47.2% | 
|              
|Cost of sales  |  | 8,516,164               |  | 5,161,369  |  | 3,354,795   |  | 65.0% | 
|              
|Gross Profit   |  | $  3,208,658            |  | $2,804,428 |  | $   404,230 |  | 14.4% | 
|              
|Gross Profit % |  | 27.4%                   |  | 35.2%      | 

Consolidated
net sales increased $3,759,025, or 47.2%, to $11,724,822 in 2008 from $7,965,797 in 2007.
Canadian net sales increased $156,535, or 5.1% (-11.7% excluding foreign exchange), to
$3,246,792 in 2008 from $3,090,257 in 2007. This increase was driven by favorable exchange
of $516,579 associated with a 14.3% strengthening of the Canadian dollar, partially offset
by lower sales of $360,044. Higher than normal sales in the first quarter 2007 to increase
the Companys exclusive Canadian distributors inventory to correct shortages
and better meet customer service requirements is principally responsible for the 2008
sales decrease. Ongoing price erosion associated with the renewal of bid contracts at
lower overall selling prices and lower private label sales to the distributor also
contributed. Real growth as measured by sales of the Companys products reported by
the distributor, unadjusted for foreign exchange, approximated 9.4%. U.S. net sales
increased $3,602,490, or 73.9%, to $8,478,030 in 2008 from $4,875,540 in 2007. The
increase was driven by the addition of incremental FAD sales of $3,779,356, coupled with
higher advanced wound care sales of $451,887 and traditional wound care sales of $124,848,
partially offset by lower private label, specialty fixation device and skin care and
bathing sales. The higher advanced wound care line sales reflect strong growth of the
Companys recently launched honey product together with the balance of the line in
response to increased sales and marketing support. Gross Medihoney sales in the quarter
were $293,587. The decrease in private label sales reflects timing and softening demand
from several customers. Specialty fixation device sales declined due to the
discontinuation of a private label agreement in 2007 and the non-recurrence of incremental
sales associated with a large backorder fulfillment in 2007. Excluding FAD sales, U.S.
sales decreased $176,866, or 3.6%.

Consolidated
gross profit increased $404,230, or 14.4%, to $3,208,658 in 2008 from $2,804,428 in 2007.
Company gross profit margin percentage decreased to 27.4% in 2008 from 35.2% in 2007.
Canadian gross profit decreased $314,806, or 27.4%, to $832,289 in 2008 from $1,147,095
in 2007. The Canadian gross profit margin percentage decreased to 25.6% in 2008 from
37.1% in 2007. The decrease in Canadian 2008 gross profit dollars and percentage
principally reflects a significant reduction in the volume of product produced in the
Toronto facility in 2008 versus 2007. In 2007, Toronto was operating at a higher than
normal operating level producing a number of new private label products in addition to
its normal production. This higher level of production resulted in the realization of
favorable labor and overhead absorption variances. Conversely, demand for these products
and others was less in 2008. This lower level of production resulted in the realization
of unfavorable labor and overhead absorption variances in 2008. Higher 2008 facility and
product validation costs also contributed. U.S. gross profit increased $719,036, or
43.4%, to $2,376,369 in 2008 from $1,657,333 in 2007. The U.S. gross profit margin
percentage decreased to 28.0% in 2008 from 34.0% in 2007. The improvement in U.S. gross
profit margin dollars reflects the impact of higher sales, partially offset by the
decline in gross profit margin percentage. The decrease in gross profit margin percentage
is principally attributable to the addition of lower margined FAD sales. FAD gross profit
margin percentage in the first quarter 2008 was 18.3%, below plan due principally to the
need to continue higher cost domestic manufacturing to meet customer demand. Excluding
FAD, U.S. gross profit increased $28,894, or 1.7%, and the gross profit margin percentage
would have been 35.9%. The increase in gross profit margin

19

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Index

percentage excluding FAD is
attributable to favorable product mix consisting of higher sales of higher margined
advanced wound care products coupled with lower sales of lower margined private label
products.

Operating Expenses

The
following table highlights 2008 versus 2007 operating expenses by type:

|                       |  |                         |  |             |  |              |   |         | 
|---------------------- |  | ----------------------- |  | ----------- |  | ------------ | - | ------- | 
|                       |  | Quarter Ended March 31, | 
|                       |  | 2008                    |  | 2007        |  | Variance     |  
|                      
|Distribution           |  | $   479,987             |  | $   228,019 |  | $    251,968 |   | 110.5%  | 
|Marketing              |  | 395,990                 |  | 288,227     |  | 107,763      |   | 37.4%   | 
|Sales                  |  | 1,340,472               |  | 557,556     |  | 782,916      |   | 140.4%  | 
|Research & development |  | 48,108                  |  | 125,000     |  | (76,892      | ) | (61.5%) | 
|General administrative |  | 2,170,417               |  | 1,594,352   |  | 576,065      |   | 36.1%   | 
|                      
|Total                  |  | $4,434,974              |  | $2,793,154  |  | $ 1,641,820  |   | 58.8%   | 

Operating
expense increased $1,641,820, or 58.8%, to $4,434,974 in 2008 from $2,793,154 in 2007
including an increase of $107,003, or 3.8%, in Canadian operating expense attributable to
exchange associated with a 14.3% strengthening of the Canadian dollar.

Distribution
expense increased $251,968, or 110.5%, in 2008 versus 2007. Expenses in Canada increased
$796 (including $13,399 expense related to exchange) while expenses in the U.S increased
$251,172. The increase in Canada was principally attributable to exchange, partially
offset by the reallocation of a portion of tax and utility costs to manufacturing based on
space realignments made to better rationalize operations. The U.S. increase was driven by
the addition of incremental FAD expense of $225,549 in Houston coupled with incremental
personnel and operating costs in St. Louis required to support the non-FAD business.

Marketing
expense increased $107,763, or 37.4%, in 2008 versus 2007. The increase is attributable to
planned increases in clinical personnel, trade show and promotion expense in support of
the Companys growth initiatives. Incremental FAD expense of $16,807 also
contributed.

Sales
expense increased $782,916, or 140.4%, in 2008 versus 2007. Expenses in Canada increased
$60,240 (including $23,025 expense related to exchange) while expenses in the U.S.
increased $722,676. Excluding exchange, expenses in Canada increased principally due to
consulting costs related to the sale of honey products, higher travel costs, higher
buying group administrative fees (distributor sales volume related) and implementation of
a distributor sales incentive program. The U.S. increase was principally attributable to
an expansion of the sales force starting in June 2007 to one
national sales director and ten sales representatives (from two) together with a higher
level of operating costs associated therewith, higher sampling expense of $43,549 and
royalty expense of $22,019 associated with the launch of Medihoney in October 2007,
higher customer service expenses consisting of personnel and one-time IT related expenses
principally to support the integration of the FAD business and $314,025 of incremental
FAD related expenses. Included in the FAD expenses are $111,287 of broker commission and
$42,639 of royalty costs.

Research
& development expense in 2008 consisted of expenses associated with initiation of the
DSC 127 phase II clinical trials during the quarter. The 2007 expense consists of $125,000
associated with the license of certain anti-microbial technology in March 2007.

General
administrative expense increased $576,065, or 36.1%, in 2008 versus 2007. Expenses in
Canada increased $77,747 (including $70,759 expense related to exchange) while expenses in
the U.S. increased $498,318. The increase in Canada principally reflects normal
year-to-year compensation and benefit increases, coupled with higher travel and accounting
expense, partially offset by lower Sarbanes Oxley consulting expenses (more extensive and
costly first year testing in 2007 not repeated in 2008) and bad debt expenses. The U.S.
increase principally reflects incremental intangible amortization expense of approximately
$151,600 related to the FAD acquisition, higher finance and IT employee costs of
approximately $67,000 associated with new hires in the second half of 2007 and in 2008,
legal costs of approximately $53,000, higher travel costs of approximately $41,000,
recruiting costs of approximately $40,000 related to a new hire, higher accounting, tax
and audit fees of approximately $33,000, higher

20

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Index

investor relations expenses of
approximately $27,000 due to expanded efforts in this area, higher directors fees of
approximately $25,000, higher bad debt expense of approximately $25,000, higher rent
expense of approximately $25,000 together with normal year-to-year compensation and
benefit and other inflationary cost increases, partially offset by lower Sarbanes Oxley
consulting expense of approximately $54,000.

Interest Expense

Interest
expense increased $214,669 to $264,915 in 2008 from $50,246 in 2007. Interest expense in
Canada decreased $10,208 while interest expense in the U.S. increased $224,877. The
decrease in Canada reflects the payoff of all Canadian debt in September 2007. The U.S.
increase is due to the financing associated with the FAD acquisition in November 2007.

Other Income/Expense

Other
expense net decreased $17,943 to $8,614 expense in 2008 from $26,557 expense in 2007. The
main drivers for the other expense of $8,614 in 2008 were an increase in foreign exchange
expense, partially offset by higher royalty income. The 2007 other expense of $26,557
includes various miscellaneous items.

Income Taxes

The
Company recorded a $90,057 deferred foreign income tax benefit for 2008 based on the net
operating loss of the Companys Canadian subsidiary. The Canadian tax benefit is
deferred in nature as net operating loss carry forwards continue to be utilized to offset
taxes payable. No provision was made for the Companys U.S. operations in 2008 due to
a net operating loss coupled with available net operating loss carry forwards. The Company
recorded a $73,424 deferred foreign tax provision in 2007 related to its Canadian
subsidiarys operating income.

Due
to uncertainties surrounding the Companys ability to use its U.S. net operating loss
carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net
deferred tax assets has been provided. Effective December 31, 2006 the Companys
Canadian subsidiary realized its net operating loss carry forwards and deferred tax assets
and liabilities.

Net Income (Loss)

The
Company generated a net loss of $1,409,788, or ($0.04) per share (basic and diluted), in
2008 compared to a net loss of $138,953, or ($0.01) per share (basic and diluted), in
2007.

Liquidity and Capital
Resources

Operational Overview

Net
sales increased 47.2% (40.7% adjusted for foreign exchange) in 2008 over 2007. This
growth was driven by a sales increase in the U.S. of 73.9%, together with an increase in
Canadian sales of 5.1% (-11.7% adjusted for foreign exchange). Sales growth in the U.S.
was driven by incremental sales associated with the FAD business (acquired November 8,
2007) of $3,779,356 coupled with growth of the advanced and traditional wound care lines.
Sales of the Companys new honey product launched in October 2007 were $293,587 in
the first quarter 2008 versus $113,394 in fourth quarter 2007. Interest in this product
has exceeded expectations. Sales of the Companys silver alginate product were
$274,724 in the first quarter 2008 versus $229,858 in the fourth quarter 2007. The
product continues to exhibit steady quarter-to-quarter growth since its launch in
November 2006. Product sales for the balance of the advanced wound care line have also
benefited from the increased level of marketing and sales support directed to this key
growth area of the business. FAD sales are expected to grow as the Company works out its
transition related product supply issues. The decrease in private label sales reflects
timing, softening demand from several OEM customers and an overstock situation with one
customer that resulted in no first quarter sales. Private label performance is expected
to improve going forward based upon an anticipated increase in core product demand and
the realization of new business opportunities. Skin care sales continue to deteriorate in
the face of competitive pressure and a reduction of resources allocated to support the
line. Sales for the specialty fixation and closure device line met expectations in the
first quarter 2008. Canadian sales in 2008 were lower than in 2007 principally due to
higher than normal sales in the first quarter 2007 to increase the Companys
exclusive Canadian

21

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Index

distributors inventory to
better meet customer service requirements. Real growth as measured by sales of the Companys
products reported by the Canadian distributor approximated 9.4% in local currency in
2008. Expanded marketing and sales efforts, a continued focus on contract compliance,
exploring opportunities in other market segments (other than the Companys
traditional strength in the acute care segment) and working closely with the Companys
exclusive Canadian distributor to capitalize on sales growth opportunities are generating
positive results. With sales of $25,592 the Companys new honey product started to
gain some traction in Canada during the first quarter 2008.

The
Company has realized significant product cost improvement over the last several years as a
result of its manufacturing and sourcing initiatives. The savings generated by these
initiatives have helped mitigate the adverse impact of price erosion and foreign exchange
on a large portion of the Companys business and served to sustain or improve its
gross profit dollars and margin percentage. Prospectively, this trend will become
increasingly difficult to perpetuate. Product cost savings associated with implementation
of China and other sourcing initiatives have been another contributor to the
Companys cost reduction success. Current market conditions in China and, to a lesser
extent, in other markets portend increasing product cost pressure. The Company will
continue to seek opportunities to lower product costs wherever possible.

At
the time of the FAD acquisition in November 2007, the seller was in the process of
transferring its domestic production to a third party supplier in China and
decommissioning most of its U.S. manufacturing infrastructure and overhead. Completion of
this initiative will allow the FAD business to significantly reduce its existing product
costs thereby allowing it to better compete in the marketplace. Since the acquisition, the
Company has had to continue manufacturing a portion of its adhesive strip requirements in
its U.S. facility at higher cost while working to complete the transfer of products to the
Chinese supplier and evaluating other cost effective sources of supply. It is presently
estimated that U.S. production will continue at a diminishing rate through the third
quarter of 2008. Gross profit margins presently running at approximately 18% are expected
to improve to approximately 35% once the transfer is complete and the U.S. manufacturing
activity is for the most part curtailed.

Operating
expenses increased 58.8% (55.0% adjusted for foreign exchange) in 2008 over 2007 in line
with expectations. The increase is attributable to incremental FAD expenses (intangible
asset amortization, planned sales and marketing expenses), planned increases in
distribution, marketing and sales expenses in support of the Companys growth
initiatives and higher professional service fees as a result of increasing regulatory
requirements. Excluding these expenses, growth in the balance of operating expenses is in
line with inflation and continues to be closely monitored.

In
November 2007, the Company made a significant investment in research and development via
the licensing of certain angiotensin analog technology. The initial evaluation of the
market potential and probability of obtaining approval for sale of products employing this
technology was determined to be favorable. Products employing this technology entered
phase II trials in the first quarter 2008. Completion of the phase II study is expected to
take several years. Presently, the Company plans to take the product through phase II at
an estimated cost of $1,450,000. The Company spent $48,108 on research and development in
the first quarter 2008 and plans to spend an additional $700,000 by year-end. Upon
completion of the phase II study in 2010, the Company will reevaluate the market potential
of the product and the probability of it ultimately being approved for sale to determine
the best course of action.

In
November 2007, in connection with the FAD acquisition, the Company entered into a new
five-year credit and security agreement comprised of an $8,000,000 revolver and a
$6,000,000 term loan. Given the significant increase in debt, interest expense will become
a more significant component of the Companys overall cost structure going forward.

The
Company reported a loss of $1,409,788 for 2008. Components of the loss include lower
gross margin associated with unfavorable sales mix, higher product costs, incremental
research and development costs together with a significant investment in incremental
sales and marketing resources. Not unexpectedly, but also contributing, has been a
significant increase in mandated operational and external reporting costs to remain
compliant with increasingly stringent regulatory requirements. The Company anticipates it
will continue to operate at a loss in the near term as it attempts to leverage its growth
initiatives with incremental investment, continues to support the angiotensin analog
phase II study and completes the transfer of the FAD products to lower cost third party
suppliers.

22

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Index

Cash Flow and Working
Capital

At
March 31, 2008 and December 31, 2007, the Company had cash and cash equivalents on hand of
$711,662 and $577,096, respectively. The $134,566 increase in cash reflects net cash
provided by financing activities of $3,489,426, net cash used in operating activities of
$3,044,982, net cash used in investing activities of $238,854 and cash used as a result of
exchange rate changes of $71,024.

Net
cash used in operating activities of 3,044,982 stems from $543,065 cash used in
operations (net loss plus non-cash items), together with $2,501,917 cash used from the net
change in operating assets and liabilities. The decrease in cash used from operations
reflects the operating loss incurred, partially offset by non-cash items. Funding of
higher receivable and inventory levels, coupled with reductions in accounts payable,
accrued expenses and other current liabilities, partially offset by a reduction in prepaid
and other current assets, were the main drivers behind the net change in ongoing operating
assets and liabilities. The changes in receivables, prepaid and other current assets and
accounts payable principally relate to timing and the Companys return to normal
business activity levels at March 31, 2008 versus December 31, 2007 when the Company was
in the midst of integrating the FAD business. The increase in inventory principally
reflects the planned build up of FAD inventory to better meet customer service
requirements. The decrease in accrued expenses and other current liabilities principally
reflects payment of the USC license fees of $840,000 in the first quarter.

Net
cash used in investing activities of $238,854 reflects cash used for FAD acquisition
related costs incurred during the quarter of $104,426. In addition, $134,428 was used
principally for purchases of equipment at the Companys manufacturing operation in
Canada, trade show booth upgrades to support the Companys growing sales and
marketing activities, leasehold improvements and furniture at corporate headquarters and
new computer equipment.

Net
cash provided by financing activities of $3,489,426 reflects increased line of credit
borrowings of $3,983,185 and net cash received of $89,177, net of expenses from the
exercise of common stock warrants and options, less deferred financing fees of $262,776
principally related to the amendment of the Companys bank covenants and regularly
scheduled debt payments of $320,160.

Working
capital decreased $1,424,555, or 26.5%, at March 31, 2008 to $3,944,483 from $5,369,038 at
December 31, 2007. This working capital together with the net proceeds of $3,000,000
designated for general working capital purposes from the March 2008 private equity raise
that was concluded on April 2, 2008 is considered sufficient to support ongoing operations
for the next twelve months.

Financing Arrangements

In
March 2008, the Company modified the terms of its five-year revolving credit and security
agreement to support its growth initiatives. The modified terms amend the existing minimum
EBITDA, fixed charge coverage, senior debt coverage and total debt coverage covenants and
change the measurement date to quarterly, versus monthly. Amendment of the covenants was
predicated on the Company raising a minimum of $3,000,000 from the sale of equity to be
used to pay down the outstanding revolving credit balance and agreeing to limit its
maximum revolver borrowing to the lesser of (a) the revolver loan commitment ($8,000,000)
or (b) the borrowing base (as defined), less $1,500,000.

In
the first quarter 2008, the Company commenced efforts to raise additional cash through the
private sale of its common stock and warrants to fund working capital requirements needed
to implement its growth strategy. The equity raise was completed on April 2, 2008 with the
receipt of $5,700,822 (net of $399,178 in commission and other offering expenses) from the
sale of 6,100,000 shares of common stock and 3,192,500 warrants.

Prospective Assessment

The
Companys strategic objective is to in-license, develop and launch novel higher
margined advanced wound care products while utilizing its core business (to the extent
possible) to fund this objective. In addition, the Company will continue to evaluate
external opportunities to leverage its core capabilities for growth. To the extent the
Company determines that it cannot finance its growth initiatives internally, it will
evaluate the feasibility of doing so via the sale of equity.

23

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Index

Beginning
in 2005, the Company expanded its product in-licensing and development efforts. As a
result of these efforts, the Company launched its silver alginate product in November
2006. Sales of this product have increased each quarter since its launch. The Company
launched its first honey product in October 2007. This product represents the first of its
kind and interest in the product has been high. Sales have increased steadily and current
indications are that the planned honey based line of products could result in significant
incremental sales. In addition, the Company has several other promising products in its
pipeline that it expects to launch over the next twelve to eighteen months. The Company
anticipates its core business sales will remain relatively stable over the near term.

Consistent
with its strategic objectives, the Company has taken the following actions beginning in
the second half of 2007:

|1. |  | The Company expanded its direct sales force from three to eleven personnel and
                    its clinical support staff by one, principally to sell the Companys new
                    advanced wound care products with the launch of Medihoney in October 2007 as the
                    anchor product. Depending on Medihoneys results, the plan is to gradually
                    add an additional ten to fifteen personnel comprised of sales and clinical
                    support staff in 2008 to leverage this opportunity.
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|2. |  | The Company invested in new product development with the first product being DSC
                    127. While the launch of DSC 127 is several years away, the market potential for
                    this product is considered to be significant. The product recently began phase
                    II trials (to achieve proof of principle in a human model) which is expected to
                    be completed by mid-2010. The projected cost to complete the phase II trial is
                    approximately $1,450,000. The results of the phase II trial will determine the
                    efficacy and safety of the product and further refine its market potential. The
                    cost of the phase III trial and bringing the product to market are expected to
                    be significant. Should the Company decide to proceed with the DSC 127
                    development plan after completion of phase II, it plans to fund the additional
                    development costs out of available cash flow or the sale of equity.
                    Alternatively, the Company may determine to sublicense or sell the rights to the
                    compound.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|3. |  | In November 2007, the Company purchased the assets of the FAD for approximately
                    $13,800,000. The FAD is a leading manufacturer and marketer of adhesive strips
                    and related first aid products. The integration of existing FAD business will
                    serve to expand the Companys existing basic and advanced wound care lines
                    to new customers and markets, especially the retail market where the Company did
                    not previously have a presence. In addition, the Company expects to be able to
                    reduce existing FAD product costs by completing the transfer of production of
                    certain FAD products to lower cost suppliers.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Based
upon actions taken since mid-2007 and the desire to leverage its growth opportunities in
2008 and beyond, the Company determined that it would need additional financing in order
to implement its strategic objectives. Accordingly, on March 31, 2008, the Company entered
into stock purchase agreements (SPAs) totaling $5,700,822, (net of $399,178 in
estimated commission and other offering expenses) for the sale of common stock and
warrants. The Company closed on the SPAs and received the funds on April 2, 2008. In
addition, the Company negotiated an amendment to the debt covenants governing its credit
facility. The new covenants are consistent with the Companys growth strategy for
2008.

With
the equity infusion and the new debt covenants, the Company anticipates having sufficient
liquidity in place to meet its operating needs through the next twelve months.

The
Common Stock of the Company is traded on the OTC Bulletin Board under the symbol
DSCI.OB. The Common stock is listed on the Boston Stock Exchange under the
symbol DMS. The Company has paid no cash dividends in respect of its Common
Stock and does not intend to pay cash dividends in the near future.

Update of Factors
Affecting Future Prospects

The
following factors affecting future prospects update the related factors set forth in the
Companys annual report on Form 10-KSB filed with the Securities and Exchange
Commission on April 1, 2008:

24

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Index

The potential increase in common
shares due to the conversion, exercise or vesting of outstanding derivative securities may
have a depressive effect upon the market value of the Companys shares.

Up
to 21,926,146 shares of the Companys common stock are potentially issuable upon the
conversion, exercise or vesting of outstanding convertible preferred stock, warrants,
options and restricted stock awards (dilutive securities). The shares of
common stock potentially issuable upon conversion, exercise or vesting of dilutive
securities are substantial compared to the 40,140,743 shares of common stock currently
outstanding.

Earnings
per share of common stock will be substantially diluted by the existence of these
dilutive securities regardless of whether they are converted, exercised or issued. This
dilution of earnings per share could have a depressive effect upon the market value of the
Companys common stock.

The Company has generated only
nominal income and it cannot guarantee future profitability.

The
Company incurred a net loss of $1,409,788 (unaudited) in the first three months of 2008,
earned net income of $668,739 in 2006, $22,241 in 2003, $61,368 in 2002 and $192,398 in
2001 and incurred losses of $2,284,605 in 2007, $1,099,990 in 2005, $2,338,693 in 2004,
$2,581,337 in 2000 and $2,998,919 in 1999. At March 31, 2008, the Company had an
accumulated deficit of $17,111,674 (unaudited). Although the Company achieved
profitability in 2006, 2003, 2002 and 2001, the Company cannot offer any assurance that it
will be able to generate sustained or significant earnings.

The Companys stock price has
been volatile and this volatility is likely to continue.

Historically,
the market price of the Companys common stock has been volatile. The high and low
prices for the years 2003 through 2007 and the first four months of 2008 are set forth in
the table below:

| |                                                           |  |       |  |       | 
| | --------------------------------------------------------- |  | ----- |  | ----- | 
| | Derma Sciences, Inc.
        Trading Range  Common Stock | 
|
| | Year                                                      |  | Low   |  | High  | 
|
| | 2003                                                      |  | $0.35 |  | $2.30 | 
| | 2004                                                      |  | $0.43 |  | $1.90 | 
| | 2005                                                      |  | $0.42 |  | $0.78 | 
| | 2006                                                      |  | $0.45 |  | $0.90 | 
| | 2007                                                      |  | $0.58 |  | $1.40 | 
| | 2008(*)                                                   |  | $0.74 |  | $1.35 | 
| |                                                           |  |       |  |       | 
| | (*) January 1 through April 30.                           | 

Events
that may affect the Companys common stock price include:

| |  |  | Quarter
to quarter variations in its operating results;
| | - |  | -------------------------------------------------------

| |  |  | Changes
in earnings estimates by securities analysts;
| | - |  | -----------------------------------------------------

| |  |  | Changes
in interest rates or other general economic conditions;
| | - |  | ---------------------------------------------------------------

| |  |  | Changes
in market conditions in the wound care and skin care industries;
| | - |  | ------------------------------------------------------------------------

| |  |  | The
introduction of new products either by the Company or by its competitors; and
| | - |  | ---------------------------------------------------------------------------------

| |  |  | The
loss of a major customer.
| | - |  | -----------------------------

25

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Index

Although
all publicly traded securities are subject to price and volume fluctuations, it is likely
that the Companys common stock will experience these fluctuations to a greater
degree than the securities of more established and better capitalized organizations.

Additional Financial
Information

Forward Looking Statements

Statements
that are not historical facts, including statements about the Companys confidence,
strategies, expectations about new or existing products, technologies, opportunities,
market demand or acceptance of new or existing products are forward-looking statements
that involve risks and uncertainties. These uncertainties include, but are not limited to,
product demand and market acceptance risk, impact of competitive products and prices,
product development, commercialization or technological delays or difficulties, and trade,
legal, social, financial and economic risks.

Critical Accounting
Policies

Estimates
and assumptions are required in the determination of sales deductions for trade rebates,
sales incentives, discounts and allowances. Significant estimates and assumptions are also
required in determining the appropriateness of amortization periods for identifiable
intangible assets, the potential impairment of goodwill and the valuation of inventory.
Some of these judgments can be subjective and complex and, consequently, actual results
may differ from these estimates. For any individual estimate or assumption made by the
Company, there may also be other reasonable estimates or assumptions. The Company
believes, however, that given current facts and circumstances, it is unlikely that
applying any such other reasonable judgment would cause a material adverse effect on the
consolidated results of operations, financial position or cash flows for the periods
presented. The Companys most critical accounting policies are described below.

Revenue Recognition and
Adjustments to Revenue

Revenue
is recognized when product is shipped and title passes to the customer and collectability
is reasonably assured. When the Company recognizes revenue from the sale of its products,
it simultaneously adjusts revenue for estimated trade rebates and distribution fees (in
Canada). A trade rebate represents the difference between the invoice price to the
wholesaler and the indirect customers contract price. These rebates are estimated
based on historical experience, estimated future trends, estimated customer inventory
levels, current contract sales terms with wholesale and indirect customers and other
competitive factors. The Company pays its exclusive Canadian distributor a fixed fee based
on sales subject to the fee (as defined) for distribution services in Canada. The
distribution fee is accrued monthly based on the estimated percentage of distribution fee
expense to net sales. If the assumptions used to calculate these rebates and fees do not
appropriately reflect future activity, the Companys financial position, results of
operations and cash flows could be impacted. The Company continually monitors the factors
that influence these rebates and fees and makes adjustments as necessary.

Goodwill

At
March 31, 2008, the Company had $9,407,404 of goodwill consisting of $6,967,362
(preliminary) relating to the FAD acquisition in November, 2007 and $2,440,042 relating
to the Western Medical acquisition in April 2006. The goodwill is included in the wound
care segment for reporting purposes. The Company tests goodwill for impairment in the
fourth quarter of each year or when impairment indicators are present. The process of
evaluating the potential impairment of goodwill is highly subjective and requires
significant judgments and assumptions in estimating future cash flows to determine the
fair value of each reporting unit. These assumptions include future growth rates,
discount factors, future tax rates and other factors. The Companys cash flow
forecasts are based on assumptions that are consistent with the plans and estimates used
to manage the underlying business. In addition, the Company makes
certain judgments about allocating shared assets to the balance sheet for this segment.
If the expected cash flows are not realized, impairment losses may be recorded in the
future.

26

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Index

Inventory

The
Company writes down the value of inventory by the estimate of the difference between the
cost of the inventory and its net realizable value. The estimate takes into account
projected sales of the inventory on hand and the age of the inventory in stock. If actual
future demand or market conditions are less favorable than those projected by management,
additional inventory write-downs may be required. The provision for the write-down of
inventory is recorded in cost of sales.

Stock-Based Compensation

Effective
January 1, 2006 the Company adopted Statement of Financial Accounting Standards No. 123R,
Share-Based Payment (SFAS 123R). SFAS 123R requires that
share-based payment transactions with employees, such as grants of stock options and
restricted stock, be recognized in the financial statements based on their fair value at
the grant date and recognized as compensation expense over their vesting periods. The
Company estimates the fair value of stock options as of the date of grant using the
Black-Scholes or binomial/lattice pricing model (as applicable) and restricted stock based
on the quoted market price. SFAS 123R requires significant judgment and the use of
estimates to value equity based compensation, particularly surrounding Black-Scholes or
binomial/lattice pricing model assumptions such as stock price volatility and expected
option lives, as well as expected option forfeiture rates.

27

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Index

Item 4.  CONTROLS AND PROCEDURES

The
Companys management, with the participation of the Companys Chief Executive
Officer and Chief Financial Officer, has evaluated the effectiveness of the Companys
disclosure controls and procedures as of March 31, 2008. Based on this evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that the
Companys disclosure controls and procedures are effective for gathering, analyzing
and disclosing the information the Company is required to disclose in the reports it files
under the Securities Exchange Act of 1934, within the time periods specified in the
SECs rules and forms.

During
the three months ended March 31, 2008, there was no change in the Companys internal
controls over financial reporting that materially affected, or is reasonably likely to
materially affect, the Companys internal controls over financial reporting.

28

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Index

Part II - Other
Information

Item 6. Exhibits

All
exhibits required by Item 601 of Regulation S-B and required hereunder, as filed with the
Securities and Exchange Commission in Form 10-KSB on April 1, 2008, are incorporated
herein by reference.

| |         |                                                                                                                                                           
| | ------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | Exhibit | Description                                                                                                                                               
|
| | 31.1    | Certification of the Principal Executive Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 31.2    | Certification of the Principal Financial Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 32.1    | Certification of the Principal Executive Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | 32.2    | Certification of the Principal Financial Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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

|                     |                      |                                            | 
|-------------------- | -------------------- | ------------------------------------------ | 
|                     | DERMA SCIENCES, INC. |                                           
|Dated:  May 14, 2008 | By:                  | /s/ John E. Yetter                         | 
|                     |                      | John E. Yetter, CPAChief Financial Officer | 

29

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Index

EXHIBIT INDEX

| |         |                                                                                                                                                           
| | ------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | Exhibit | Description                                                                                                                                               
| | 31.1    | Certification of the Principal Executive Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 31.2    | Certification of the Principal Financial Officer pursuant to Section
     302 of the Sarbanes-Oxley Act of 2002                                           
| | 32.1    | Certification of the Principal Executive Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
| | 32.2    | Certification of the Principal Financial Officer pursuant to U.S.C.
     Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002