UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION





Washington,
DC 20549










FORM
10-Q





(Mark
One)





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





For
      the quarterly period ended June 30,
2010





 ̈
            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 registrant as specified in its charter)





Pennsylvania
            
            23-2328753(State
      or other jurisdiction of Incorporation)
            
            (IRS
      employer identification number)





214
Carnegie Center, Suite 300


Princeton,
NJ  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.





Yes           x           No            ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).





Yes            ̈           No            ̈





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





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





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





Yes            ̈           No           x





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





Date:  August
      12, 2010
            Class:
      Common Stock, par value $.01 per shareShares Outstanding:  6,561,826










PART
I – FINANCIAL INFORMATION





DERMA
SCIENCES, INC.





FORM
10-Q





INDEX





Description
                              
                              PagePart
      I – Financial Information
                              
                              2Item
      1.  Financial Statements
                              
                              2Condensed
      Consolidated Balance Sheets – June 30, 2010 (Unaudited) and December 31,
      2009
                              
                              3Condensed
      Consolidated Statements of Operations – Three months ended June 30, 2010
      and June 30, 2009 (Unaudited)
                              
                              4Condensed
      Consolidated Statements of Operations – Six months ended June 30, 2010 and
      June 30, 2009 (Unaudited)
                              
                              5Condensed
      Consolidated Statements of Cash Flows – Six months ended June 30, 2010 and
      June 30, 2009 (Unaudited)
                              
                              6Notes
      to Condensed Consolidated Financial Statements (Unaudited)
                              
                              7Item
      2.  Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
                              
                              16Item
      4.  Controls and Procedures
                              
                              28Part
      II - Other Information
                              
                              29Item
      1A.  Risk Factors
                              
                              29Item
      6.  Exhibits
                              
                              30





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


Part
I – Financial Information





Item
1.  FINANCIAL STATEMENTS




2


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Condensed
Consolidated Balance Sheets







June
      30,2010
                  
                  
                  December 31,(Unaudited)
                  
                  
                  2009ASSETSCurrent
      AssetsCash
      and cash equivalents
                  
                  $
                  385,424
                  
                  
                  $
                  243,524Accounts
      receivable, net
                  
                  
                  4,679,530
                  
                  
                  
                  3,372,712Inventories
                  
                  
                  14,004,377
                  
                  
                  
                  11,489,724Prepaid
      expenses and other current assets
                  
                  
                  431,058
                  
                  
                  
                  456,675Total
      current assets
                  
                  
                  19,500,389
                  
                  
                  
                  15,562,635Cash
      – restricted
                  
                  
                  -
                  
                  
                  
                  2,032,164Equipment
      and improvements, net
                  
                  
                  3,364,131
                  
                  
                  
                  3,741,347Goodwill
                  
                  
                  7,119,726
                  
                  
                  
                  7,119,726Other
      intangible assets, net
                  
                  
                  7,695,950
                  
                  
                  
                  3,994,250Other
      assets, net
                  
                  
                  365,409
                  
                  
                  
                  849,753Total
      Assets
                  
                  $
                  38,045,605
                  
                  
                  $
                  33,299,875LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      LiabilitiesLine
      of credit borrowings
                  
                  
                  4,107,476
                  
                  
                  
                  2,306,306Current
      maturities of long-term debt
                  
                  
                  23,009
                  
                  
                  
                  1,759,185Accounts
      payable
                  
                  
                  3,983,431
                  
                  
                  
                  3,363,096Accrued
      expenses and other current liabilities
                  
                  
                  2,121,591
                  
                  
                  
                  1,342,467Total
      current liabilities
                  
                  
                  10,235,507
                  
                  
                  
                  8,771,054Long-term
      debt
                  
                  
                  -
                  
                  
                  
                  2,305,851Other
      long-term liabilities
                  
                  
                  78,351
                  
                  
                  
                  96,564Deferred
      tax liability
                  
                  
                  312,670
                  
                  
                  
                  355,349Total
      Liabilities
                  
                  
                  10,626,528
                  
                  
                  
                  11,528,818Shareholders’
      EquityConvertible
      preferred stock, $.01 par value; 1,468,750 shares authorized; issued and
      outstanding:  284,844 shares (liquidation preference of
      $4,201,426 at June 30, 2010)
                  
                  
                  2,848
                  
                  
                  
                  2,851Common
      stock, $.01 par value; 18,750,000 authorized; issued and outstanding:
      6,561,826 at June 30, 2010; 5,039,468 at December 31, 2009
                  
                  
                  65,618
                  
                  
                  
                  50,395Additional
      paid-in capital
                  
                  
                  48,393,839
                  
                  
                  
                  41,221,613Accumulated
      other comprehensive income – cumulative translation
      adjustments
                  
                  
                  1,231,626
                  
                  
                  
                  1,303,293Accumulated
      deficit
                  
                  
                  (22,274,854
                  )
                  
                  
                  (20,807,095
                  )Total
      Shareholders’ Equity
                  
                  
                  27,419,077
                  
                  
                  
                  21,771,057Total
      Liabilities and Shareholders’ Equity
                  
                  $
                  38,045,605
                  
                  
                  $
                  33,299,875





See
accompanying consolidated notes.


3


DERMA
SCIENCES, INC. AND SUBSIDIARIES





Condensed
Consolidated Statements of Operations (Unaudited)





Three
      Months ended June 30,2010
                  
                  
                  2009Net
      Sales
                  
                  $
                  13,230,106
                  
                  
                  $
                  11,563,341Cost
      of sales
                  
                  
                  9,202,202
                  
                  
                  
                  8,135,574Gross
      Profit
                  
                  
                  4,027,904
                  
                  
                  
                  3,427,767Operating
      ExpensesSelling,
      general and administrative
                  
                  
                  4,689,774
                  
                  
                  
                  3,703,038Research
      and development
                  
                  
                  123,744
                  
                  
                  
                  87,580Total
      operating expenses
                  
                  
                  4,813,518
                  
                  
                  
                  3,790,618Operating
      loss
                  
                  
                  (785,614
                  )
                  
                  
                  (362,851
                  )Other
      expense, net:Interest
      expense
                  
                  
                  134,707
                  
                  
                  
                  239,600Other
      income
                  
                  
                  (68,625
                  )
                  
                  
                  (42,252
                  )Total
      other expense
                  
                  
                  66,082
                  
                  
                  
                  197,348Loss
      before provision for income taxes
                  
                  
                  (851,696
                  )
                  
                  
                  (560,199
                  )Provision
      for income taxes
                  
                  
                  81,159
                  
                  
                  
                  303Net
      Loss
                  
                  $
                  (932,855
                  )
                  
                  $
                  (560,502
                  )Net
      loss per common share – basic and diluted
                  
                  $
                  (0.14
                  )
                  
                  $
                  (0.11
                  )Shares
      used in computing net loss per common share – basic
      and  diluted
                  
                  
                  6,558,562
                  
                  
                  
                  5,029,372




See
accompanying consolidated notes.


4





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Condensed
Consolidated Statements of Operations (Unaudited)





Six
      Months ended June 30,2010
                  
                  
                  2009Net
      Sales
                  
                  $
                  26,074,487
                  
                  
                  $
                  21,995,232Cost
      of sales
                  
                  
                  18,021,184
                  
                  
                  
                  15,213,830Gross
      Profit
                  
                  
                  8,053,303
                  
                  
                  
                  6,781,402Operating
      ExpensesSelling,
      general and administrative
                  
                  
                  8,913,019
                  
                  
                  
                  7,567,164Research
      and development
                  
                  
                  239,851
                  
                  
                  
                  217,926Total
      operating expenses
                  
                  
                  9,152,870
                  
                  
                  
                  7,785,090Operating
      loss
                  
                  
                  (1,099,567
                  )
                  
                  
                  (1,003,688
                  )Other
      expense, net:Interest
      expense
                  
                  
                  294,599
                  
                  
                  
                  411,070Loss
      on debt extinguishment
                  
                  
                  114,072
                  
                  
                  
                  -Other
      income
                  
                  
                  (178,131
                  )
                  
                  
                  (43,789
                  )Total
      other expense
                  
                  
                  230,540
                  
                  
                  
                  367,281Loss
      before provision (benefit) for income taxes
                  
                  
                  (1,330,107
                  )
                  
                  
                  (1,370,969
                  )Provision
      (benefit) for income taxes
                  
                  
                  137,652
                  
                  
                  
                  (52,388
                  )Net
      Loss
                  
                  $
                  (1,467,759
                  )
                  
                  $
                  (1,318,581
                  )Net
      loss per common share – basic and diluted
                  
                  $
                  (0.24
                  )
                  
                  $
                  (0.26
                  )Shares
      used in computing net loss per common share – basic
      and  diluted
                  
                  
                  6,105,386
                  
                  
                  
                  5,023,515





See
accompanying consolidated notes.


5





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Condensed
Consolidated Statements of Cash Flows (Unaudited)





Six
      Months Ended June 30,2010
                          
                          
                          2009Operating
      ActivitiesNet
      Loss
                          
                          $
                          (1,467,759
                          )
                          
                          $
                          (1,318,581
                          )Adjustments
      to reconcile net loss to net cash (used in) provided by operating
      activities:Depreciation
      of equipment and improvements
                          
                          
                          485,242
                          
                          
                          
                          416,163Amortization
      of intangible assets
                          
                          
                          807,300
                          
                          
                          
                          658,880Amortization
      of deferred financing costs
                          
                          
                          61,575
                          
                          
                          
                          72,458Loss
      on debt extinguishment
                          
                          
                          114,072
                          
                          
                          
                          -Provision
      for (recovery of) bad debts
                          
                          
                          9,312
                          
                          
                          
                          (62,325
                          )Allowance
      for sales adjustments
                          
                          
                          (32
                          )
                          
                          
                          386,851Provision
      for inventory obsolescence
                          
                          
                          247,967
                          
                          
                          
                          115,280Deferred
      rent expense
                          
                          
                          (10,422
                          )
                          
                          
                          38,534Compensation
      charge for employee stock options
                          
                          
                          417,130
                          
                          
                          
                          478,842Compensation
      charge for restricted stock
                          
                          
                          17,067
                          
                          
                          
                          18,148Gain
      on sale of equipment
                          
                          
                          -
                          
                          
                          
                          (59,031
                          )Deferred
      income taxes
                          
                          
                          (38,992
                          )
                          
                          
                          (22,704
                          )Changes
      in operating assets and liabilities:Accounts
      receivable
                          
                          
                          (1,316,098
                          )
                          
                          
                          396,033Inventories
                          
                          
                          (2,758,137
                          )
                          
                          
                          957,665Prepaid
      expenses and other current assets
                          
                          
                          22,005
                          
                          
                          
                          44,824Other
      assets
                          
                          
                          310,662
                          
                          
                          
                          (299
                          )Accounts
      payable
                          
                          
                          615,278
                          
                          
                          
                          (1,034,217
                          )Accrued
      expenses and other current liabilities
                          
                          
                          737,782
                          
                          
                          
                          (895,339
                          )Other
      long-term liabilities
                          
                          
                          (4,092
                          )
                          
                          
                          7,310Net
      cash (used in) provided by operating activities
                          
                          
                          (1,750,140
                          )
                          
                          
                          198,492Investing
      ActivitiesPurchase
      of equipment and improvements
                          
                          
                          (139,236
                          )
                          
                          
                          (113,200
                          )Purchase
      of intangible asset
                          
                          
                          (2,250,000
                          )
                          
                          
                          -Proceeds
      from sale of equipment
                          
                          
                          -
                          
                          
                          
                          61,000Net
      cash used in investing activities
                          
                          
                          (2,389,236
                          )
                          
                          
                          (52,200
                          )Financing
      ActivitiesNet
      change in bank line of credit
                          
                          
                          1,801,170
                          
                          
                          
                          334,776Long-term
      debt repayments
                          
                          
                          (4,042,027
                          )
                          
                          
                          (652,957
                          )Net
      change in restricted cash
                          
                          
                          2,032,164
                          
                          
                          
                          (11,300
                          )Proceeds
      from issuance of stock, net of costs
                          
                          
                          4,491,279
                          
                          
                          
                          (5,000
                          )Net
      cash provided by (used in) financing activities
                          
                          
                          4,282,586
                          
                          
                          
                          (334,481
                          )Effect
      of exchange rate changes on cash
                          
                          
                          (1,310
                          )
                          
                          
                          (35,809
                          )Net
      increase (decrease) in cash and cash equivalents
                          
                          
                          141,900
                          
                          
                          
                          (223,998
                          )Cash
      and cash equivalentsBeginning
      of period
                          
                          
                          243,524
                          
                          
                          
                          391,038End
      of period
                          
                          $
                          385,424
                          
                          
                          $
                          167,040Supplemental
      disclosures of cash flow information:Issuance
      of common stock and warrants for purchase of intangible
    asset
                          
                          $
                          2,259,000
                          
                          
                          $
                          -Cash
      paid during the period for:Interest
                          
                          $
                          257,685
                          
                          
                          $
                          303,613





See
accompanying consolidated notes.


6




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 facilities are located in
St. Louis, Missouri and Houston, Texas, while the Company’s Canadian
distribution facility is located in Toronto.  The Company has
manufacturing facilities in Toronto, Canada and Nantong, China.





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 six months ended June 30, 2010,
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2010.  Information included in the condensed
balance sheet as of December 31, 2009 has been derived from the consolidated
financial statements and footnotes thereto for the year ended December 31, 2009,
included in Form 10-K previously filed with the Securities and Exchange
Commission.  For further information, refer to that Form
10-K.





Reverse Stock Split –The
accompanying financial statements reflect a 1-for-8 reverse split of the
Company’s common and preferred stock approved by the board of directors and
stockholders of the Company and made effective by an amendment to the Company’s
articles of incorporation on February 1, 2010.  All share and per
share information herein that relates to the Company’s common and preferred
stock has been retroactively restated to reflect the reverse stock
split.





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 and six months ended
June 30, 2010 and 2009 as the effect would be anti-dilutive.





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





2010
                  
                  
                  2009Dilutive
      shares:Convertible
      preferred stock
                  
                  
                  284,844
                  
                  
                  
                  285,051Restricted
      common stock
                  
                  
                  20,000
                  
                  
                  
                  -Warrants
                  
                  
                  1,734,531
                  
                  
                  
                  1,099,407Stock
      options
                  
                  
                  1,282,975
                  
                  
                  
                  1,176,953Total
      dilutive shares
                  
                  
                  3,322,350
                  
                  
                  
                  2,561,411




7





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





2.
            Inventories





Inventories
include the following:





June 30,
                    2010
                  
                  
                  December 31,
                    2009Finished
      goods
                  
                  $
                  9,078,185
                  
                  
                  $
                  7,804,339Work
      in process
                  
                  
                  833,283
                  
                  
                  
                  466,365Packaging
      materials
                  
                  
                  929,016
                  
                  
                  
                  722,148Raw
      materials
                  
                  
                  3,163,893
                  
                  
                  
                  2,496,872Total
      inventory
                  
                  $
                  14,004,377
                  
                  
                  $
                  11,489,724





3.
            Line
      of Credit Borrowings





In
November 2007, the Company entered into a five-year revolving credit agreement
providing for maximum borrowings of $8,000,000 with a U.S.
lender.  The revolving credit agreement was amended from time to time,
the latest of which was March 26, 2010.  Advances under the revolving
credit agreement, as amended may be drawn,  up to 85% of eligible
receivables (as defined) and 44% of eligible inventory (as defined) less a
minimum excess availability reserve of $1,000,000.  Interest on
outstanding advances under the amended revolving credit agreement is payable at
the three month LIBOR rate subject to a 1.50% floor plus 4.25%
..   In addition, the Company pays a monthly unused line fee of
0.5% per annum on the difference between the daily average amount of advances
outstanding under the amended agreement and $8,000,000 together with a monthly
collateral management fee of $2,000.  At June 30, 2010 the effective
interest rate was 5.75% and the outstanding balance was $4,107,476.





Outstanding
balances under the amended 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.





The
revolving credit agreement, as amended, is subject to financial covenants which
require maintaining a minimum of fixed charge coverage and total leverage ratios
(as defined).  Additional covenants governing permitted investments,
indebtedness and liens, together with payments of dividends and protection of
collateral, are also included in the agreement.  The amended 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.





4.
            Long-Term
      Debt





Long-term debt consists of the
following:





June 30,
                        2010
                      
                      
                      December
      31,
                        2009U.S.
      term loan
                      
                      $
                      -
                      
                      
                      $
                      3,500,000Promissory
      note
                      
                      
                      -
                      
                      
                      
                      500,000Capital
      lease obligation
                      
                      
                      23,009
                      
                      
                      
                      65,036Total
      debt
                      
                      
                      23,009
                      
                      
                      
                      4,065,036Less:  current
      maturities
                      
                      
                      23,009
                      
                      
                      
                      1,759,185Long-term
      debt
                      
                      $
                      -
                      
                      
                      $
                      2,305,851




8





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





U.S. Term Loan





In
November 2007, the Company entered into a five-year $6,000,000 term loan
agreement with a U.S. lender.  On February 23, 2010 the term loan was
paid off which resulted in a $114,072 loss on debt extinguishment.





Promissory Note





In connection with an April, 2006
acquisition  a portion of the purchase price was paid via a
12%  unsecured promissory note issued to the seller.  The
promissory note provided for quarterly  interest installments of
$15,000 and a final payment of the outstanding principal balance of $500,000
plus interest. The promissory note was paid off on March 31, 2010.





Capital Lease Obligations





The Company has an outstanding capital
lease obligation for certain office furniture totaling $23,009 as of June 30,
2010.  The capital lease obligation bears interest at 6.8% with the
lease term expiring in February 2011.





5.
            Shareholders’
      Equity





Preferred
Stock





There are
18,598 shares of series A convertible preferred stock outstanding at June 30,
2010.  The series A preferred stock is convertible into common stock
on a one-for-one basis, bears no dividend, maintains a liquidation preference of
$32.00 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
54,943 shares of series B convertible preferred stock outstanding at June 30,
2010.  The series B preferred stock is convertible into common stock
on a one-for-one basis, bears no dividend, maintains a liquidation preference of
$48.00 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 77,384 shares of series C
convertible preferred stock outstanding at June 30, 2010.  The series
C preferred stock is convertible into common stock on a one-for-one basis, bears
no dividend, maintains a liquidation preference averaging $5.60 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 133,919 shares of series D
convertible preferred stock outstanding at June 30, 2010.  The series
D preferred stock is convertible into common stock on a one-for-one basis, bears
no dividend, maintains a liquidation preference averaging $4.00 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.





Common
Stock





In April,
2010 the Company issued 220 common stock shares for the conversion of series A
and series B preferred stock shares and 626 shares upon the exercise of stock
options.  Additionally, in June, 2010, 3,125 common stock shares were
issued upon the exercise of stock options.





In
February 2010, the Company raised $4,478,801 (net of $1,110,199 in commission
and other offering expenses) from the sale of 1,117,800 shares of common stock
at a price of $5.00 per share, together with 372,600 five-year warrants to
purchase common stock at $5.50 per share.  In addition, the placement
agent received 29,160 five-year warrants to purchase common stock at $6.25 per
share.  A portion of the proceeds along with restricted cash of
$2,032,164 were used to acquire the perpetual worldwide Medihoney® licensing
rights from Comvita (Note 9) and pay off the outstanding U.S. term loan balance
of $3,300,000 and the $500,000 promissory note.


9





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





Also in
February 2010, the Company issued 400,000 shares of its common stock together
with 133,333 warrants to purchase its common stock at an exercise price of $5.50
per share and 100,000 warrants to purchase its common stock at an exercise price
of $6.25 per share in connection with the purchase of the world-wide Medihoney
license rights (see Note 9).





Effective
May 12, 2009, 21,875 shares of common stock were issued to outside directors
upon vesting of compensatory restricted stock granted on May 12,
2006.





Stock Purchase Warrants





At June 30, 2010, the Company had
warrants outstanding to purchase 1,734,531 shares of the Company’s common stock
as outlined below:





Series
                    
                    Number of Warrants
                    
                    
                    Exercise Price
                    
                    Expiration DateH
                    
                    
                    331,915
                    
                    
                    $
                    8.00
                    
                    April
      30,2011I
                    
                    
                    94,351
                    
                    
                    $
                    5.76
                    
                    April
      30, 2011J
                    
                    
                    267,858
                    
                    
                    $
                    6.16
                    
                    May
      31, 2013K
                    
                    
                    399,064
                    
                    
                    $
                    9.60
                    
                    April
      1, 2013L
                    
                    
                    6,250
                    
                    
                    $
                    3.12
                    
                    March
      31, 2014N
                    
                    
                    100,000
                    
                    
                    $
                    6.25
                    
                    February
      22, 2015O
                    
                    
                    372,600
                    
                    
                    $
                    5.50
                    
                    February
      22, 2015P
                    
                    
                    29,160
                    
                    
                    $
                    6.25
                    
                    February
      16, 2015Q
                    
                    
                    133,333
                    
                    
                    $
                    5.50
                    
                    February
      22, 2015Total
                    
                    
                    1,734,531





Stock
      Options





The
Company has a stock option plan under which options to purchase a maximum of
1,250,000 shares of common stock may be issued (“plan options”).  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.  Plan options to purchase 236,625 and 205,000
shares of common stock were granted to officers, directors, agents and employees
during the six months ended June 30, 2010 and 2009, respectively, with exercise
prices ranging from $3.12 to $5.12 per share.  During the six months
ended June 30, 2010 and 2009, 16,249 and 1,250 plan options were forfeited,
respectively, and during the six months ended June 30, 2010, 3,751 were
exercised.  As of June 30, 2010, options to purchase 1,075,974 shares
of the Company’s common stock were issued and outstanding under the
plan.





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.  During the six months ended June 30, 2009,
29,625 non-plan options expired.  As of June 30, 2010, non-plan
options to purchase 207,001 shares of the Company’s common stock were issued and
outstanding.


10





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





A summary
of the Company’s stock option activity and related information for the six
months ended June 30, 2010 and 2009 follows:





2010
                                        
                                        
                                        2009Options
                                        
                                        
                                        Weighted
                                          Average
                                          Exercise Price
                                        
                                        
                                        Options
                                        
                                        
                                        Weighted
                                          Average
                                          Exercise PriceOutstanding
      – January 1
                                        
                                        
                                        1,066,350
                                        
                                        
                                        $
                                        5.08
                                        
                                        
                                        
                                        1,002,828
                                        
                                        
                                        $
                                        5.52Granted
                                        
                                        
                                        236,625
                                        
                                        
                                        $
                                        5.11
                                        
                                        
                                        
                                        205,000
                                        
                                        
                                        $
                                        3.04Forfeited
                                        
                                        
                                        (16,249
                                        )
                                        
                                        $
                                        4.43
                                        
                                        
                                        
                                        (1,250
                                        )
                                        
                                        $
                                        6.00Expired
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (29,625
                                        )
                                        
                                        $
                                        8.88Exercised
                                        
                                        
                                        (3,751
                                        )
                                        
                                        $
                                        3.33
                                        
                                        
                                        
                                        -Outstanding
      – June 30
                                        
                                        
                                        1,282,975
                                        
                                        
                                        $
                                        5.10
                                        
                                        
                                        
                                        1,176,953
                                        
                                        
                                        $
                                        5.04Exercisable
      at June 30
                                        
                                        
                                        988,029
                                        
                                        
                                        $
                                        5.22
                                        
                                        
                                        
                                        823,828
                                        
                                        
                                        $
                                        5.44





During the six months ended June 30,
2010 and 2009 the fair value of each service and performance based option award
was estimated at the date of grant using the Black-Scholes option pricing
model.  The weighted-average assumptions used during the three and six
months ended June 30, 2010 and 2009 were as follows:





Three Months Ended June 30,
                  
                  
                  Six Months Ended June 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Risk-free
      interest rate
                  
                  
                  2.43
                  %
                  
                  
                  2.34
                  %
                  
                  
                  2.56
                  %
                  
                  
                  2.30
                  %Volatility
      factor
                  
                  
                  78.6
                  %
                  
                  
                  89.9
                  %
                  
                  
                  79.2
                  %
                  
                  
                  92.3
                  %Dividend
      yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %
                  
                  
                  0
                  %
                  
                  
                  0
                  %Expected
      option life (years)
                  
                  
                  6.25
                  
                  
                  
                  6.25
                  
                  
                  
                  6.25
                  
                  
                  
                  6.25Contractual
      life (years)
                  
                  
                  10
                  
                  
                  
                  10
                  
                  
                  
                  10
                  
                  
                  
                  10





In both
2010 and 2009, 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 2010 and 2009, 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.  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.  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.





The weighted average fair value per
share of options granted during the six months ended June 30, 2010 and 2009 was
$3.59 and $2.34, respectively.During the three and six
months ended June 30, 2010 and 2009, stock option compensation expense was
recorded as follows:





Three Months Ended June 30,
                      
                      
                      Six Months Ended June 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Cost
      of sales
                      
                      $
                      19,398
                      
                      
                      $
                      23,327
                      
                      
                      $
                      39,498
                      
                      
                      $
                      50,437Selling,
      general and administrative expenses
                      
                      
                      229,739
                      
                      
                      
                      226,432
                      
                      
                      
                      377,632
                      
                      
                      
                      428,405Total
      stock option compensation expense
                      
                      $
                      249,137
                      
                      
                      $
                      249,759
                      
                      
                      $
                      417,130
                      
                      
                      $
                      478,842




11





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





As of June 30, 2010, there was $756,265
of unrecognized compensation cost related to nonvested
service   and $119,130 nonvested performance based awards granted
under the plan.  These costs are expected to be recognized over the
options’ remaining weighted average vesting period of 1.68 years for the service
and .50 years for the performance based awards.





For the
six months ended June 30, 2010 and 2009, no income tax benefit was recognized
related to stock option activity.





Restricted
Common Stock





The Company has a restricted common
stock plan in which 312,500 shares of common stock are reserved for
issuance.





In May, 2010, 20,000 shares of
restricted common stock were granted under the plan to non-employee members of
the Company’s board of directors and vest one year from date of the
grant.  The fair market value at the date of grant, determined by the
quoted market price, was $102,400 or $5.12 per share.  For the six
months ended June 30, 2010, $17,067 was recorded in operating expense for these
grants.





In May, 2006, 21,875 shares of
restricted common stock were granted to non-employee members of the Company’s
board of directors and vested 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 $6.64 per share.  The fair market
value of the grant was recognized as compensation expense over the three-year
service period.  For the six months ended June 30, 2009, $18,148 was
recorded in operating expense for these grants.





Shares
Reserved for Future Issuance





At June 30, 2010, the Company had
reserved the following shares of common stock for future issuance:





Convertible
      preferred shares (series A – D)
                  
                  
                  284,844Common
      stock options available for grant
                  
                  
                  174,026Common
      stock options outstanding
                  
                  
                  1,282,975Common
      stock warrants outstanding (series H – Q)
                  
                  
                  1,734,531Restricted
      common stock available for grant
                  
                  
                  270,625Restricted
      common stock grants
                  
                  
                  20,000Total
      common stock shares reserved
                  
                  
                  3,767,001





6.
            Comprehensive
      Loss





The
      Company’s comprehensive loss was as
follows:





Three
      Months Ended
                        June 30,
                      
                      
                      Six
      Months Ended
                        June 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Net
      loss as reported
                      
                      $
                      (932,855
                      )
                      
                      $
                      (560,502
                      )
                      
                      $
                      (1,467,759
                      )
                      
                      $
                      (1,318,581
                      )Other
      comprehensive income (loss):Foreign
      currency translation adjustment
                      
                      
                      (247,940
                      )
                      
                      
                      438,787
                      
                      
                      
                      (71,667
                      )
                      
                      
                      246,202Comprehensive
      loss
                      
                      $
                      (1,180,795
                      )
                      
                      $
                      (121,715
                      )
                      
                      $
                      (1,539,426
                      )
                      
                      $
                      (1,072,379
                      )


12





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





7.
            Operating
      Segments





The
Company consists of three operating segments:  wound care, wound
closure – 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 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 2010 and 2009 are as
follows:





Three Months Ended June 30, 2010Wound Care
                                
                                
                                Wound Closure-
                                  Specialty
                                  Securement Devices
                                
                                
                                Skin Care
                                
                                
                                Other
                                
                                
                                Total
                                  CompanyNet
      sales
                                
                                $
                                12,693,017
                                
                                
                                $
                                401,680
                                
                                
                                $
                                135,409
                                
                                
                                
                                -
                                
                                
                                $
                                13,230,106Gross
      profit
                                
                                
                                3,776,908
                                
                                
                                
                                216,708
                                
                                
                                
                                34,288
                                
                                
                                
                                -
                                
                                
                                
                                4,027,904Total
      expenses
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                $
                                (4,960,759
                                )
                                
                                
                                (4,960,759
                                )Net
      loss
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                (932,855
                                )





Three Months Ended June 30, 2009Net
      sales
                            
                            $
                            10,934,794
                            
                            
                            $
                            436,690
                            
                            
                            $
                            191,857
                            
                            
                            
                            -
                            
                            
                            $
                            11,563,341Gross
      profit
                            
                            
                            3,144,448
                            
                            
                            
                            236,713
                            
                            
                            
                            46,606
                            
                            
                            
                            -
                            
                            
                            
                            3,427,767Total
      expenses
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            $
                            (3,988,269
                            )
                            
                            
                            (3,988,269
                            )Net
      loss
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            (560,502
                            )





Six Months Ended June 30, 2010Wound Care
                                
                                
                                Wound Closure-
                                  Specialty
                                  Securement Devices
                                
                                
                                Skin Care
                                
                                
                                Other
                                
                                
                                Total
                                  CompanyNet
      sales
                                
                                $
                                24,940,037
                                
                                
                                $
                                875,151
                                
                                
                                $
                                259,299
                                
                                
                                
                                -
                                
                                
                                $
                                26,074,487Gross
      profit
                                
                                
                                7,509,833
                                
                                
                                
                                478,213
                                
                                
                                
                                65,257
                                
                                
                                
                                -
                                
                                
                                
                                8,053,303Total
      expenses
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                $
                                (9,521,062
                                )
                                
                                
                                (9,521,062
                                )Net
      loss
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                (1,467,759
                                )




13





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)





Six Months Ended June 30, 2009Wound Care
                                
                                
                                Wound Closure-
                                  Specialty
                                  Securement Devices
                                
                                
                                Skin Care
                                
                                
                                Other
                                
                                
                                Total
                                  CompanyNet
      sales
                                
                                $
                                20,734,277
                                
                                
                                $
                                897,762
                                
                                
                                $
                                363,193
                                
                                
                                
                                -
                                
                                
                                $
                                21,995,232Gross
      profit
                                
                                
                                6,205,071
                                
                                
                                
                                482,737
                                
                                
                                
                                93,594
                                
                                
                                
                                -
                                
                                
                                
                                6,781,402Total
      expenses
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                $
                                (8,099,983
                                )
                                
                                
                                (8,099,983
                                )Net
      loss
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                (1,318,581
                                )




The
following table presents net sales by geographic region.





Three Months Ended
                    June 30,
                  
                  
                  Six Months Ended
                    June 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009United
      States
                  
                  
                  67
                  %
                  
                  
                  72
                  %
                  
                  
                  67
                  %
                  
                  
                  73
                  %Canada
                  
                  
                  27
                  %
                  
                  
                  24
                  %
                  
                  
                  28
                  %
                  
                  
                  22
                  %Other
                  
                  
                  6
                  %
                  
                  
                  4
                  %
                  
                  
                  5
                  %
                  
                  
                  5
                  %





For the six months ended June 30, 2010,
one U.S. customer was responsible for 13% of U.S. sales.  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 June 30, 2010.





8.
            Income
      Taxes





The
Company recorded a $137,652 foreign income tax provision for the six months
ended June 30, 2010 and a $52,388 foreign income tax benefit for the six months
ended June 30, 2009 based on the operating results of the Company’s wholly owned
Canadian subsidiary.  The 2010 provision was comprised of $176,644
current foreign tax payable and $38,992 deferred foreign tax benefit while the
2009 benefit was comprised of $29,684 current foreign tax and $22,704 deferred
foreign tax benefits.  No benefit was realized for the Company’s net
loss from U.S. operations in the six months ended June 30, 2010 and 2009 due to
uncertainties surrounding the Company’s ability to utilize its net operating
loss carry forwards.





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.





9.
            Comvita
      Licensing, Manufacturing and Sales
Agreement





On February 23, 2010, the Company
entered into various agreements with Comvita in which the Company principally
received perpetual and exclusive worldwide licensing rights for Medihoney®
professional wound and skin care products covering distribution and sales to all
markets outside of the consumer market.   In connection with the
agreements the Company paid $2,250,000 and issued Comvita 400,000 shares of its
common stock together with 133,333 warrants to purchase its common stock at an
exercise price of $5.50 per share and 100,000 warrants to purchase its common
stock at a price of $6.25 per share.  The total consideration paid to
Comvita was valued at $4,509,000.  The $4,509,000 cost of the
perpetual and worldwide licensing rights has been recorded as an intangible
asset and will be amortized over an estimated useful life of 10
years.


14





DERMA
SCIENCES, INC. AND SUBSIDIARIES





Notes to
Condensed Consolidated Financial Statements (Unaudited)







The
agreement calls for royalty payments on all sales and additional payments to
Comvita if certain Medihoney® net sales milestones are achieved over the course
of the license. The license rights may be terminated or rendered non-exclusive
by Comvita if the Company fails to meet certain minimum royalty
requirements.


15




Item
2.  Management's Discussion and Analysis of Financial Condition and
Results of Operations




Quarter
Ended June 30, 2010 Compared to Quarter Ended June 30, 2009





Overview





The
following table highlights the quarter ended June 30, 2010 versus 2009 operating
results:




Quarter Ended June 30,
                
                
                Variance2010
                
                
                2009Gross
      Sales
                
                $
                15,813,393
                
                
                $
                13,709,673
                
                
                $
                2,103,720
                
                
                
                15.3
                %Sales
      adjustments
                
                
                (2,583,287
                )
                
                
                (2,146,332
                )
                
                
                (436,955
                )
                
                
                20.4
                %Net
      sales
                
                
                13,230,106
                
                
                
                11,563,341
                
                
                
                1,666,765
                
                
                
                14.4
                %Cost
      of sales
                
                
                9,202,202
                
                
                
                8,135,574
                
                
                
                1,066,628
                
                
                
                13.1
                %Gross
      profit
                
                
                4,027,904
                
                
                
                3,427,767
                
                
                
                600,137
                
                
                
                17.5
                %Selling,
      general and administrative expense
                
                
                4,689,774
                
                
                
                3,703,038
                
                
                
                986,736
                
                
                
                26.6
                %Research
      and development expense
                
                
                123,744
                
                
                
                87,580
                
                
                
                36,164
                
                
                
                41.3
                %Interest
      expense
                
                
                134,707
                
                
                
                239,600
                
                
                
                (104,893
                )
                
                
                (43.8
                )%Other
      income, net
                
                
                (68,625
                )
                
                
                (42,252
                )
                
                
                (26,373
                )
                
                
                62.4
                %Total
      expenses
                
                
                4,879,600
                
                
                
                3,987,966
                
                
                
                891,634
                
                
                
                22.4
                %Loss
      before income taxes
                
                
                (851,696
                )
                
                
                (560,199
                )
                
                
                (291,497
                )
                
                
                52.0
                %Provision
      for income taxes
                
                
                81,159
                
                
                
                303
                
                
                
                80,856Net
      loss
                
                $
                (932,855
                )
                
                $
                (560,502
                )
                
                $
                (372,353
                )
                
                
                66.4
                %





Gross
to Net Sales Adjustments





Gross to
net sales adjustments comprise the following:





Quarter Ended June 30,2010
                            
                            
                            2009Gross
      Sales
                            
                            $
                            15,813,393
                            
                            
                            $
                            13,709,673Trade
      rebates
                            
                            
                            (1,956,035
                            )
                            
                            
                            (1,604,132
                            )Distributor
      fees
                            
                            
                            (339,280
                            )
                            
                            
                            (238,459
                            )Sales
      incentives
                            
                            
                            (113,163
                            )
                            
                            
                            (130,875
                            )Returns
      and allowances
                            
                            
                            (76,308
                            )
                            
                            
                            (80,549
                            )Cash
      discounts
                            
                            
                            (98,501
                            )
                            
                            
                            (92,317
                            )Total
      adjustments
                            
                            
                            (2,583,287
                            )
                            
                            
                            (2,146,332
                            )Net
      sales
                            
                            $
                            13,230,106
                            
                            
                            $
                            11,563,341





Trade
rebates increased in 2010 versus 2009 due principally to higher Canadian sales
subject to rebate, partially offset by the discontinuation of a significant U.S.
private label customer rebate program effective November 1, 2009. The increase
in distribution fee expense is commensurate with the increase in Canadian net
sales upon which it is based. The decrease in sales incentive expense reflects a
reduction in the number of the traditional wound care and first aid products
sales incentive programs in 2010 versus 2009. The slight sales returns and
allowances decrease is principally due to the non-recurrence of higher first aid
products related returns in 2009, partially offset by higher Canadian returns.
The increase in cash discounts reflects higher U.S. sales subject to cash
discount.




16




Rebate
Reserve Roll Forward





A three
month roll forward of the trade rebate accruals at June 30, 2010 and 2009 is
outlined below:





Quarter Ended June 30,2010
                      
                      
                      2009Beginning
      balance – March 31
                      
                      $
                      2,344,157
                      
                      
                      $
                      2,673,350Rebates
      paid
                      
                      
                      (1,914,623
                      )
                      
                      
                      (1,968,178
                      )Rebates
      accrued
                      
                      
                      1,956,035
                      
                      
                      
                      1,604,132Ending
      balance – June 30
                      
                      $
                      2,385,569
                      
                      
                      $
                      2,309,304





The
$41,412 increase in the trade rebate reserve balance for the three months ended
June 30, 2010 is due to timing. There has been no other discernable change in
the nature of our business in 2010 as it relates to the accrual and subsequent
payment of rebates.





Net
Sales and Gross Margin





The
following table highlights the June 30, 2010 versus 2009 product line net sales
and gross profit:





Quarter Ended June 30,
                    
                    
                    Variance2010
                    
                    
                    2009Net
      Sales
                    
                    $
                    13,230,106
                    
                    
                    $
                    11,563,341
                    
                    
                    $
                    1,666,765
                    
                    
                    
                    14.4
                    %Cost
      of sales
                    
                    
                    9,202,202
                    
                    
                    
                    8,135,574
                    
                    
                    
                    1,066,628
                    
                    
                    
                    13.1
                    %Gross
      Profit
                    
                    $
                    4,027,904
                    
                    
                    $
                    3,427,767
                    
                    
                    $
                    600,137
                    
                    
                    
                    17.5
                    %Gross
      Profit %
                    
                    
                    30.4
                    %
                    
                    
                    29.6
                    %





Consolidated
net sales increased $1,666,765, or 14.4% (11.4% adjusted for exchange), in 2010
versus 2009. Canadian net sales increased $814,867, or 29.7%, to $3,559,150 in
2010 from $2,744,282 in 2009. This increase was driven by favorable exchange of
$352,827 associated with a 11.9% strengthening of the Canadian dollar, coupled
with sales growth of $462,040. The sales growth reflects the impact of inventory
rationalization on the part of our exclusive Canadian distributor of $603,605,
partially offset by $141,565, or 3.8%, attributable to lower demand. U.S. net
sales increased $555,673, or 6.3%, to $9,374,731 in 2010 from $8,819,058 in
2009. The increase was principally driven by higher advanced wound care sales of
$471,506, or 27.1%, and first aid product sales of $260,112, or 8.4%. The
balance of U.S. sales consisting of traditional wound care, private label,
specialty fixation, burn care and skin care and bathing sales were down 4.4%
quarter to quarter. The higher advanced wound care sales reflect continued
growth of our new products in response to expanded sales and marketing efforts.
The increase in first aid products sales reflects new business and improving
demand. Sales of $296,225 associated with our recently initiated international
growth strategy also contributed





Consolidated
gross profit increased $600,137, or 17.5%, in 2010 versus 2009. The consolidated
gross profit margin percentage increased to 30.4% in 2010 from 29.6% in 2009.
The change in gross profit dollars reflects the higher sales, together with the
improved gross profit margin percentage. The higher gross margin profit
percentage reflects favorable mix towards higher margined products, partially
offset by increasing product costs and higher obsolescence and transportation
expense.





17


Selling,
General and Administrative Expenses





The
following table highlights June 30, 2010 versus 2009 selling, general and
administrative expenses by type:





Quarter Ended June 30,
                  
                  
                  Variance2010
                  
                  
                  2009Distribution
                  
                  $
                  454,010
                  
                  
                  $
                  459,741
                  
                  
                  $
                  (5,731
                  )
                  
                  
                  (1.2
                  )%Marketing
                  
                  
                  524,782
                  
                  
                  
                  438,855
                  
                  
                  
                  85,927
                  
                  
                  
                  19.6
                  %Sales
                  
                  
                  1,669,958
                  
                  
                  
                  1,221,821
                  
                  
                  
                  448,137
                  
                  
                  
                  36.7
                  %General
      and administrative
                  
                  
                  2,041,024
                  
                  
                  
                  1,582,621
                  
                  
                  
                  458,403
                  
                  
                  
                  29.0
                  %Total
                  
                  $
                  4,689,774
                  
                  
                  $
                  3,703,038
                  
                  
                  $
                  986,736
                  
                  
                  
                  26.6
                  %





Selling,
general and administrative expenses increased $986,736, or 26.6% (24.6% adjusted
for exchange), in 2010 versus 2009, including an increase of $72,282 in Canadian
selling, general and administrative expenses attributable to
exchange.





Distribution
expense decreased $5,731, or 1.2% (2.8% adjusted for exchange), in 2010 versus
2009, including an increase of $7,329 due to exchange.  This decrease
reflects lower labor requirements in the Houston distribution center and lower
utilities due to a warmer average temperature in 2010, partially offset by
higher inflation related compensation and benefit costs and higher U.S. lease
costs





Marketing
expense increased $85,927, or 19.6% (18.6% adjusted for exchange), in 2010
versus 2009, including an increase of $4,377 due to exchange. The increase is
attributable to higher U.S., Canada and international promotion/literature and
show spending in support of our growth initiatives.





Sales expense increased $448,137, or 36.7% (26.3% adjusted for
exchange), in 2010 versus 2009. Expenses in Canada increased $53,322 (including
a $21,642 increase related to exchange) due to higher compensation and benefit
costs, advanced wound care related consulting expenses and sales volume related
group purchasing organization fees.  Expenses in the U. S. increased
$235,517. This increase is principally attributable to incremental expense
associated with the planned expansion of the U.S. sales force from ten to twenty
representatives that was completed by the end of the quarter, partially offset
by lower first aid products compensation and benefits associated with a position
eliminated in the first quarter and not replaced. Incremental international
expenses of $159,298 for compensation and benefits, travel, recruiting and
sample expenses associated with the start up of our international growth
initiative also contributed.





General
and administrative expense increased $458,403, or 29.0% (26.3% adjusted for
exchange), in 2010 versus 2009. Expenses in Canada increased $99,426 (including
a $41,934 increase related to exchange). Net of exchange, expenses were up
$57,492 driven principally by compensation and benefits associated with
inflationary increases and one new position, coupled with higher travel and
information technology (upgrading computer software) expenses. Expenses in the
U. S. increased $307,692. This increase reflects incremental amortization
expense of $114,800 associated with the Worldwide Medihoney License Agreement
signed in February 2010, higher planned investor relations expenses of $68,840
designed to increase investor awareness and improve our stock’s trading volume,
bad debt expense of $45,366, together with higher equity based compensation,
travel and board related expenses. Inflation related increases in professional
services and general operating expenses also contributed.  Incremental
international expenses of $51,285 consisting of transition related management,
legal and travel expenses associated with the start up of our international
growth initiative were incurred.





Research
and Development Expense





Research
and development expense increased $36,164 to $123,744 in 2010 from $87,580 in
2009. The increase principally reflects data management expenses that originated
in the second half of 2009.





Interest
Expense





Interest
expense decreased $104,893 to $134,707 in 2010 from $239,600 in 2009. The
decrease is principally attributable to lower term and promissory note interest
associated with the payoff of these loans in February 2010, lower loan related
fees and lower deferred financing expense due to the write-off of a portion of
the outstanding deferred financing balance in connection with the payoff of the
term loan. Line of credit interest was comparable quarter to quarter as the
impact of slightly lower borrowing levels was offset by slightly higher interest
rates.





18


Other
Income





Other
income increased $26,373 to $68,625 in 2010 from $42,252 in 2009. The main
driver for the net quarter to quarter increase was an exchange gain of $26,896
and slightly higher royalty income, partially offset by higher miscellaneous
expense





Income
Taxes





We
recorded a $81,159 foreign income tax provision for 2010 consisting of a $90,125
current foreign tax provision and a $8,966 deferred foreign tax benefit based on
our Canadian subsidiary’s operating results. No tax benefit was recorded for our
U.S. operations in 2010 or 2009 due to uncertainty surrounding our ability to
use available net operating loss carry forwards and net deferred tax
assets.  In 2009, we recorded a $303 foreign income tax provision
consisting of a $8,872 current foreign tax provision and a $8,569 deferred
foreign tax benefit based on our Canadian subsidiary’s operating
results.





Due to
uncertainties surrounding our ability to use our 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.




Net
Loss





We
generated a net loss of $932,855, or $0.14 per share (basic and diluted), in
2010 compared to a net loss of $560,502, or $0.11 per share (basic and diluted),
in 2009.





19


Six
Months Ended June 30, 2010 Compared to Six Months Ended June 30,
2009





Overview





The
following table highlights the six months ended June 30, 2010 versus 2009
operating results:




Six
      Months Ended June 30,
                    
                    
                    Variance2010
                    
                    
                    2009Gross
      Sales
                    
                    $
                    31,264,529
                    
                    
                    $
                    26,311,433
                    
                    
                    $
                    4,953,096
                    
                    
                    
                    18.8
                    %Sales
      adjustments
                    
                    
                    (5,190,042
                    )
                    
                    
                    (4,316,201
                    )
                    
                    
                    (873,841
                    )
                    
                    
                    20.2
                    %Net
      sales
                    
                    
                    26,074,487
                    
                    
                    
                    21,995,232
                    
                    
                    
                    4,079,255
                    
                    
                    
                    18.6
                    %Cost
      of sales
                    
                    
                    18,021,184
                    
                    
                    
                    15,213,830
                    
                    
                    
                    2,807,354
                    
                    
                    
                    18.5
                    %Gross
      profit
                    
                    
                    8,053,303
                    
                    
                    
                    6,781,402
                    
                    
                    
                    1,271,901
                    
                    
                    
                    18.8
                    %Selling,
      general and administrative expense
                    
                    
                    8,913,019
                    
                    
                    
                    7,567,164
                    
                    
                    
                    1,345,855
                    
                    
                    
                    17.8
                    %Research
      and development expense
                    
                    
                    239,851
                    
                    
                    
                    217,926
                    
                    
                    
                    21,925
                    
                    
                    
                    10.1
                    %Interest
      expense
                    
                    
                    294,599
                    
                    
                    
                    411,070
                    
                    
                    
                    (116,471
                    )
                    
                    
                    (28.3
                    )%Loss
      on debt extinguishment
                    
                    
                    114,072
                    
                    
                    
                    -
                    
                    
                    
                    114,072Other
      income, net
                    
                    
                    (178,131
                    )
                    
                    
                    (43,789
                    )
                    
                    
                    (134,342
                    )
                    
                    
                    306.8
                    %Total
      expenses
                    
                    
                    9,383,410
                    
                    
                    
                    8,152,371
                    
                    
                    
                    1,231,039
                    
                    
                    
                    15.1
                    %Loss
      before income taxes
                    
                    
                    (1,330,107
                    )
                    
                    
                    (1,370,969
                    )
                    
                    
                    40,862Provision
      (benefit) for income taxes
                    
                    
                    137,652
                    
                    
                    
                    (52,388
                    )
                    
                    
                    (190,040
                    )Net
      loss
                    
                    $
                    (1,467,759
                    )
                    
                    $
                    (1,318,581
                    )
                    
                    $
                    (149,178
                    )
                    
                    
                    11.3
                    %




Gross
to Net Sales Adjustments





Gross to
net sales adjustments comprise the following:





Six Months Ended June 30,2010
                        
                        
                        2009Gross
      Sales
                        
                        $
                        31,264,529
                        
                        
                        $
                        26,311,433Trade
      rebates
                        
                        
                        (3,903,902
                        )
                        
                        
                        (3,113,426
                        )Distributor
      fees
                        
                        
                        (668,952
                        )
                        
                        
                        (445,197
                        )Sales
      incentives
                        
                        
                        (236,973
                        )
                        
                        
                        (288,700
                        )Returns
      and allowances
                        
                        
                        (173,462
                        )
                        
                        
                        (266,048
                        )Cash
      discounts
                        
                        
                        (206,753
                        )
                        
                        
                        (202,830
                        )Total
      adjustments
                        
                        
                        (5,190,042
                        )
                        
                        
                        (4,316,201
                        )Net
      sales
                        
                        $
                        26,074,487
                        
                        
                        $
                        21,995,232





Trade
rebates increased in 2010 versus 2009 due principally to higher Canadian sales
subject to rebate, partially offset by the discontinuation of a significant U.S.
private label customer rebate program effective November 1, 2009. The increase
in distribution fee expense is commensurate with the increase in Canadian net
sales upon which it is based. The decrease in sales incentive expense reflects a
reduction in the number of the traditional wound care and first aid products
sales incentive programs in 2010 versus 2009. The sales returns and allowances
decrease is principally due to the non-recurrence of higher first aid products
related returns in 2009, partially offset by higher Canadian returns. The
increase in cash discounts reflects higher U.S. sales subject to cash
discount.





20


Rebate
Reserve Roll Forward





A six
month roll forward of the trade rebate accruals at June 30, 2010 and 2009 is
outlined below:





Six Months Ended June 30,2010
                  
                  
                  2009Beginning
      balance – January 1
                  
                  $
                  2,493,232
                  
                  
                  $
                  2,660,086Rebates
      paid
                  
                  
                  (4,011,565
                  )
                  
                  
                  (3,464,208
                  )Rebates
      accrued
                  
                  
                  3,903,902
                  
                  
                  
                  3,113,426Ending
      balance – June 30
                  
                  $
                  2,385,569
                  
                  
                  $
                  2,309,304





The
$107,663 decrease in the trade rebate reserve balance for the six months ended
June 30, 2010 reflects the decision of one significant U.S. private label
customer to discontinue its rebate program effective November 1, 2009 and the
subsequent payment of the outstanding balance due this customer in 2010,
partially offset by an increase in the Canadian reserve due to higher sales.
There has been no other discernable change in the nature of our business in 2010
as it relates to the accrual and subsequent payment of rebates.





Net
Sales and Gross Margin





The
following table highlights the June 30, 2010 versus 2009 product line net sales
and gross profit:





Six Months Ended June 30,
                  
                  
                  Variance2010
                  
                  
                  2009Net
      Sales
                  
                  $
                  26,074,487
                  
                  
                  $
                  21,995,232
                  
                  
                  $
                  4,079,255
                  
                  
                  
                  18.6
                  %Cost
      of sales
                  
                  
                  18,021,184
                  
                  
                  
                  15,213,830
                  
                  
                  
                  2,807,354
                  
                  
                  
                  18.5
                  %Gross
      Profit
                  
                  $
                  8,053,303
                  
                  
                  $
                  6,781,402
                  
                  
                  $
                  1,271,901
                  
                  
                  
                  18.8
                  %Gross
      Profit %
                  
                  
                  30.9
                  %
                  
                  
                  30.8
                  %





Consolidated
net sales increased $4,079,255, or 18.6% (15.0% adjusted for exchange), in 2010
versus 2009. Canadian net sales increased $2,160,238, or 43.6%, to $7,109,925 in
2010 from $4,949,687 in 2009. This increase was driven by favorable exchange of
$783,369 associated with a 14.2% strengthening of the Canadian dollar, coupled
with sales growth of $1,376,869. The sales growth reflects the impact of
inventory rationalization on the part of our exclusive Canadian distributor of
$1,406,566, partially offset by $29,697 attributable to lower demand. U.S. net
sales increased $1,502,070, or 8.8%, to $18,547,615 in 2010 from $17,045,545 in
2009. The increase was principally driven by higher advanced wound care sales of
$1,198,603, or 39.1%, and first aid product sales of $479,196, or 7.9%. The
balance of U.S. sales consisting of traditional wound care, private label,
specialty fixation, burn care and skin care and bathing sales were down 2.2%
period to period. The higher advanced wound care sales reflect continued growth
of our new products in response to expanded sales and marketing efforts. The
increase in first aid products sales reflects new business and improving demand.
Sales of $416,947 associated with our recently initiated international growth
strategy also contributed





Consolidated
gross profit increased $1,271,901, or 18.8%, in 2010 versus 2009. The
consolidated gross profit margin percentage increased slightly to 30.9% in 2010
from 30.8% in 2009. The change in gross profit dollars reflects the higher
sales. While comparable period to period, the slight improvement in gross profit
percentage reflects a favorable sales mix towards higher margined products,
offset by increasing products costs and higher obsolescence and transportation
expense.





21


Selling,
General and Administrative Expenses





The
following table highlights June 30, 2010 versus 2009 selling, general and
administrative expenses by type:





Six Months Ended June 30,
                  
                  
                  Variance2010
                  
                  
                  2009Distribution
                  
                  $
                  905,437
                  
                  
                  $
                  887,474
                  
                  
                  $
                  17,963
                  
                  
                  
                  2.0
                  %Marketing
                  
                  
                  852,864
                  
                  
                  
                  829,787
                  
                  
                  
                  23,077
                  
                  
                  
                  2.8
                  %Sales
                  
                  
                  3,128,385
                  
                  
                  
                  2,436,862
                  
                  
                  
                  691,523
                  
                  
                  
                  28.4
                  %General
      and administrative
                  
                  
                  4,026,333
                  
                  
                  
                  3,413,041
                  
                  
                  
                  613,292
                  
                  
                  
                  18.0
                  %Total
                  
                  $
                  8,913,019
                  
                  
                  $
                  7,567,164
                  
                  
                  $
                  1,345,855
                  
                  
                  
                  17.8
                  %





Selling,
general and administrative expenses increased $1,345,855, or 17.8% (15.2%
adjusted for exchange), in 2010 versus 2009, including an increase of $197,455
in Canadian selling, general and administrative expenses attributable to
exchange.





Distribution
expense increased $17,963, or 2.0%, in 2010 versus 2009 due to exchange.
Excluding exchange, distribution expenses decreased $408. This slight decrease
reflects lower labor requirements in the Houston distribution center and lower
utilities due to a warmer average temperature in 2010, partially offset by
higher inflation related compensation and benefit, lease and operating
expenses





Marketing
expense increased $23,077, or 2.8% (1.5% adjusted for exchange), in 2010 versus
2009, including an increase of $10,693 due to exchange. The increase is
attributable to higher U.S., Canada and international promotion/literature and
show spending in support of our growth initiatives, partially offset by lower
sampling expense in Canada and product development related consulting expense in
the U.S..





Sales
expense increased $691,523, or 28.4% (26.3% adjusted for exchange), in 2010
versus 2009. Expenses in Canada increased $93,348 (including a $50,442 increase
related to exchange) due to higher compensation and benefit costs, advanced
wound care related consulting expenses, sales volume related group purchasing
organization and travel expenses.  Expenses in the U. S. increased
$396,378. This increase is attributable to incremental costs of approximately
$342,000 consisting of compensation and benefits, travel and recruiting expenses
associated with the expansion of the advanced wound care sales force from ten to
twenty representatives that was completed in June 2010 and approximately
$124,000 of first aid products severance expense associated with the termination
of an executive in the first quarter 2010, partially offset by lower
administrative related operating expenses. Also contributing were incremental
international expenses of $201,797 consisting of compensation and benefits,
travel, recruiting and sample expenses associated with the start up of our
international growth initiative.





General
and administrative expense increased $613,292, or 18.0% (14.5% adjusted for
exchange), in 2010 versus 2009. Expenses in Canada increased $172,388 (including
a $117,950 increase related to exchange). Net of exchange, expenses were up
$54,438 driven principally by compensation and benefits associated with
inflationary increases and one new position, coupled with higher travel and
information technology expenses. Expenses in the U.S. increased $347,671. This
increase reflects incremental amortization expense of $148,587 associated with
the Worldwide Medihoney License Agreement signed in February 2010, higher
planned investor relations expenses of $104,258 designed to increase investor
awareness and improve our stock’s trading volume, bad debt expense of $67,354,
together with slightly higher overall operating expenses.  Incremental
international expenses of $93,233 consisting principally of transition related
management, legal and travel expenses associated with the start up of our
international growth initiative also contributed.





Research
and Development Expense





Research
and development expense increased $21,925 to $239,851 in 2010 from $217,926 in
2009. The increase principally reflects higher data management expense that
started in the second half of 2009, less lower patent related legal
expenses.





22


Interest
Expense





Interest
expense decreased $116,471 to $294,599 in 2010 from $411,070 in 2009. The
decrease is principally attributable to lower term and promissory note interest
associated with the payoff of these loans in February 2010, lower loan related
fees and lower deferred financing expense due to the write-off of a portion of
the outstanding deferred financing balance in connection with the payoff of the
term loan. These decreases were partially offset by higher line of credit
interest principally attributable to higher interest rates.





Loss
on Extinguishment of Debt





In
connection with the payoff of our term loan in February 2010, we took a charge
of $114,072 representing that portion of the unamortized deferred financing
costs relating to the term loan.





Other
Income





Other
income increased $134,342 to $178,131 in 2010 from $43,789 in 2009. The main
drivers for the net period to period increase was an exchange gain of $199,450
(2010 income of $162,910 versus a 2009 loss of $36,540), partially offset by the
non-recurrence of approximately $60,000 of gains on miscellaneous asset sales
principally associated with the closure of the first aid product manufacturing
operation





Income
Taxes





We
recorded a $137,652 foreign income tax provision for 2010 consisting of a
$176,644 current foreign tax provision and a $38,992 deferred foreign tax
benefit based on our Canadian subsidiary’s operating results. No tax benefit was
recorded for our U.S. operations in 2010 or 2009 due to uncertainty surrounding
our ability to use available net operating loss carry forwards and net deferred
tax assets.  In 2009, we recorded a $52,388 foreign income tax benefit
consisting of a $29,684 current tax benefit and a $22,704 deferred foreign tax
benefit based on our Canadian subsidiary’s operating results.





Due to
uncertainties surrounding our ability to use our 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.





Net
Loss





We
generated a net loss of $1,467,759, or $0.24 per share (basic and diluted), in
2010 compared to a net loss of $1,318,581, or $0.26 per share (basic and
diluted), in 2009.





Liquidity and Capital
Resources





Cash
Flow and Working Capital





At
June 30, 2010 and December 31, 2009, we had cash and cash equivalents of
$385,424 and $243,524, respectively. The $141,900 increase in cash reflects net
cash provided by financing activities of $4,282,586, partially offset by cash
used in investing activities of $2,389,236 and operating activities of
$1,750,140, together with cash used as a result of exchange rate changes of
$1,310.





Net cash
used in operating activities of $1,750,140 stems from $642,460
cash provided from operations (net loss plus non-cash items), together with
$2,392,600
cash used from the net change in operating assets and liabilities. The increase
in cash provided from operations reflects the non-cash items, partially offset
by the operating loss. Higher receivables and inventory, offset by accounts
payable and accrued liabilities, were the main drivers behind the net cash used
in connection with the change in operating assets and liabilities. The increase
in receivables reflects a higher level of sales in June, addition of receivables
related to the international business and the final payoff of rebates owed in
connection with the discontinuation of a significant rebate program. The
increase in inventory reflects a build up to support new products, addition of
the international business and to improve customer service levels in certain
segments of our business. The increase in accounts payable reflects an increase
in payables related to inventory purchases, addition of the international
business and higher overall spending levels. The increase in accrued expenses
and other current liabilities principally reflects higher Canadian rebates due
to higher sales, accrued foreign taxes payable and the recording of a severance
accrual.





23


Net cash
used in investing activities of $2,389,236 reflects $2,250,000 cash used to
purchase the worldwide Medihoney license rights and capital expenditures of
$139,236.





Net cash
used in financing activities of $4,282,586 reflects net proceeds of $4,491,279
from the sale of stock in connection with a secondary public offering completed
in February and the exercise of stock options, removal of the restriction on the
use of $2,032,164 in cash and $1,801,170 from an increase in the amount drawn
against our line of credit. Offsetting these increases were $4,042,027 in debt
payments consisting of regularly scheduled debt repayments, together with the
full payment of the balances of our term loan and our promissory
note.





Working
capital increased $2,473,301 at June 30, 2010 to $9,264,882 from $6,791,581 at
December 31, 2009. This increase principally reflects the cash infusion
associated with the equity raise completed in February, a portion of the
proceeds of which were used to pay off short term debt of $1,700,000, and the
net balance of $461,619 that was used for general working capital purposes.
Working capital of this magnitude is considered sufficient to support ongoing
operations





Based on
current forecasts, there are no Medihoney sales related milestone payments
anticipated in the next twelve months.





Financing
Arrangements





With cash
on hand of $385,424, together with available cash under our line of credit of
$2,125,247, we had $2,510,671 of available liquidity at June 30, 2009, versus
$2,342,579 at December 31, 2009





On
February 22, 2010, we raised $4,478,801 (net of commission and other offering
expenses) from the sale in a secondary public offering of shares of our common
stock. These proceeds, together with $2,032,818 of previously restricted cash,
were used to acquire the worldwide Medihoney licensing rights for $2,250,000,
pay off the outstanding U.S. term loan of $3,300,000 and pay off our $500,000
promissory note due April 14, 2010, leaving $461,619 of the net proceeds
available for general working capital purposes. Payment of the foregoing
indebtedness has had a positive impact on cash flow by eliminating associated
debt service





On March
26, 2010, our U.S. lender modified the terms of our five year revolving credit
and security agreement to take into account the payment of the term
loan.  The existing financial covenants were replaced with twelve
month rolling fixed charge coverage and total debt coverage covenants. The
lender also reduced the minimum 3 month LIBOR rate from 3.00% to 1.50% and
authorized the payment of our $500,000 unsecured promissory note, which was paid
on March 31, 2010. In addition, the minimum excess availability reserve was
reduced from $1,500,000 to $1,000,000, thereby increasing our borrowing
availability by $500,000 upon satisfactory completion of the lenders’ latest
field exam in May 2010.





Prospective
Assessment





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





The
launch of a number of new products in recent years bodes well for the future
growth of our higher-margined advanced wound care products both domestically and
abroad. We continue to work on our pipeline and have identified several product
line extensions for existing products and new products that are capable of
contributing to future sales growth. We believe that the first aid products line
continues to represent a solid growth opportunity. Sales for the balance of our
product lines are expected to remain relatively stable.





24


Our
strategy for growth is:




1.
              Assuming the existing resources
      in place are generating the expected return, we will continue to expand
      our investment in sales and marketing resources in support of our advanced
      wound care products in the U.S. Starting with ten sales representatives at
      the beginning of the year, we presently have twenty direct sales
      representatives in place.
 
 2.
              The first aid products business
      represents a growth opportunity. In addition to its core business
      opportunities, the first aid products business will serve as a platform
      for introducing our existing advanced and traditional wound care products
      to new customers and markets, especially the retail market. We continue to
      work on completion of a cost effective supply chain for first aid
      products. The supply chain is expected to be fully operational within the
      next six months, at which time we expect to be able to improve liquidity
      by reducing the level of inventory required to support the
      business.
 
 3.
              In February 2010, we licensed the
      worldwide rights to Medihoney. This will serve as the catalyst for the
      expansion of our international business. Plans are in place to establish a
      direct presence in Europe immediately and, ultimately, in other areas of
      the world employing a direct presence or distributor model as the basis
      for conducting business, as circumstances
  dictate.
  4.
              We made a significant investment in DSC 127 beginning in
      December 2007. While the launch of DSC 127 is several years away, we
      believe the market potential for this product is considerable. The product
      began Phase II trials in early 2008 to achieve proof of principle in a
      human model. The projected cost to complete the Phase II trial is
      approximately $1,750,000, including $1,292,735 incurred through June 2010.
      We plan to continue with this investment and anticipate spending
      approximately $457,265 to complete the Phase II trial.  We
      expect to announce top-line efficiency data by the end of the year and
      complete the study in the first quarter of
  2011.




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 we
decide to proceed with the DSC 127 development plan after completion of Phase
II, we plan to fund the additional development costs via a joint venture, out of
available cash flow or the sale of equity. Alternatively, we may determine to
sublicense or sell the rights to the compound.





With the
planned improvement in operations and expected working capital requirements,
together with the available cash on hand and available borrowing capacity as of
June 30, 2010, we anticipate having sufficient liquidity in place to meet our
operating needs and debt covenants for the foreseeable future.





Our
common stock is traded on the NASDAQ Capital Market under the symbol “DSCI.” We
have paid no cash dividends in respect of our common stock and do not intend to
pay cash dividends in the near future.





Additional Financial
Information





Forward
Looking Statements





Statements
that are not historical facts, including statements about our 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.





25


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 us, there may also be other
reasonable estimates or assumptions. We believe, 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. Our most
critical accounting policies are described below.





Revenue
Recognition and Adjustments to Revenue





We sell
our products through our own direct sales force and through independent
distributors and manufacturers’ representatives. The primary end users of our
products are nursing homes, hospitals, clinics and home healthcare agencies. We
recognize revenue from the sale of our products when persuasive evidence of an
arrangement exists, delivery has occurred, the sales price is fixed and
determinable, and collectability is reasonably assured, which is generally at
the time of shipment or receipt by our customers, depending on the terms of the
related sales or distribution agreement. When we recognize revenue from the sale
of our products, we simultaneously adjust revenue for estimated trade rebates
and distribution fees (in Canada), and estimates of returns and allowances, cash
discounts and other sales incentives.





A trade
rebate represents the difference between the invoice price to the
wholesaler/distributor and the end user’s contract price. These rebates are
estimated monthly based on historical experience, distributor rebate submission
trends, estimated distributor inventory levels, and existing contract sales
terms with our distributors and end users. We have a contract with our exclusive
Canadian distributor and we pay a fixed fee based on sales subject to the fee
(as defined) for distribution services in Canada. Because the services performed
by the distributor cannot be separated from the purchase of our products by the
distributor, we treat this distribution fee as a reduction of revenue. The
distribution fee is accrued monthly based on net sales to the distributor
multiplied by the ratio of recent historical distributor fee expense to net
sales. The percentage of distributor fee expense to net sales is re-evaluated
quarterly for reasonableness.





Sales
incentives represent credits granted to specific customers based on attainment
of pre-determined sales objectives. Sales incentives are accrued monthly in
accordance with the terms of the underlying sales incentive agreement and actual
customer sales. Sales incentive agreements are generally for a period of one
year.





We
provide our customers certain limited return rights and we have a formal
returned goods policy that guides the disposition of returns with our customers.
We accrue for sales returns and allowances and cash discounts monthly based on
current sales and historical activity. We do not offer our customers price
protection rights or concessions. Returns have historically represented less
than 1% of gross sales.





We
continually monitor the factors that influence rebates and fees, returns and
allowances, and other discounts and sales incentives and make adjustments as
necessary.





Goodwill





At June
30, 2010, we had $7,119,726 of goodwill consisting of $4,679,684 relating to the
First Aid Products acquisition in November 2007 and $2,440,042 relating to the
Western Medical acquisition in April 2006. We assess the impairment of goodwill
annually in the fourth quarter or whenever events or changes in circumstances
indicate that the carrying value of goodwill may not be recoverable. The
assessment is performed using the two-step process required by FASB accounting
guidance relating to goodwill. The first step is a review for potential
impairment, while the second step measures the amount of the impairment, if any.
The first step of the goodwill impairment test compares the fair value of a
reporting unit with its carrying amount, including goodwill. For 2009 and 2008,
the first step of our goodwill impairment test reflected a fair value in excess
of the carrying value of our reporting units. Accordingly, we did not perform
the second step of this test during these periods.





The cash
generating unit level or reporting unit at which we test goodwill for impairment
is the operating segment level as that term is used in FASB accounting guidance
relating to segment reporting. We have three operating segments: wound care,
wound closure – specialty securement devices and skin care. Products are
allocated to each segment based on the nature and intended use of the product.
All of our goodwill has been allocated to the wound care segment as the business
acquisitions which gave rise to the goodwill were wound care
businesses.





26


For 2009
and 2008 and consistent with prior periods, we estimated the fair value of our
wound care segment using the “income approach” where we use a discounted cash
flow model (“DCF”) in preparing our goodwill impairment
assessment.  This approach calculates fair value by estimating the
after-tax cash flows attributable to a reporting unit and then discounting these
after-tax cash flows to a present value using a risk-adjusted discount
rate.  We selected this method as being the most meaningful in
preparing our goodwill assessments because we believe the income approach most
appropriately measures our income producing assets.





Significant
estimates used in the fair value calculation include: (i) estimates of future
revenue and expense growth, (ii) future estimated effective tax rates, (iii)
future estimated capital expenditures, (iv) future required investments in
working capital, (v) average cost of capital, and (vi) the terminal value of the
reporting unit.





The
amount and timing of future cash flows within our DCF analysis is based on our
five year forecast.   Beyond our five year forecast we assumed a
terminal value to calculate the value of cash flows beyond the last projected
period in our DCF analysis.  Annual revenue growth rates in our DCF
model reflect expected growth in our advanced wound care products as well as
growth in the products which we gained access to when we acquired First Aid
Products in November of 2007 as we introduce these products across our existing
customer base.  The weighted average cost of capital used to discount
cash flows for the annual 2009 goodwill impairment test was estimated to be
17%.





Over
time, our wound care segment has become an increasingly significant portion of
our overall business. For the year ended December 31, 2009, our wound care
segment accounted for approximately 95% of our consolidated revenue. Given the
significance of this segment to our overall results, we also look to our
publicly traded market value, which we may adjust in consideration of an
appropriate control premium, as an indicator of the fair value of our wound care
segment and the reasonableness of our DCF model.





There
have been no substantial changes to the methodology employed, significant
assumptions or calculations applied in the first step of the goodwill impairment
test over the past several years.





Inventory





We write
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





We record compensation expense
associated with stock options and other equity-based compensation based on their
fair value at the grant date and recognized over the requisite service
periods.  We estimate the fair value of stock options as of the date
of grant using the Black-Scholes for service and performance based awards or
binomial/lattice pricing model for market based awards and restricted stock
based on the quoted market price.  Significant judgment and the use of
estimates to value the 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, are made by the Company.




27


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 June 30, 2010.  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 six months ended June 30,
2010, 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


PART
II – OTHER INFORMATION





Item
1A.  Risk Factors





The following risk factors update the
related risk factors set forth in the Company’s annual report on Form 10-K filed
with the Securities and Exchange Commission:





We
have a history of losses and can offer no assurance of future
profitability.





We
incurred losses of $1,467,759 for the six months ended June 30, 2010
(unaudited), $1,143,272 in 2009, $3,961,937 in 2008, $2,284,605 in 2007,
$1,099,990 in 2005 and $2,338,693 in 2004. At June 30, 2010, we had an
accumulated deficit of $22,274,854 (unaudited). We cannot offer any assurance
that we will be able to generate sustained or significant future
earnings.





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





Up to
3,322,350 shares of our common stock are potentially issuable upon the
conversion, exercise or vesting of outstanding convertible preferred stock,
warrants and options (“dilutive securities”). The shares of common stock
potentially issuable upon conversion, exercise or vesting of dilutive securities
are substantial compared to the 6,561,826 shares of common stock currently
outstanding.





Earnings
per share of common stock may 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 our common stock.





Our
stock price has been volatile and this volatility is likely to
continue.





Historically,
the market price of our common stock has been volatile. The high and low stock
prices for the years 2005 through 2009 and the first six months of 2010 are set
forth in the table below:





Derma
Sciences, Inc.


Trading
Range – Common Stock





Year
                  
                  Low
                  
                  
                  High2005
                  
                  $
                  3.36
                  
                  
                  $
                  6.242006
                  
                  $
                  3.60
                  
                  
                  $
                  7.202007
                  
                  $
                  4.64
                  
                  
                  $
                  11.202008
                  
                  $
                  1.60
                  
                  
                  $
                  10.802009
                  
                  $
                  1.92
                  
                  
                  $
                  6.802010
      *
                  
                  $
                  4.67
                  
                  
                  $
                  9.00





(*)
January 1 through June 30.





Events
that may affect our common stock price include:





•
            Quarter to quarter variations in
      our 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 industry;


•
            Fluctuations in stock market
      prices and trading volumes of similar
  companies;


•
              Discussion
      of us or our stock price by the financial and scientific press and in
      online investorcommunities;


•
            Additions or departures of key
      personnel;


•
            Changes in third party
      reimbursement policies;


•
            The introduction of new products
      either by us or by our competitors;
and




29




•
            The loss of a major
      customer.





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





Item
6.  Exhibits





All
exhibits required by Item 601 of Regulation S-K and required hereunder, as filed
with the Securities and Exchange Commission in Form 10-K on March 31, 2010, are
incorporated herein by reference.





Exhibit
                  
                  Description31.1
                  
                  Certification
      of the Principal Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200231.2
                  
                  Certification
      of the Principal Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 200232.1
                  
                  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
      200232.2
                  
                  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 caused this report to be
signed on its behalf by the undersigned thereunto duly authorized.




DERMA
      SCIENCES, INC.Dated:  August
      12, 2010
              By:
              /s/ John E.
    YetterJohn
      E. Yetter, CPAChief
      Financial Officer




30