**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**





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




**FOR
      THE FISCAL YEAR ENDED DECEMBER 30, 2006**




**or**




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




**Commission
      File No. 1-15445**





**FAMILYMEDS
      GROUP, INC.**


**(Name
      of registrant as specified in its charter)**





**STATE
                OF NEVADA**
            
            **34-1755390****(State
                or other jurisdiction of**
              **incorporation
                or organization)**
            
            **(IRS
                Employer**
              **Identification
                No.)****312
                Farmington Avenue**
              **Farmington,
                CT**
            
            **06032-1968****(Address
                of Principal Executive Officers)**
            
            **(Zip
                Code)**




**Issuer’s
      telephone number: (860) 676-1222**





**Securities
      registered pursuant to Section 12(b) of the Exchange Act: None.**


**Securities
      registered pursuant to Section 12(g) of the Exchange Act:**


**Common
      Stock, Par value $.001 per share**


**(Title
      of Class)**





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act.  Yes o  No x





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act. Yes o No x





Indicate
      by check mark whether the issuer (1) filed all reports required to be filed
      by
      Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the past
      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 o





Indicate
      by check mark if disclosure of delinquent filers in response to Item 405 of
      Regulation S-B is not contained herein, and no disclosure will be contained,
      to
      the best of registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-K or any
      amendment to this Form 10-K. x





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):




Large
      accelerated filer o  Accelerated
      filer o  Non-accelerated
      filer x




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





The
      aggregate market value of the Common Stock, $.001 par value, held by
      non-affiliates of the Registrant based upon the last price at which the common
      stock was sold as of the last business day of the Registrant’s most recently
      completed second fiscal quarter, July 1, 2006, as reported on the NASDAQ Capital
      Market was approximately $15,777,486. Shares of Common Stock held by each
      officer and director and by each person who owns 5% or more of the outstanding
      Common Stock have been excluded in that such persons may be deemed to be
      affiliates. This determination of affiliate status is not necessarily a
      conclusive determination for other purposes.





The
      number of shares outstanding of common stock as of April 10, 2007 was 6,962,821.





**DOCUMENTS
      INCORPORATED BY REFERENCE**




Portions
      of the Registrant’s Form 10-K/A, which Familymeds Group, Inc. expects to file on
      or before April 30, 2006, are incorporated by reference in Part III, Items
      10-14
      of this Form 10-K. Except with respect to information specifically incorporated
      by reference in this Form 10-K, the Form 10-K/A is not deemed to be
      filed as a part hereof.





**CAUTIONARY
      STATEMENTS**




This
      Form
      10-K contains forward-looking statements within the meaning of the Private
      Securities Litigation Reform Act of 1995. Familymeds bases these forward-looking
      statements on its expectations and projections about future events, which
      Familymeds has derived from the information currently available to it. In
      addition, from time to time, Familymeds or its representatives may make
      forward-looking statements orally or in writing. Furthermore, forward-looking
      statements may be included in Familymeds’ filings with the United States
      Securities and Exchange Commission or press releases or oral statements made
      by
      or with the approval of one of Familymeds’ executive officers. For each of these
      forward-looking statements, Familymeds claims the protection of the safe harbor
      for forward-looking statements contained in the Private Securities Litigation
      Reform Act of 1995. These forward-looking statements relate to future events
      or
      Familymeds’ future performance, including but not limited to:




·
            expected
                closing and timing of the closing of Familymeds’ anticipated asset sales
                and liquidation;




·
            expected
                cash to be received from the asset sales and cash to be disbursed
                to
                settle our obligations and liabilities, both known and
                unknown;




·
            expected
                cash distributions to shareholders amounts and the timing of these
                distributions;




·
            expected
                expenses in connection with the asset sales and the
                liquidation;




·
            possible
                or assumed future results of operations;
                and




·
            future
                revenue and earnings.




Forward-looking
      statements are those that are not historical in nature, particularly those
      that
      use terminology such as may, could, will, should, likely, expects, anticipates,
      contemplates, estimates, believes, plans, projected, predicts, potential or
      continue or the negative of these or similar terms. The statements contained
      in
      this Form 10-K that are not purely historical are forward-looking statements
      within the meaning of Section 27A of the Securities Act of 1933, as
      amended, and Section 21E of the Securities Exchange Act of 1934, as
      amended, including statements regarding Familymeds’ expectations, beliefs,
      intentions or strategies regarding the future. Forward-looking statements are
      subject to certain known and unknown risks and uncertainties that could cause
      actual results to differ materially from those expressed in any forward-looking
      statements. These risks and uncertainties include, but are not limited to,
      the
      following important factors with respect to Familymeds:




·
            the
                satisfaction of conditions to complete the asset sales, regulatory
                approvals and third party consents;




·
            the
                amount of costs, fees and expenses related to the asset sales, interim
                operations, sales of the other remaining assets, and subsequent
                liquidation and dissolution of
                Familymeds;




·
            the
                uncertainty of general business and economic
                conditions;




·
            the
                amount to be recovered for inventories and other assets and the amount
                collected from accounts receivable and the amount paid to settle
                our
                obligations and liabilities;




·
            the
                loss of key personnel including
                pharmacists;




2




·
            the
                impact of competition, both expected and
                unexpected;




·
            adverse
                developments, outcomes and expenses in legal proceedings; and




·
            other
                risk factors as further described in this Form
                10-K.




Forward-looking
      statements are only predictions as of the date they are made and are not
      guarantees of performance. All forward-looking statements included in this
      document are based on information available to Familymeds on the date of this
      Form 10-K. Readers are cautioned not to place undue reliance on forward-looking
      statements. The forward-looking events discussed in this Form 10-K and other
      statements made from time to time by Familymeds or its representatives may
      not
      occur, and actual events and results may differ materially and are subject
      to
      risks, uncertainties and assumptions about Familymeds including without
      limitation those discussed elsewhere in this Form 10-K and the risks discussed
      in our United States Securities and Exchange Commission filings. Except for
      its
      ongoing obligations to disclose material information as required by the federal
      securities laws, Familymeds is not obligated to publicly update or revise any
      forward-looking statement, whether as a result of new information, future events
      or otherwise.


3


**TABLE
      OF CONTENTS**




**ITEM**
            
            
            **PAGE****PART
                I**
            
            51.
            Business
            
            51A.
            Risk
                Factors
            
            181B.
            Unresolved
                Staff Comments
            
            222.
            Properties
            
            223.
            Legal
                Proceedings
            
            234.
            Submission
                of Matters to a Vote of Security Holders
            
            24**PART
                II**
            
            255.
            Market
                for Registrant’s Common Equity, Related Shareholder Matters and Issuer
                Purchases of Equity Securities
            
            256.
            Selected
                Financial Data
            
            257.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            
            287A.
            Quantitative
                and Qualitative Disclosures About Market Risks
            
            428.
            Financial
                Statements and Supplemental Data
            
            F-19.
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure
            
            439A.
            Controls
                and Procedures
            
            439B
            Other
                Information
            
            44**PART
                III**
            
            4510.
            Directors
                and Executive Officers of the Registrant
            
            4511.
            Executive
                Compensation
            
            4512.
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Shareholder Matters
            
            4513.
            Certain
                Relationships and Related Transactions
            
            4514.
            Principal
                Accountant Fees and Services
            
            45**PART
                IV**
            
            4615.
            Exhibits,
                Financial Statement Schedule, and Reports on Form 8-K
            
            46Signatures
            
            52Certifications




4


**PART
      I**





**Item
      1. BUSINESS.**





***Recent
      Developments - Plan of Liquidation***





On
      February 7, 2007, our Board of Directors approved the sale of a majority of
      our
      pharmacy assets (the “Asset Sale”) to Walgreen Co., an Illinois corporation, and
      Walgreen Eastern Co., Inc., a New York corporation (collectively, “Walgreens”)
      and a related plan of complete liquidation and dissolution of the Company (the
      “Plan of Complete Liquidation and Dissolution”) based upon a review of our past
      performance, projected future growth, ongoing liquidity constraints, vendor
      relations, industry outlook, and strategic alternatives. At a special meeting
      of
      shareholders held on March 30, 2007, our shareholders ratified the sale of
      a
      majority of our pharmacy assets and the Plan of Complete Liquidation and
      Dissolution.





Pursuant
      to the Plan of Complete Liquidation and Dissolution, as approved by our
      shareholders, our Board of Directors, without further action by our
      shareholders, may:




·
            dissolve
                the Company;




·
            liquidate
                our assets;




·
            pay,
                or provide for the payment of, any remaining, legally enforceable
                obligations of the Company; and




·
            distribute
                any remaining assets to our
                shareholders.





Since
      the
      approval of the Plan of Complete Liquidation and Dissolution by our shareholders
      on March 30, 2007, we have begun implementing the plan by attempting to sell
      our
      assets and satisfy our obligations. Among other things, on April 4, 2007, we
      began to the process of closing the Asset Sale to Walgreens. The Asset Sale
      to
      Walgreens will be completed on a staggered basis. The closing of the sale of
      all
      of the assets to Walgreens is expected to be completed by the end the second
      quarter of 2007.





Pursuant
      to our Asset Purchase Agreement with Walgreens, dated February 14, 2007, we
      will, subject to certain terms and conditions, sell up to 53 of our locations
      and related assets to Walgreens. Of the 53 locations, 33 of the clinic and
      Worksite locations will remain open and continue to operate in place. As
      consideration for this sale, Walgreens will assume only certain of our
      liabilities, including certain automobile and real estate leases, and will
      pay
      us approximately $43.0 million for pharmacy assets, in addition to amounts
      for
      customer accounts receivable and inventories related to those locations, subject
      to certain adjustments.. Up to $3.0 million of the cash proceeds will be placed
      in escrow for up to one year to satisfy our post-closing indemnification
      obligations, if any.





In
      connection with the Asset Sale, Wells Fargo Retail Finance, LLC, as agent for
      the revolving credit lenders pursuant to the Loan and Security Agreement dated
      as of October 12, 2005 (as amended, modified, supplemented or restated and
      in
      effect from time to time, the “Loan Agreement”) among (i) Familymeds Group, Inc.
      (f/k/a Drugmax, Inc.), as Lead Borrower, (ii) the other Borrowers party thereto
      from time to time, (iii) the Revolving Credit Lenders party thereto from time
      to
      time, (iv) and Wells Fargo, has consented to the Asset Sale and the consummation
      of the sale, subject to various terms and conditions. Among those conditions,
      we
      agreed that all proceeds received by us from the sale shall be paid to Wells
      Fargo for application to the credit facility until all amounts due under the
      facility are paid in full and the Loan Agreement is terminated. Each such
      payment of proceeds applied to the credit facility shall permanently reduce
      the
      commitments in the amount of such payment.





We
      intend
      to sell our remaining assets to several other national and regional pharmacy
      operators. We also have begun this process. During the first quarter of 2007,
      we
      sold 10 underperforming pharmacy locations.  In addition, we have a signed
      letter of intent to sell or assign 6-8 additional locations which we expect
      will
      also close during the second quarter of 2007.




5




Additionally,
      we have begun to satisfy certain of our obligations and we have begun to reduce
      our credit facility with Wells Fargo from the proceeds received from the Asset
      Sale.





Once
      the
      liquidation process is completed, we estimate that the aggregate amount of
      cash
      distributions to our shareholders may be in the range of $2.35 to $2.55 per
      share of Familymeds common stock. However, uncertainties as to the precise
      net
      value of our assets, the ultimate amount of our liabilities, the amount of
      operating costs during this process and the related timing to complete such
      transactions make it impossible to predict with certainty the actual net cash
      amount that will ultimately be available for distribution to our shareholders
      or
      the timing of any such distribution. See “Risk Factors.”





In
      connection with the Plan of Liquidation and Dissolution, once the Asset Sale
      is
      completed, we intend to file a certificate of dissolution with the State of
      Nevada, dissolving the Company. Pursuant to Nevada law, we will continue to
      exist for two years after the dissolution becomes effective or for such longer
      period as the Nevada courts shall direct, for the purpose of prosecuting and
      defending suits against us and enabling us gradually to close our business,
      to
      dispose of our property, to discharge our liabilities and to distribute to
      our
      shareholders any remaining assets. See “Risk Factors.”





Additionally,
      we intend to close our stock transfer books and discontinue recording transfers
      of our common stock at the close of business on the date we file the certificate
      of dissolution with the Nevada Secretary of State, which we refer to as the
      “final record date.” Thereafter, certificates representing our common stock will
      not be assignable or transferable on our books except by will, intestate
      succession or operation of law. The proportionate interests of all of our
      shareholders will be fixed on the basis of their respective stock holdings
      at
      the close of business on the final record date, and, after the final record
      date, any distributions made by us will be made solely to the shareholders
      of
      record at the close of business on the final record date, except as may be
      necessary to reflect subsequent transfers recorded on our books as a result
      of
      any assignments by will, intestate succession or operation of law. See “Risk
      Factors.”





***General
      Description of the Business***





Familymeds
      Group, Inc. (“Familymeds,” the “Company,” or “we” and other similar pronouns) is
      a pharmacy and drug distribution provider formed by the merger on November
      12,
      2004 of DrugMax, Inc. and Familymeds Group, Inc.  Familymeds Group, Inc.
      was formerly known as DrugMax, Inc. and on July 10, 2006, the Company amended
      its Articles of Incorporation to change its name from DrugMax, Inc. to
      Familymeds Group, Inc. As of December 30, 2006, we operated 77 Company-owned
      locations including 74 pharmacies, one health and beauty location, one
      non-pharmacy mail order center, and a drug distribution business primarily
      focused on the direct distribution of specialty pharmaceuticals to physicians,
      medical clinics and other health care providers known as Familymeds Medical
      Supply.  The Company also franchises 7 pharmacies.  During the first
      quarter of 2007, we have sold 10 underperforming pharmacy locations and we
      expect to sell 53 additional locations by the end of the second quarter of
      2007
      pursuant to a signed asset purchase agreement.  In addition, we have a
      signed letter of intent to sell or assign 6-8 additional locations which we
      expect will also close during the second quarter of 2007.  Our pharmacies
      are located in 13 states and operate under the Familymeds Pharmacy, Arrow
      Pharmacy & Nutrition Center, and Worksite Pharmacy SM brand
      names.




As
      of
      December 30, 2006, the Company had a net shareholders’ deficit of $14.3 million
      and had incurred net losses of $7.2 million, $54.9 million and $39.8 million
      for
      the years ended December 30, 2006, December 31, 2005, and January 1, 2005,
      respectively.




We
      are
      incorporated in the state of Nevada and our corporate offices are located at
      312
      Farmington Avenue, Farmington, CT 06032, telephone (860) 676-1222.





On
      January 17, 2007, Familymeds received a letter from The NASDAQ Stock Market
      notifying Familymeds that NASDAQ had determined to delist Familymeds’ shares of
      common stock from the NASDAQ Capital Market effective as of the open of business
      on January 18, 2007 as a result of Familymeds failure to maintain compliance
      with 4310(c)(2)(B) (the requirement to maintain a minimum shareholders
      equity, market value of listed securities, or net income from continuing
      operations).




6




On
      January 18, 2007, Familymeds’ common stock began being quoted on the
      Over-the-Counter Bulletin Board, which we refer to as the “OTC Bulletin Board,”
under the symbol “FMRX.OB.” The OTC Bulletin Board is a regulated quotation
      service that displays real-time quotes, last-sale prices and volume information
      in over-the-counter equity securities. As a result of our common stock being
      delisted from the Nasdaq Capital Market, your ability to resell your shares
      of
      our common stock could be adversely affected.




General
      information, financial news releases and filings with the United States
      Securities and Exchange Commission, including annual and quarterly reports
      on
      Forms 10-K and 10-Q, current reports on Form 8-K, and all amendments to these
      reports are available free of charge on our website at www.Familymedsgroup.com or www.sec.gov .





***Background
      and Reason for the Asset Sale***





During
      the past two years, we have taken significant steps to improve our operating
      results, reduce costs and improve our financial performance. These include
      the
      sale of common stock for net proceeds of $47.4 million, the redemption of all
      of
      its outstanding Series A Preferred Stock, the refinancing of the senior credit
      facility with a new $65.0 million facility, which allowed for additional
      borrowing availability, and the sale and discontinuation of a majority of our
      full-line wholesale drug distribution operations, which had incurred significant
      losses.




Further,
      during the second quarter of 2006, we entered into a Note and Warrant Purchase
      Agreement and certain other agreements described below, each effective as of
      June 23, 2006, with Deerfield Special Situations Fund, L.P. and Deerfield
      Special Situations Fund International, Limited (collectively, “Deerfield”),
      pursuant to which Deerfield purchased two secured promissory notes in the
      aggregate principal amount of $10.0 million (one note in the principal amount
      of
      $3.3 million and the second note in the amount of $6.7 million, collectively
      the
“Notes”) and eight warrants to purchase an aggregate of 1.65 million shares of
      our common stock (the “Warrants”), for an aggregate purchase price of $10.0
      million.  The $10.0 million purchase price for the Notes and Warrants was
      used entirely for an early repayment, settlement and termination of
      approximately $23.0 million in outstanding subordinated debt and accrued unpaid
      interest with our former supplier AmerisourceBergen Drug
      Corporation.




Also
      during the third and fourth quarters of 2006, we closed or sold underperforming
      stores and continued to evaluate our ongoing operations to improve
      results.  Despite these efforts, we continued to experience a reduction in
      gross margins due to the increased number of participants enrolled in Medicare
      Part D plans and the increased pressure by other third parties to reduce
      prescription reimbursement rates.   We anticipate that this trend
      coupled with the announcement that reimbursement for generic prescriptions
      paid
      for by state Medicaid agencies would soon be determined as a percentage of
      Average Manufacturer’s Price or “AMP” will result in further decreases in gross
      margin.





Further,
      the introduction of Medicare Part D in 2006 and the resulting decrease in cash
      paying customers has negatively impacted our cash flow.  Our largest
      suppliers typically require payment 7 days from the date of purchase; however,
      payment from Medicare Part D providers and other third party payors is typically
      received on a 14 to 30 day basis.  As more of our customers continue to
      enroll in managed care plans such as Medicare Part D, we will continue to
      experience a decline in our liquidity.




These
      negative pressures on gross margin coupled with the increasing demand for
      pharmacists, rising salary requirements, increasing health care costs and
      professional liability insurance costs, will continue to negatively impact
      our
      ability to become profitable.




7




During
      the 2nd half of 2006, we implemented selling and general administrative expense
      reduction measures, including a workforce reduction of 33 employees at our
      headquarters in Farmington, Connecticut in July 2006, directed at reducing
      costs
      and improving overall liquidity.




In
      addition, during the second, third and fourth quarters of 2006, we also
      contacted various banking and investment firms in an effort to improve
      liquidity, provide capital for growth and improve financial results either
      through a private investment in a public equity (“PIPE”), the refinancing of the
      current credit facility or through a subordinated tranche B type loan. 
These financing alternatives were determined to be very expensive and highly
      dilutive to our current shareholders.




Further,
      the continued gross margin pressure on prescription drug sales, among other
      factors, has created a more urgent need for a larger scaled enterprise for
      our
      clinic and Worksite Pharmacy business model. We exhaustively sought new capital;
      however, such financing opportunities were highly dilutive.




Familymeds
      strategic plan has been to seek long term sustainable profits by increasing
      sales through organic growth, continued focus on same store sales growth and
      expansion of new pharmacies in clinic and Worksite settings. However, in light
      of the factors noted above, the current competitive environment and our highly
      leveraged capital structure, the Board of Directors believed that we lacked
      the
      capital resources necessary in the long-term to compete effectively in our
      industry.  In an effort to maximize the value of the shareholders’
investment in the Company, the Board of Directors decided to examine certain
      financial and strategic alternatives to the Company remaining
      independent.




In
      October 2006, the Board of Directors retained JMP Securities LLC (“JMP
      Securities”) as its financial advisor to examine these alternatives and to
      contact certain potential strategic and financial partners with respect to
      a
      transaction with us.  With the Board of Directors frequent consultation and
      guidance throughout a process extending many months, management and JMP
      Securities considered a number of strategic alternatives for us and our
      business.  This included an analysis of the operating history and prospects
      for growth of the Company as a whole.




By
      December 2006, we received several written indications of interest and verbal
      expressions of continued interest.  The proposals were in the form of
      financing commitments, stock exchanges, and others in the form of asset
      purchases, including the proposal submitted by Walgreens.





The
      Board
      of Directors carefully considered each of the offers in light of the current
      industry issues, the ongoing liquidity issues and the strategic alternatives
      available to the Company.  The Board of Directors considered the value of
      each offer, the certainty of closure, the availability of financing to
      consummate the transaction, the currency offered and the value to
      shareholders.  After thorough discussions and extensive debate, the Board
      of Directors agreed to pursue the Walgreens offer.




On
      February 7, 2007, our Board of Directors approved the Asset Purchase Agreement
      and the Plan of Complete Liquidation and Dissolution of the Company.  Its
      decision was based on a review of our past performance, projected future growth,
      ongoing liquidity constraints, vendor relations, industry outlook, and strategic
      alternatives.




***Overview
      of the Asset Sale***





On
      February 14, 2007, Familymeds Group, Inc. together with its wholly owned
      subsidiaries Familymeds, Inc. and Arrow Prescription Corp., entered into an
      Asset Purchase Agreement with Walgreen Co., an Illinois corporation, Walgreen
      Eastern Co., Inc., a New York corporation (together with Walgreen Co.,
“Walgreens”), pursuant to which we will, subject to certain terms and
      conditions, sell up to 53 of our locations and related assets to Walgreens
      (the
“Asset Sale”). Of the 53 locations, 33 of the clinic and Worksite locations will
      remain open and continue to operate in place. As consideration for this sale,
      Walgreens will assume only certain of our liabilities, including certain
      automobile and certain real estate leases, and will pay us approximately $43.0
      million for pharmacy assets, in addition to amounts for customer accounts
      receivable and inventories related to those locations, subject to certain
      adjustments.




8




We
      intend
      to sell our remaining assets to several other national and regional pharmacy
      operators for cash and assumption of certain real estate leases, subject to
      closing physical inventory counts .





*Assets
      to be Sold*




The
      assets to be sold include all of Familymeds’ right, title and interest in, to
      and under the assets used to operate its pharmacy business (other than certain
      excluded assets described below), including:




·
            prescriptions,
                prescription files and records, customer lists and patient profiles,
                including refill status reports and insurance
                coverages;




·
            inventory;




·
            personal
                property, including furniture, fixtures, equipment, vehicles, leasehold
                improvements and signage;




·
            improvements,
                fixtures and other appurtenants located at any of the leased pharmacy
                locations, including any security deposits, rent credits and allowances
                paid;




·
            rights
                and interests in all other Familymeds’ pharmacy
                assets;




·
            permits
                and other similar governmental
                rights;




·
            copies
                of all books and records;




·
            intellectual
                property, including copyrights, patent rights, trademarks and trade
                secrets;




·
            certain
                assumed contracts;




·
            outstanding
                customer accounts receivable; and




·
            real
                property located in Tupelo,
                Mississippi.




The
      assets excluded from the Asset Sale are all cash, accounts receivable (other
      than with respect to customers), certain excluded contracts, employee benefit
      plans and programs, software and websites, corporate minute books, certain
      excluded inventory, and all tax refunds and credits. Additionally, if the
      Company fails to receive certain landlord or client consents, Walgreens may
      choose not to purchase the corresponding locations and the purchase price will
      be reduced accordingly.




*Liabilities
      to be Assumed*




As
      additional consideration for the assets to be sold, Walgreens has agreed to
      assume the obligations of Familymeds under certain assumed contracts, including
      certain automobile and certain real estate leases. However, Walgreens will
      not
      assume, nor be obligated to pay, perform or otherwise discharge any other
      liability or obligation of Familymeds.




9




*Purchase
      Price*




Pursuant
      to the Asset Purchase Agreement, Walgreens has agreed to pay us an aggregate
      estimated purchase price of $43.0 million plus the cost of inventory and
      customer accounts receivable which we estimate at approximately $17.0 million,
      for a total estimated purchase price of approximately $60.0 million. However,
      if
      the Company fails to receive certain landlord or client consents, Walgreens
      may
      choose not to purchase the corresponding locations and the purchase price will
      be reduced accordingly.





*Indemnification*




The
      Asset
      Purchase Agreement provides that the parties will indemnify each other for
      any
      losses and expenses incurred by, among other things, breaches of
      representations, warranties and covenants, subject to specified dollar and
      time
      limitations. To secure the Company’s indemnity obligations, the Asset Purchase
      Agreement provides that $3.0 million of the purchase price shall be placed
      into
      escrow until the earlier of one year from the closing date or the final
      distribution of assets to the Company’s shareholders or dissolution of
      Familymeds.





***Plan
      of Complete Liquidation and Dissolution***





The
      Board
      of Directors approved the proposed Plan of Complete Liquidation and Dissolution
      of the Company (referred to herein as the “Plan of Complete Liquidation and
      Dissolution”) on February 7, 2007, and our shareholders ratified the plan on
      March 30, 2007.





The
      Plan
      of Complete Liquidation and Dissolution provides that upon its approval by
      our
      shareholders, the Board of Directors, without further action by our
      shareholders, may:




·
            dissolve
                the Company;




·
            liquidate
                our assets;




·
            pay,
                or provide for the payment of, any remaining, legally enforceable
                obligations of the Company; and




·
            distribute
                any remaining assets to our
                shareholders.




We
      estimate that the aggregate amount of cash distributions to our shareholders
      upon the liquidation of the Company may be in the range of $2.35 to $2.55 per
      share of Familymeds common stock. However, uncertainties as to the precise
      net
      value of our assets, the ultimate amount of our liabilities, the amount of
      operating costs during this process and the related timing to complete such
      transactions make it impossible to predict with certainty the actual net cash
      amount that will ultimately be available for distribution to our shareholders
      or
      the timing of any such distribution. See “Risk Factors.”




***Prior
      Strategy***




Prior
      to
      the adoption of the Plan of Complete Liquidation and Dissolution, our strategy
      since the sale of substantially all of our full-line wholesale drug distribution
      business in December of 2005 has been to focus on our core business, which
      includes pharmacy operations, specialty sales, institutional sales, and direct
      distribution to physicians, medical clinics and other health care providers.
      Our
      primary strategy was to build an integrated specialty drug pharmacy platform
      with multiple sales channels including: clinic and apothecary pharmacies,
      Worksite Pharmacies SM ,
      institutional “closed door” type pharmacies, a central fill mail order based
      pharmacy and a pharmaceutical distribution center focused on medical specialty
      sales.




10




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





We
      offer
      a comprehensive selection of branded and generic prescription and
      non-prescription pharmaceuticals, specialty injectables, generic biologics,
      compounded medicines, healthcare-related products and diagnostic products.
      These
      products are used for the treatment of acute or chronic medical conditions
      and
      may be purchased through our platforms. Also, during 2006, we had placed
      significant emphasis on the injectable and orally administered specialty
      pharmaceuticals.





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





As
      of
      December 30, 2006, we operated 77 Company owned locations including 74
      pharmacies, one home health center, one health and beauty location and one
      non-pharmacy mail order center, in 13 states under the Familymeds Pharmacy,
      Arrow Pharmacy & Nutrition Center, and Worksite Pharmacy SM brand
      names. We had 43 pharmacies which were located at the point of care between
      physicians and patients, oftentimes inside medical office buildings or on a
      medical campus. The balance of our locations are usually nearby medical
      facilities though more retail accessible. The majority of our revenues from
      pharmacy operations come from the sale of prescription pharmaceuticals, which
      represented approximately 94% of our net revenues for the fiscal years ended
      December 30, 2006 and December 31, 2005, respectively. Our corporate pharmacies
      provide services to approximately 400,000 acute or chronically ill patients,
      many with complex specialty and medical product needs.




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





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




11




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





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




On
      January 2, 2007, our third Worksite Pharmacy opened to provide exclusive service
      to Toyota team members, participating on-site suppliers and their dependants.
      Under the contract with Toyota, Familymeds operates a full service pharmacy
      at
      the site of Toyota's newly constructed plant in San Antonio. The plant employs
      approximately 2,000 Toyota personnel.





***Medical
      Supply***





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





Revenues
      from this operation for the fiscal years ended December 30, 2006 and December
      31, 2005 were $11.9 million and $2.3 million, respectively.




***Patient
      Compliance***





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





***Medicare
      Part D***





As
      of
      January 1, 2006, Medicare beneficiaries had the opportunity to receive
      subsidized prescription drug coverage through the Medicare Part D program.
      The
      new drug benefit is delivered by competing plans, and our pharmacies have
      contracted with each of the major providers to ensure our customers can continue
      purchasing their prescriptions from our pharmacies. While the new Medicare
      drug
      benefit is entirely voluntary, we believe a significant portion of the Medicare
      population will enjoy this new benefit. During the fiscal year ended December
      30, 2006, net revenues from Medicare Part D prescriptions represented 19% of
      total prescription sales, respectively. The gross margin from this business
      is
      less than what the traditional prescription drug plans provide and the accounts
      receivable days outstanding is more than what the traditional prescription
      drug
      plans.




12


***Supply
      Chain Management***





Because
      of higher purchasing costs due to our inability to buy on a more credit worthy
      basis during fiscal year ended December 31, 2005, we began to experience a
      decrease in our ability to supply products to our customers and a decline in
      our
      gross margin.





McKesson
      Corporation and Familymeds Group, Inc. entered into a Supply Agreement effective
      as of December 28, 2006 and continuing for a term of 3 years. The Supply
      Agreement may be terminated prior to the 3 year term upon certain conditions
      including ninety (90) days written notice to the other party. Under the terms
      of
      the Supply Agreement, McKesson has agreed to continue as our primary supplier
      for prescription and non-prescription items. McKesson will continue to provide
      delivery to our locations up to 5 times per week and we will pay for such goods
      delivered 7 days from the date of invoice.





***Discontinued
      Operations***





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





The
      original lease (dated December 30, 2003) (the “Original Lease”) provided for a
      term of 15 years, expiring December 30, 2018, and monthly lease payments of
      $0.017 million.  When the Original Lease was executed, Becan and Valley
      North entered into a Consent, Subordination and Assumption Agreement (the
“Guarantee”) with the Pennsylvania Industrial Development Authority (“PIDA”) and
      Regional Industrial Development Corporation of Southwest Pennsylvania (“RIDC”)
      dated December 30, 2003, pursuant to which, among other things, Becan and Valley
      Drug Company (Valley North”), jointly and severally, assumed all obligations of
      RIDC to make payments and discharge all obligations expenses, costs and
      liabilities of RIDC in connection with the PIDA note (the “PIDA Note”). 
The PIDA Note is also secured by the Original Lease and the property.




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




13




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




Net
      revenues related to the discontinued operations were $0.0 million and $103.6
      million for the fiscal years ended December 30, 2006 and December 31, 2005,
      respectively.  During the third quarter 2006, we received notification of a
      tax assessment from a state tax authority relating to our discontinued
      operations.  We have accrued $0.2 million of estimated income taxes
      relating to this matter and is reflected as a component of discontinued
      operations. The loss from discontinued operations was $1.3 million and $33.0
      million the fiscal years ended December 30, 2006 and December 31, 2005,
      respectively.




**Industry
      Overview**





The
      pharmaceutical distribution industry faces numerous challenges and
      opportunities. While we expect significant growth in this segment of healthcare
      due to an aging population, the introduction of new pharmaceuticals, rising
      pharmaceutical prices, increased use of injectable drug therapies, and the
      expiration of patents for branded pharmaceuticals, we also face challenges
      due
      to changes in contracting practices, new Medicare and Medicaid regulations,
      and
      third party reimbursement issues.





Our
      industry has undergone significant changes driven by various efforts to reduce
      costs. These changes include changes to Medicare, Medicaid or similar government
      health benefit programs or the amounts paid by those programs for our services.
      The Medicare Modernization Act, or the MMA, includes a major expansion of the
      Medicare prescription drug benefit under new Medicare Part D. Beginning in
      2006,
      Medicare beneficiaries may enroll in prescription drug plans offered by private
      entities that will provide coverage of outpatient prescription drugs. The MMA
      changes Medicare’s payment methodology from a system based on average wholesale
      price, or AWP, to one based on average selling price, or ASP. As the ASP
      methodology of reimbursement is implemented, it may affect our current AWP
      based
      reimbursement structure with our private payors.





While
      we
      cannot predict the eventual results of these law changes, the effect of the
      MMA
      has been to reduce prices and gross margins on some of the drugs that we
      distribute. Further, if other third-party payors revise their pricing based
      on
      new methods of calculating the AWP, or based on ASP, this could have a material
      adverse affect on our business, financial condition and results of operation,
      by
      reducing the pricing and margins on certain of our products should we continue
      as a going concern.





**Credit
      Facility**





On
      October 12, 2005, we entered into a secured senior credit agreement with Wells
      Fargo Retail Finance, LLC (“WFRF”), which matures in October 2010. Available
      credit under this facility is based on eligible receivables, inventory and
      prescription files, as defined in the agreement. The $65.0 million of maximum
      availability is reduced by a $7.0 million minimum reserve. While the credit
      facility currently does not require compliance with financial covenants, we
      have
      the ability to reduce this minimum reserve by agreeing to implement certain
      financial covenants. As of December 30, 2006, $37.5 million was outstanding
      on
      the line and $0.6 million was available for additional borrowings. The Credit
      Facility is secured by substantially all of our assets.




In
      connection with the Asset Sale, Wells Fargo Retail Finance, LLC, as agent for
      the revolving credit lenders pursuant to the Loan and Security Agreement dated
      as of October 12, 2005 (as amended, modified, supplemented or restated and
      in
      effect from time to time, the “Loan Agreement”) among (i) Familymeds Group, Inc.
      (f/k/a Drugmax, Inc.), as Lead Borrower, (ii) the other Borrowers party thereto
      from time to time, (iii) the Revolving Credit Lenders party thereto from time
      to
      time, (iv) and Wells Fargo, has consented to the Asset Sale and the consummation
      of the sale, subject to various terms and conditions. Among those conditions,
      we
      agreed that all proceeds received by us from the sale shall be paid to Wells
      Fargo for application to the credit facility until all amounts due under the
      facility are paid in full and the Loan Agreement is terminated. Each such
      payment of proceeds applied to the credit facility shall permanently reduce
      the
      commitments in the amount of such payment.




14




**Competition**





The
      healthcare industry in which we operate is highly competitive. Our failure
      to
      compete effectively in this segment has adversely affected our business,
      financial condition and results of operations. Many of our competitors are
      offering similar products and services. Some of our competitors have greater
      resources than we have. These competitive pressures have a material adverse
      effect on our business, financial condition or results of
      operations.





We
      compete on the basis of breadth of our product lines, marketing programs,
      support services and pricing. Increased competition may result in price
      reductions, reduced gross margins and loss of market share. Competitors, many
      of
      which have significantly greater financial, technical, marketing and other
      resources, include:





·
            
            Chain
                drugstores including CVS, Rite Aid and Walgreen’s;·
            
            Mass
                marketers including Target and Wal-Mart;·
            
            Warehouse
                clubs including BJ’s, Costco and Sam’s Club;·
            
            Mail
                order prescription providers including Express Scripts and
                Medco;·
            
            Online
                drugstores including drugstore.com;·
            
            Specialty
                medication providers including Accredo Health and Priority Healthcare;
                and·
            
            Specialty
                pharmaceutical distributors including Florida Infusion Pharmacy,
                Allion
                Healthcare, Inc., and Bioscrip.





In
      addition, certain of our competitors have developed or may be able to develop
      e-commerce operations that compete with our pharmacy and e-commerce operations,
      and may be able to devote substantially more resources to web site development
      and systems development. The online commerce market is rapidly evolving and
      intensely competitive. We expect competition to intensify in the future because
      barriers to entry are minimal, and current and new competitors can launch new
      web sites at relatively low cost.





**Government
      Regulations and Legal Uncertainties**





We
      are
      subject to extensive federal, state and local licensing and registration laws
      and regulations with respect to our business, including our pharmacy and
      franchise operations and the pharmacists we employ. Regulations in these areas
      often involve subjective interpretation and we do not know if our attempts
      to
      comply with these regulations will be deemed sufficient by the appropriate
      regulatory agencies. We believe we have satisfied our licensing and registration
      requirements and continue to actively monitor our compliance with these
      requirements. However, violations of any of these regulations could result
      in
      various penalties, including suspension or revocation of our licenses or
      registrations, and seizure of our inventory or monetary fines, any of which
      could adversely affect our operations and damage our brand.





Our
      industry has undergone significant changes driven by various efforts to reduce
      costs. These changes include changes to Medicare, Medicaid or similar government
      health benefit programs or the amounts paid by those programs for our services.
      The Medicare Modernization Act, the MMA, includes a major expansion of the
      Medicare prescription drug benefit under new Medicare Part D. Medicare
      beneficiaries may enroll in prescription drug plans offered by private entities
      that will provide coverage of outpatient prescription drugs. The MMA changes
      Medicare’s payment methodology over the next three years from a system based on
      average wholesale price, or AWP, to one based on average selling price, or
      ASP.
      As the ASP methodology of reimbursement is implemented, it may affect our
      current AWP based reimbursement structure with our private payors.




15




We
      also
      are subject to requirements under the Controlled Substances Act and Federal
      Drug
      Enforcement Agency regulations, as well as state and local laws and regulations
      related to our pharmacy operations such as registration, security, record
      keeping and reporting requirements related to the purchase, storage and
      dispensing of controlled substances, prescription drugs and certain
      over-the-counter drugs. Under the Food, Drug & Cosmetic Act of 1938, the
      distribution of adulterated or misbranded homeopathic remedies or other drugs
      is
      prohibited. Violations could result in substantial fines and other monetary
      penalties, seizure of the misbranded or adulterated items, and/or criminal
      sanctions. We also are required to comply with the Dietary Supplement Health
      and
      Education Act when selling dietary supplements and vitamins.




In
      addition, our pharmacy compounding services are subject to FDA regulation.
      The
      FDA also regulates drug advertising and promotion, including direct-to-patient
      advertising, done by or on behalf of manufacturers and marketers. If we expand
      our product and service offerings, more of our products and services will likely
      be subject to Food and Drug Administration regulation. Failure to comply with
      these regulations could result in significant penalties which may be material.
      We also are subject to federal statutes and state legislation that prohibit
      the
      offer, payment, solicitation, or receipt of any remuneration directly or
      indirectly in exchange for, or intended to induce, the referral of patients
      or
      the sale or purchase of services and supplies covered by certain governmental
      programs (Anti-Kickback Laws). We also are subject to the Ethics in Patient
      Referrals Act of 1989, commonly referred to as “Stark Law,” which prohibits the
      billing of federally-funded health care programs for certain health care
      services provided by entities with which the referring physician has certain
      financial arrangements. Violations of these laws are punishable by civil
      sanctions, including significant monetary penalties and exclusion from
      participation in the Medicare and Medicaid programs, and criminal sanctions
      in
      the case of the Anti-Kickback Law. Due to the breadth and complexity of these
      laws, there can be no assurance that we, any of our personnel, or any of our
      significant customers or business partners, will not become subject to sanctions
      that could have a material adverse effect on our business, financial condition
      and results of operations. Additionally, the sanctioning or exclusion of a
      manufacturer or recipient of our products or services, even for activities
      unrelated to us, could also have a material adverse effect on our business,
      financial condition and results of operations.





Pursuant
      to the Omnibus Budget and Reconciliation Act of 1990 and similar state and
      local
      laws and regulations, our pharmacists are required to offer counseling to our
      customers about medication, dosage, delivery systems, common side effects,
      adverse effects or interactions and therapeutic contraindications, proper
      storage, prescription refill and other information deemed significant by our
      pharmacists. In the event that our pharmacists or our mail order and online
      pharmacies provide erroneous or misleading information to our customers, we
      may
      be subject to liability or negative publicity that could have an adverse impact
      on our business. Although we carry general, professional and product liability
      insurance, our insurance may not cover potential claims of this type or may
      not
      be adequate to protect us from all liability that may be imposed.





The
      Health Insurance Portability and Accountability Act of 1996, and regulations
      promulgated thereunder (collectively “HIPAA”), require health care providers,
      like us, to comply with specified standards for electronic billing and other
      transactions and to adopt and comply with policies and procedures to protect
      the
      security and privacy of an individual’s protected health information consistent
      with HIPAA requirements, and prohibit the use or dissemination of an
      individual’s protected health information without the individual’s consent.
      There are significant civil monetary and criminal penalties for failure to
      comply.





Although
      we do not offer franchises for sale at this time, in the case of renewing
      franchisees, we are subject to the disclosure requirements of the Federal Trade
      Commission and may be subject to pre-sale disclosure requirements and
      registration requirements of various state laws regulating the offer and sale
      of
      franchises. In addition, with respect to our existing franchisees, we also
      may
      be subject to certain state laws regulating the franchisor-franchisee
      relationship. Failure to comply with these regulations could result in
      substantial financial penalties. As of December 30, 2006, we held franchise
      agreements for seven stores and are not materially dependent on these
      agreements.




16




We
      also
      are subject to laws governing our relationship with employees, including minimum
      wage requirements, overtime and working conditions. Increases in the federal
      minimum wage rate, employee benefit costs or other costs associated with
      employees could adversely affect our results of operations. Other legislation
      being considered at the federal and state level could affect our business
      including state legislation related to the regulation of nonresident pharmacies.
      We believe we are currently in material compliance with the state and federal
      laws and regulations governing our business.





As
      a
      publicly traded company, we are subject to numerous federal securities laws
      and
      regulations. These laws include the Securities Act of 1933 and the Securities
      Exchange Act of 1934 and related rules and regulations promulgated by the SEC.
      These laws and regulations impose significant requirements in the areas of
      financial reporting, accounting practices, and corporate governance among
      others.





Recently,
      many states have passed or have proposed laws and regulations that are intended
      to protect the integrity of the supply channel. These laws and regulations
      may
      also restrict our ability to purchase drugs from alternate source supplier
      and
      are likely to increase the overall regulatory burden and costs associated with
      our drug distribution operations.




The
      costs
      associated with complying with various federal and state regulations could
      be
      significant and the failure to comply with any such legal requirements could
      have a significant impact on our business, results of operations and financial
      condition.





**Intellectual
      Property**





We
      hold
      various trademarks, trade names, service marks, patents and business licenses.
      These trademarks, service marks and licenses have varying statutory lives and
      are generally renewable indefinitely. Although we believe that our trademarks
      and other proprietary products do not infringe upon the intellectual property
      rights of any third parties, third parties may assert infringement claims
      against us from time to time.





**Employees**





At
      December 30, 2006, we employed 630 persons, which represent 471 full-time
      equivalents. Approximately 24% of our employees are pharmacists. Labor unions
      do
      not represent any of these employees. We believe our relationship with our
      employees is good.


17


**Item
      IA. RISK FACTORS**





An
      investment in our common stock involves a high degree of risk. You should
      consider carefully the following information about these risks, together with
      the other information contained or incorporated by reference in this Form 10-K,
      before you decide to invest. If any of the following risks actually occur,
      our
      business, financial condition or results of operations would likely suffer.
      In
      this case, the market price of our common stock could decline, and you could
      lose all or part of your investment.





***We
      have a history of losses. Our independent registered public accounting firm
      has
      issued an opinion with an explanatory paragraph discussing the substantial
      doubt
      about our ability to continue as a going concern.***





As
      of
      December 30, 2006, we had a net stockholders’ deficit of $14.3 million, had
      incurred net losses of $7.2 million, $54.9 million and $39.8 million for the
      years ended December 30, 2006, December 31, 2005, and January 1, 2005,
      respectively and in March 2007 our shareholders approved a Plan of Complete
      Liquidation and Dissolution of our Company.  The opinion from the
      independent registered public accounting firm on our consolidated financial
      statements as of December 30, 2006 and December 31, 2005 and for each of the
      three years in the period ended December 30, 2006 was modified with respect
      to
      the substantial doubt surrounding our ability to continue as a going
      concern.




***Claims
      related to the plan of liquidation could result in substantial costs and reduce
      our distributions to shareholders.***




Extraordinary
      corporate actions, such as our plan of liquidation, often are not entirely
      predictable and may lead to claims and lawsuits being filed against companies
      such as ours. We face the risk that claims might be brought against us by
      vendors, landlords, customers, employees or shareholders. Any such claim or
      litigation may be expensive and, even if we ultimately prevail, the process
      may
      divert management’s attention from implementing the plan of liquidation and the
      sale of our remaining assets. It is not possible to predict if any such claims
      or litigation will be filed against us or the amount attributable to such
      claims, if any.  Any liability would reduce our cash available for
      distribution and the ultimate amount of our liquidating distributions to holders
      of our common stock.




***Failure
      to complete the Asset Sale may seriously affect our liquidity and ability to
      continue as a going concern.***




The
      Board
      of Directors approved the Asset Sale and the Plan of Complete Liquidation in
      part because we believe that our existing cash and amounts available under
      our
      senior credit facility and cash generated from operating activities may not
      be
      sufficient to meet our vendor terms and anticipated cash needs for the next
      12
      months.




If
      we do
      not complete the Asset Sale, then we will be required to raise additional
      financing to continue funding our operations. If our capital resources are
      insufficient to satisfy our liquidity requirements, we may seek to sell
      additional equity securities or debt securities or obtain other debt financing.
      The sale of additional equity securities or convertible debt securities would
      result in additional dilution to our shareholders. Additional debt would result
      in increased expenses and could result in covenants that would restrict our
      operations. We have explored obtaining additional financing and there is no
      assurance that financing will be available in amounts or on terms acceptable
      to
      us, if at all.





In
      the
      absence of such financing, we may not able to service its debts and may be
      required to continue to scale back or terminate operations and/or seek
      protection under applicable United States bankruptcy laws.




18




***If
      our expectations regarding the conversion of our assets into cash are
      inaccurate, the amount we distribute to our shareholders may be
      reduced.***




The
      amount of cash we can distribute to shareholders depends, in part, on the amount
      of cash received from the liquidation of our assets. The ultimate amount that
      we
      receive is subject to uncertainties. While we have executed asset purchase
      agreements and letters of intent, the sales prices contemplated by those
      agreements and letters of intent are subject to adjustments based on various
      factors, including our ability to receive certain consents and to maintain
      current business operations. The sales prices also are conditioned on there
      being no material adverse effects relating to the pharmacy assets being sold.
      If
      a material adverse change should occur or we fail to satisfy a closing
      condition, we may not realize the estimated amounts related to the sale of
      our
      assets. Further, the letters of intent are generally non-binding and thus are
      still subject to change. Additionally, the ultimate cash distributed to
      shareholders is also subject to the following:





·
            The
                sale to Walgreens and others is based in part on the value of our
                inventory being sold. We have estimated the inventory value. These
                estimates may change depending on a number of factors including:
                the
                actual inventory value or mix on the date of closing, inventory price
                inflation or deflation during the interim period prior to closing,
                potential shrinkage of product during the interim period prior to
                closing,
                ongoing purchases and sales of inventory during the interim period
                prior
                to closing, and certain contractual exclusions, among other
                factors.




·
            The
                estimated $60.0 million purchase price for the Asset Sale is based
                on the
                assumption that we will obtain all required landlord and client consents.
                To the extent we cannot obtain such consents, Walgreens may choose
                not to
                purchase the corresponding locations and the purchase price will
                be
                reduced accordingly.




·
            When
                estimating the amount of cash to be distributed to shareholders,
                we have
                estimated the net realizable value of our accounts receivable that
                we
                expect to receive in cash from our customers, third party payors
                and
                others. These estimates may change depending on a number of factors
                including: the actual claims outstanding on the date of closing,
                increases
                or decreases in drug reimbursement rates during the interim period
                prior
                to closing, uncollectible accounts greater than our estimates, and
                ongoing
                sales and cash collections during the interim period prior to closing
                among other factors.




·
            We
                have estimated the net realizable value of the sale of our remaining
                assets, which include a number of assumptions and estimates including
                the
                actual sales price of the assets to be sold and liabilities to be
                assumed,
                if any. These estimated may prove to be
                inaccurate.




·
            The
                timing of the sales of our assets could have an impact on the actual
                cash
                proceeds we receive when these assets are sold and liabilities are
                assumed, if any.




***If
      our expectations regarding our liquidation expenses are inaccurate, the amount
      we distribute to our shareholders may be reduced.***




The
      amount of cash ultimately distributed to shareholders also depends on the
      ultimate amount of our liabilities and the amount of operating costs during
      the
      liquidation process. We have attempted to estimate such liabilities and costs.
      However, those estimated may be inaccurate. Factors that could impact our
      estimated include the following:




·
            If
                any of the estimates regarding our plan of liquidation, including
                our
                ability to settle our real estate, equipment and other leases, the
                recovery of our estimated asset amounts, and the settlement of our
                outstanding obligations during the liquidation process, are inaccurate,
                the amount we distribute to our shareholders may be reduced. For
                instance,
                if claims asserted against us are successful, we will have to pay
                these
                claims before making distributions to our
                shareholders.




·
            We
                have made certain estimates regarding the cost of personnel required
                and
                other operating costs necessary to liquidate and dissolve the Company,
                many of which could vary significantly and are dependent on the timing
                of
                closing of the Asset Sale and the sale of our remaining assets. If
                the
                timing differs from our plans, then we may incur additional costs
                above
                our current estimates and may distribute less in cash to our
                shareholders.




19




·
            We
                have assumed that most of the contract rights that we are attempting
                to
                sell will be effectively transferred. If we are unable to obtain
                any
                required consents with the counterparties to those contracts, our
                recoveries may be materially lower.




·
            We
                will remain subject to the reporting obligations of the Securities
                Exchange Act of 1934, as amended, which we refer to as the “Exchange Act,”
                after the completion of our dissolution. Although we intend to request
                relief from these obligations after the closing of the Asset Sale,
                we may
                not receive this relief. If we do not receive this relief, our liquidation
                expenses will be higher than we expect, which will reduce the amount
                we
                are able to distribute to our common
                shareholders.




·
            We
                are required to obtain certain third party consents and approvals
                as a
                condition to closing the Asset Sale. Currently, we do not expect
                that the
                cost of these consents and approvals will be significant. However,
                if our
                expectation is incorrect, the amount we distribute to our common
                shareholders may be reduced.




***Distributions
      to our common shareholders could be reduced if our expectations regarding
      liabilities and operating expenses are inaccurate.***




Claims,
      liabilities and expenses from operations (such as operating costs, salaries,
      directors’ and officers’ insurance, payroll and local taxes, insurance, payroll
      taxes, rent, utilities, claims processing fees, legal and accounting fees and
      miscellaneous office expenses) will continue to be incurred as we seek to close
      the Asset Sale and wind down operations. Any unexpected claims, liabilities
      or
      expenses or claims, liabilities or expenses that exceed our estimates or if
      the
      timing of the closing is longer than planned, could reduce the amount of cash
      available for ultimate distribution to common shareholders. If available cash
      and amounts received on the sale of a majority of our assets are not adequate
      to
      provide for our obligations, liabilities, expenses and claims, we may not be
      able to distribute any cash at all, to our common shareholders.




***Distributions
      to our common shareholders could be delayed from our planned time
      frames.***




All
      or a
      portion of the distribution could be delayed, depending on many factors,
      including the following:




·
            If
                lease conditions change, or if we become aware of other factors that
                we
                believe could affect our ability to discharge our real property lease
                obligations, we may be required to withhold additional amounts from
                our
                initial distribution until we are able to resolve these
                obligations.




·
            The
                Walgreens Asset Purchase Agreement requires that we escrow $3.0 million
                for a period of one year to satisfy any indemnification obligations
                under
                the Asset Purchase Agreement. Further, if Walgreens makes any claims
                under
                the indemnification provisions in the Asset Purchase Agreement, we
                could
                be required to continue to withhold up to $3.0 million from our final
                distribution to satisfy such claim, or higher amounts if the claim
                is
                based on fraud or intentional misrepresentations.




·
              At
                  the time of our initial distribution to common shareholders, we
                  will not
                  have all of the information we need to estimate our remaining Exchange
                  Act
                  filing obligation expenses accurately. Although we intend to request
                  relief from the SEC regarding these obligations, we will likely
                  not have
                  obtained this relief at the time of our initial
                  distribution.
  20


Additionally,
      a creditor could seek an injunction against the making of distributions to
      our
      shareholders on the ground that the amounts to be distributed were needed to
      provide for the payment of our liabilities and expenses. Any action of this
      type
      could delay or substantially diminish the amount available for distribution
      to
      our common shareholders. As a result of these and other factors, we may need
      to
      hold back, for distribution at a later date, if at all, some or all of the
      estimated amounts that we expect to distribute to common
      shareholders.




***Our
      assumptions regarding the federal and state tax consequences of the transaction
      may be inaccurate.***




The
      proposed Asset Sale will be a taxable transaction to us for United States
      federal income tax purposes and we will recognize a gain if the Asset Sale
      is
      completed. We do not believe, however, that there will be material tax payable
      by us, other than approximately $1.1 million of federal Alternative Minimum
      Tax
      (“AMT”) as a result of limitations on the use of net operating losses under AMT
      rules. We believe we have sufficient usable net operating losses to offset
      a
      majority of the income or gain recognized by us for “regular” federal income tax
      purposes as a result of the Asset Sale (i.e., other than AMT). We expect
      that our aggregate gain for federal income tax purposes related to the Asset
      Sale will be less than $55.0 million. Therefore, we will not set aside any
      material amounts of cash specifically for the payment of any tax liability,
      other than the $1.1 million AMT payment that we will make. However, there can
      be
      no assurance that the Internal Revenue Service or relevant state tax authorities
      will ultimately assent to our tax treatment of the Asset Sale or the net
      operating losses. To the extent the Internal Revenue Service or any relevant
      state tax authorities ultimately prevail in recharacterizing the tax treatment
      of the Asset Sale or the net operating losses, there may be adverse tax
      consequences to us and our shareholders, including that we could owe income
      taxes on up to the entire purchase price and our common shareholders would
      not
      receive any distributions or be required to return any distributions they have
      received.




***If
      we fail to create an adequate contingency reserve for payment of our expenses
      and liabilities, our shareholders could be held liable for payment to our
      creditors of each such shareholder’s pro rata share of amounts owed to creditors
      in excess of the contingency reserve, up to the amount actually distributed
      to
      such shareholder.***




We
      intend
      to file a certificate of dissolution with the State of Nevada, dissolving
      Familymeds. Pursuant to Nevada law, we will continue to exist for two years
      after the dissolution becomes effective or for such longer period as the Nevada
      courts shall direct, for the purpose of prosecuting and defending suits against
      us and enabling us gradually to close our business, to dispose of our property,
      to discharge our liabilities and to distribute to our shareholders any remaining
      assets. Under Nevada law, in the event we fail to create an adequate contingency
      reserve for payment of our expenses and liabilities during this two-year period,
      each shareholder could be held liable for payment to our creditors of such
      shareholder’s pro rata share of amounts owed to creditors in excess of the
      contingency reserve, up to the amount actually distributed to such
      shareholder.




However,
      the liability of any shareholder would be limited to the amounts previously
      received by such shareholder from us (and from any liquidating trust or trusts)
      in the dissolution. Accordingly, in such event a shareholder could be required
      to return all distributions previously made to such shareholder, and in such
      event, a shareholder could receive nothing from us under Plan of Complete
      Liquidation and Dissolution of the Company. Moreover, in the event a shareholder
      has paid taxes on amounts previously received, a repayment of all or a portion
      of such amount could result in a shareholder incurring a net tax cost if the
      shareholder’s repayment of an amount previously distributed does not cause a
      commensurate reduction in taxes payable. There can be no assurance that the
      contingency reserve established by us will be adequate to cover any expenses
      and
      liabilities.




***Our
      stock transfer books will close on the date we file the certificate of
      dissolution with the Nevada Secretary of State, after which it will not be
      possible for shareholders to publicly trade our
      stock.***




We
      intend
      to close our stock transfer books and discontinue recording transfers of our
      common stock at the close of business on the date we file the certificate of
      dissolution with the Nevada Secretary of State, which we refer to as the “final
      record date.” Thereafter, certificates representing our common stock shall not
      be assignable or transferable on our books except by will, intestate succession
      or operation of law. The proportionate interests of all of our shareholders
      will
      be fixed on the basis of their respective stock holdings at the close of
      business on the final record date, and, after the final record date, any
      distributions made by us will be made solely to the shareholders of record
      at
      the close of business on the final record date, except as may be necessary
      to
      reflect subsequent transfers recorded on our books as a result of any
      assignments by will, intestate succession or operation of law.




21




***We
      will continue to incur the expenses of complying with public company reporting
      requirements.***




We
      have
      an obligation to continue to comply with the applicable reporting requirements
      of the Exchange Act even though compliance with such reporting requirements
      is
      economically burdensome. In order to curtail expenses, we intend to, after
      filing our certificate of dissolution, seek relief from the Securities and
      Exchange Commission from the reporting requirements under the Exchange Act.
      We
      anticipate that, if such relief were granted, we would continue to file current
      reports on Form 8-K to disclose material events relating to our liquidation
      and dissolution along with any other reports that the Securities and Exchange
      Commission might require. However, the Securities and Exchange Commission may
      not grant any such relief and we will be required to continue to incur the
      costs
      associated with these reporting requirements which will reduce the cash
      available for distribution to our shareholders.




***If
      we fail to retain the services of certain key personnel, the Plan of Complete
      Liquidation and Dissolution of the Company***  ***may
      not succeed.***




The
      success of the Plan of Complete Liquidation and Dissolution of the Company
      depends in large part upon our ability to retain the services of certain of
      our
      current officers. We expect certain officers to remain as employees to assist
      in
      the liquidation after the closing at their current base salaries, without bonus.
      Failure to retain these personnel could harm the implementation of the Plan
      of
      Complete Liquidation and Dissolution of the Company. If we fail to retain the
      services of these personnel, we will need to hire others to oversee our
      liquidation and dissolution, which could involve additional compensation
      expenses, if such other personnel are available at all.




***Our
      common stock was delisted from the NASDAQ.***




On
      January 17, 2007, we received a letter from The NASDAQ Stock Market notifying
      Familymeds that NASDAQ had determined to delist our shares of common stock
      from
      the NASDAQ Capital Market effective as of the open of business on January 18,
      2007 as a result of our failure to maintain compliance with
      4310(c)(2)(B) (the requirement to maintain a minimum shareholders equity,
      market value of listed securities, or net income from continuing
      operations).




On
      January 18, 2007, our common stock began being quoted on the Over-the-Counter
      Bulletin Board, which we refer to as the “OTC Bulletin Board,” under the symbol
“FMRX.OB.” The OTC Bulletin Board is a regulated quotation service that displays
      real-time quotes, last-sale prices and volume information in over-the-counter
      equity securities. As a result of our common stock being delisted from the
      Nasdaq Capital Market, your ability to resell your shares of our common stock
      could be adversely affected.





**Item 1B.
      Unresolved Staff Comments**




None.





**Item
      2. PROPERTIES.**





As
      of
      December 30, 2006, other than a single piece of property in Tupelo, Mississippi,
      we did not own or hold any legal or equitable interest in any real estate,
      but
      instead leased all of our locations, including our corporate headquarters,
      which
      is located at 312 Farmington Avenue, in Farmington, Connecticut. Our
      headquarters contains approximately 30,000 square feet. The lease for our
      headquarters expires July 31, 2007, with a monthly lease payment of $0.05
      million.




22




We
      also
      lease our various pharmacy locations many of which are within medical complexes.
      The leases vary as to rental amounts, expiration dates, renewal options and
      other rental provisions.





We
      believe all of our properties have been adequately maintained, are generally
      in
      good condition, and are suitable and adequate for our business.





**Item
      3. LEGAL PROCEEDINGS.**





We
      are
      not presently subject to any material legal proceedings other than as set forth
      below:




On
      November 12, 2003, prior to the Merger with FMG, Phil & Kathy’s, Inc. d/b/a
      Alliance Distributors (“Alliance”) served a complaint against us seeking to
      recover the non-payment of open invoices approximating $2.0 million based upon
      an alleged breach of contract for the sale of pharmaceuticals. On December
      18,
      2003, we filed an answer and counterclaim. The counterclaim seeks to recover
      lost profits and other damages relating to the sale of twenty allegedly
      counterfeit bottles of Lipitor by Alliance to us, which we later sold to QK
      Healthcare, Inc. (“QK”). Alleging that the Lipitor was counterfeit, QK later
      sued us for breach of contract, violations of the implied warranty of
      merchantability and fraud. Accordingly, one of our subsidiaries, Valley Drug
      Company (“Valley”), also filed a separate action against Alliance for breach of
      an indemnification agreement related to the sale of the twenty bottles of
      Lipitor that precipitated a lawsuit against Valley by QK in New York. We intend
      to vigorously defend Alliance’s breach of contract action and prosecute our
      counterclaim. At December 30, 2006, the amount that we recorded as a trade
      payable balance due Alliance on the above was approximately $1.5 million. Under
      our indemnification agreement with Alliance, pursuant to which Alliance is
      required to indemnify us for all losses, expenses and damages sustained by
      us as
      a result of product sold to us by Alliance, and our right to offset our losses,
      expenses and damages against any amounts due to Alliance, we reduced the payable
      to Alliance by the cost of the faulty Lipitor sold to us by Alliance plus the
      settlement and litigation expenses incurred by us directly as a result of the
      Lipitor, or an aggregate of $0.5 million. We have recorded the foregoing trade
      payable of $1.5 million as of December 30, 2006, and we believe this estimate
      is
      reasonable based on the information we have at this time; however, we cannot
      reasonably estimate the total future possible loss that we will sustain as
      a
      result of the Alliance complaint or the possible recovery through our
      counterclaim or Valley’s consolidated action. The parties have already exchanged
      written discovery.  The parties attempted to mediate this matter during the
      month of January 2006. A motion for summary judgment was filed by the plaintiffs
      and they were granted a partial judgment. The parties are awaiting disposition
      on the motion for clarification of the summary judgment. The court has set
      no
      trial date.





From
      time
      to time, we may become involved in additional litigation arising in the ordinary
      course of our business. In the opinion of management, after consultation with
      counsel, the disposition of these matters arising in the normal course of
      business is not likely to have a material adverse effect, individually or in
      the
      aggregate, on our financial statements.


23


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




The
      shareholders of the Company voted on 2 items at the special meeting of
      shareholders held on March 30, 2007:




The
      proposal to ratify and approve the Asset Purchase Agreement, including sale
      of a
      majority of the Company’s pharmacy assets to Walgreen Co. and Walgreen Eastern
      Co., Inc., received the following votes:




·
            4,120,613
            Votes for approval·
            189,203
            Votes against·
            7,329
            Abstentions




There
      were no broker non-votes for this item.




The
      proposal to approve and adopt the Plan of Complete Liquidation and Dissolution
      of the Company, including the liquidation and dissolution of Familymeds Group,
      Inc., received the following votes:




·
            4,122,003
            Votes for approval·
            187,813
            Votes against·
            7,329
            Abstentions




There
      were no broker non-votes for this item.


24


**PART
      II**





**Item
      5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY SECURITY.**





Our
      common stock has been quoted on the OTC Bulletin Board under the ticker symbol
      “FMRX.OB” since January 18, 2007. Prior to January 18, 2007 the common stock of
      Familymeds Group, Inc. was quoted on the Nasdaq Capital Market under the symbol
      “FMRX”. This table shows, for the periods indicated, the high and low trading
      price per share for our common stock as reported on the Nasdaq Capital Market.
      All high and low trading prices have been adjusted for our 1 for 10 reverse
      stock split effective on August 16, 2006.




**Familymeds
                common stock****High**
            
            **Low*****Fiscal
                Year ending December 30, 2006***Fourth
            
            $
            4.30
            
            $
            1.52Third
            
            $
            7.00
            
            $
            4.50Second
            
            $
            8.80
            
            $
            5.00First
            
            $
            12.80
            
            $
            6.90***Fiscal
                Year ended December 31, 2005***Fourth
            
            $
            17.30
            
            $
            10.40Third
            
            $
            28.00
            
            $
            10.80Second
            
            $
            32.50
            
            $
            23.50First
            
            $
            35.50
            
            $
            29.80***Fiscal
                Year ended January 1, 2005***Fourth
            
            $
            40.40
            
            $
            32.80Third
            
            $
            47.90
            
            $
            30.60Second
            
            $
            49.60
            
            $
            40.10First
            
            $
            58.70
            
            $
            19.90




On
      April
      10, 2007, Familymeds Group, Inc. common stock was held of record by
      approximately 691 shareholders.




Familymeds
      has not declared or paid any dividends on its common stock previously. We intend
      to close our stock transfer books and discontinue recording transfers of our
      common stock at the close of business on the date we file the certificate of
      dissolution with the Nevada Secretary of State, which we refer to as the “final
      record date.” Thereafter, certificates representing our common stock shall not
      be assignable or transferable on our books except by will, intestate succession
      or operation of law. The proportionate interests of all of our shareholders
      will
      be fixed on the basis of their respective stock holdings at the close of
      business on the final record date, and, after the final record date, any
      distributions made by us will be made solely to the shareholders of record
      at
      the close of business on the final record date, except as may be necessary
      to
      reflect subsequent transfers recorded on our books as a result of any
      assignments by will, intestate succession or operation of law.





**ITEM
      6. SELECTED FINANCIAL DATA**





The
      selected consolidated financial information below has been derived from
      Familymeds Group, Inc.’s consolidated financial statements. On November 12,
      2004, Familymeds Group, Inc. (“FMG”) merged with DrugMax, Inc. and for
      accounting purposes FMG was the acquirer. The historical information below
      is
      that of FMG and includes financial results for the acquired operations of
      DrugMax, Inc. for the post-Merger period subsequent to November 12, 2004. See
      Note 2 of the Notes to Consolidated Financial Statements, for a discussion
      of
      the basis of the presentation and significant accounting policies of the
      consolidated financial information set forth below. You should read this
      information in conjunction with Familymeds’ consolidated financial statements
      and related notes included elsewhere in this Form 10-K. During 2005, we sold
      or
      eliminated substantially all of the operations acquired in the Merger. Such
      operations are classified as discontinued operations below. On March 30, 2007,
      the shareholders of the Company voted to approve the sale of a majority of
      pharmacy assets to Walgreen Co. and Walgreen Eastern Co. Inc. Shareholders
      also
      voted to approve and adopt a plan of complete liquidation and dissolution of
      the
      Company and the transactions contemplated thereby pursuant to which the Company
      will be dissolved and liquidated. The information presented herein does not
      include any adjustments necessary to reflect the possible future effects on
      the
      recoverability of assets or the settlement of liabilities that will result
      from
      the liquidation. Accordingly, the information below is presented on the basis
      of
      a going concern. Any adjustments which may be required once adoption of the
      liquidation basis of accounting is required cannot be estimated at this
      time.




25




The
      data
      as of December 30, 2006 and December 31, 2005 and for the years ended December
      30, 2006, December 31, 2005 and January 1, 2005 is derived from our audited
      consolidated financial statements included elsewhere herein and should be read
      in conjunction with those consolidated financial statements and the related
      notes contained therein. The data as of January 1, 2005, December 27, 2003,
      and
      December 28, 2002 and for the years ended January 1, 2005, December 27, 2003
      and
      December 28, 2002 is derived from our audited consolidated financial statements
      not included elsewhere herein.





**Fiscal
                Years Ended****in
                thousands, except for per share amounts**
            
            **December
                30,**
              **2006**
            
            **December
                31,**
              **2005**
            
            **January
                1,**
              **2005**
            
            **December
                27,**
              **2003**
            
            **December
                28,**
              **2002****(52
                weeks) (1)**
            
            **(52
                weeks) (1)**
            
            **(53
                weeks) (1)**
            
            **(52
                weeks)**
            
            **(52
                weeks)****Statements
                of Operations Data**Net
                revenues
            
            $
            230,524
            
            $
            216,103
            
            $
            223,962
            
            $
            218,015
            
            $
            223,513Gross
                margin
            
            
            44,857
            
            
            42,435
            
            
            46,614
            
            
            47,418
            
            
            46,022Selling,
                general and administrative expenses
            
            
            53,197
            
            
            54,291
            
            
            46,202
            
            
            47,492
            
            
            47,799Depreciation
                and amortization expense
            
            
            3,366
            
            
            4,412
            
            
            4,758
            
            
            5,297
            
            
            5,076Impairment
                of goodwill and long-lived assets
            
            
            3,103
            
            
            —
            
            
            260
            
            
            792
            
            
            593Loss
                (gain) on disposal of fixed assets and intangible assets
            
            
            (1,355
            )
            
            159
            
            
            (1,027
            )
            
            (365
            )
            
            (610
            )Operating
                loss
            
            
            (13,454
            )
            
            (16,427
            )
            
            (3,579
            )
            
            (5,798
            )
            
            (6,836
            )Interest
                expense (2)
            
            
            (5,525
            )
            
            (5,900
            )
            
            (5,654
            )
            
            (7,200
            )
            
            (4,026
            )Interest
                income
            
            
            75
            
            
            84
            
            
            43
            
            
            70
            
            
            13Gain
                on extinguishment of debt
            
            
            13,086
            
            
            —
            
            
            —
            
            
            —
            
            
            —Other
                income (expense)
            
            
            (42
            )
            
            391
            
            
            605
            
            
            754
            
            
            1,443Loss
                from continuing operations before cumulative change in accounting
                principles
            
            
            (5,860
            )
            
            (21,852
            )
            
            (8,585
            )
            
            (12,174
            )
            
            (9,406
            )Cumulative
                effect of changes in accounting principles (3)
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (710
            )Loss
                from continuing operations
            
            
            (5,860
            )
            
            (21,852
            )
            
            (8,585
            )
            
            (12,174
            )
            
            (10,116
            )Loss
                from discontinued operations (4)
            
            
            (1,331
            )
            
            (33,005
            )
            
            (31,259
            )
            
            —
            
            
            —Net
                loss
            
            
            (7,191
            )
            
            (54,857
            )
            
            (39,844
            )
            
            (12,174
            )
            
            (10,116
            )Preferred
                stock dividends
            
            
            —
            
            
            (4,301
            )
            
            (10,796
            )
            
            (5,657
            )
            
            (5,657
            )Net
                loss available to common shareholders
            
            $
            (7,191
            )
            $
            (59,158
            )
            $
            (50,640
            )
            $
            (17,831
            )
            $
            (15,773
            )**Common
                Share Data**Basic
                and diluted loss per share:Loss
                from continuing operations before cumulative changes in accounting
                principles
            
            $
            (0.
                85
            )
            $
            (8.40
            )
            $
            (51.94
            )
            $
            (138.22
            )
            $
            (116.77
            )Cumulative
                effect of adoption of SFAS No. 141 and SFAS No. 142
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            (5.50
            )Loss
                from continuing operations available to common
                shareholders
            
            
            (0.85
            )
            $
            (8.40
            )
            $
            (51.94
            )
            $
            (138.22
            )
            $
            (122.27
            )Loss
                from discontinued operations
            
            
            (0.19
            )
            
            (10.60
            )
            
            (83.77
            )
            
            —
            
            
            —Net
                loss available to common shareholders
            
            $
            (1.04
            )
            $
            (19.00
            )
            $
            (135.71
            )
            $
            (138.12
            )
            $
            (122.27
            )Shares
                used in basic and diluted net loss per share (5)(6)
            
            
            6,904
            
            
            3,114
            
            
            373
            
            
            129
            
            
            129Dividends
                declared
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —





26




**As
                of****December
                30,**
              **2006**
            
            **December
                31,**
              **2005**
            
            **January
                1,**
              **2005**
            
            **December 27,**
              **2003**
            
            **December 28,**
              **2002****Balance
                Sheet and Other Data**Working
                capital (deficit)
            
            $
            (22,614
            )
            $
            (4,347
            )
            $
            (7,875
            )
            $
            (37,604
            )
            $
            4,683Total
                assets
            
            
            49,161
            
            
            64,027
            
            
            95,598
            
            
            44,153
            
            
            49,319Long-term
                accounts payable (7)
            
            
            —
            
            
            —
            
            
            22,425
            
            
            —
            
            
            —Revolving
                credit facility and notes payable
            
            
            44,296
            
            
            41,887
            
            
            35,155
            
            
            37,696
            
            
            389Long-term
                debt (7)
            
            
            -
            
            
            18,184
            
            
            —
            
            
            —
            
            
            34,484FMG
                redeemable preferred stock
            
            
            —
            
            
            —
            
            
            —
            
            
            109,325
            
            
            103,668Total
                stockholders’ (deficit) equity
            
            
            (14,306
            )
            
            (11,293
            )
            
            5,855
            
            
            (133,888
            )
            
            (116,234
            )Store
                locations:Corporate-owned
            
            
            74
            
            
            77
            
            
            77
            
            
            82
            
            
            85Franchised
            
            
            7
            
            
            7
            
            
            8
            
            
            7
            
            
            7




(1)
            Results
                for substantially all of the drug distribution operations subsequent
                to
                the November 12, 2004 Merger are included in discontinued operations.
                The
                effect of 53 weeks in the fiscal year ended January 1, 2005 was to
                increase revenues by $4.0 million.(2)
            Includes
                $1.0 million, $1.7 million and $4.3 million of non-cash interest
                in fiscal
                2005, 2004 and 2003, respectively. $4.0 million of the $4.3 million
                noncash interest expense in fiscal 2003 relates to interest on convertible
                notes issued to former FMG shareholders, which notes were converted
                to
                common stock in connection with the Merger.(3)
            During
                fiscal 2002, FMG adopted new accounting standards related to goodwill
                resulting in a charge of $0.9 million and negative goodwill resulting
                in a
                benefit of $0.2 million.(4)
            Included
                in loss from discontinued operations are operating losses of $ 1.3
                million, $5.7 million and $0.3 million, impairment write downs of
                goodwill
                and other intangible assets of $0.0 million, $22.6 million and $31.0
                million, and other exit losses, primarily representing estimated
                losses on
                accounts receivable, inventory and vendor chargebacks of $1.0 million,
                $4.7 million and $0.0 million, for fiscal years ended December 30,
                2006,
                December 31, 2005 and January 1, 2005, respectively.(5)
            The
                weighted average shares used in the calculation of net loss per share
                have
                been retroactively restated to give effect to the Merger of Familymeds
                with FMG. The transaction was accounted for as a reverse Merger with
                FMG
                deemed the accounting acquirer. Accordingly, for periods prior to
                the
                Merger, the shares outstanding represent the number of shares that
                former
                FMG common shareholders would have received in the transaction, on
                an
                as-if converted basis, had the Merger consideration not been distributed
                to the preferred shareholders based on liquidation values. For periods
                subsequent to the Merger, shares outstanding represent actual weighted
                average shares outstanding.(6)
            The
                shares used in basic and diluted loss per common share have been
                restated
                to reflect the 1 for 10 reverse stock split in August 2006.(7)
            Represents
                the long-term portion of the $23.0 million of accounts payable that
                were
                converted into two subordinated notes payable on March 21,
                2005.




27




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





The
      following Management’s Discussion and Analysis of Financial Condition and
      Results of Operations should be read in conjunction with our consolidated
      financial statements and the related notes. This discussion contains
      forward-looking statements based upon our current expectations, such as our
      plans, objectives, expectations and intentions, that involve risks and
      uncertainties as set forth under “Cautionary Statement Regarding Forward-Looking
      Statements.” Our actual results and the timing of events could differ materially
      from those anticipated in these forward-looking statements as a result of many
      factors, including, but not limited to, those set forth in the following
      discussion and under Item I.A. - “Risk Factors” and elsewhere in this Form 10-K.





On
      February 7, 2007, our Board of Directors approved the sale of the majority
      of
      its pharmacy assets and a Plan of Complete Liquidation and Dissolution of the
      Company.  Its decision was based on a review of the Company’s past
      performance, projected future growth, ongoing liquidity constraints, vendor
      relations, industry outlook, and strategic alternatives.





On
      February 14, 2007, Familymeds Group, Inc. (“Familymeds”) together with its
      wholly owned subsidiaries Familymeds, Inc. and Arrow Prescription Corp., entered
      into an Asset Purchase Agreement with Walgreen Co., an Illinois corporation,
      Walgreen Eastern Co., Inc., a New York corporation (together with Walgreen
      Co.,
“Walgreens”), pursuant to which we will, subject to certain terms and
      conditions, sell up to 53 of the Company’s locations and related assets to
      Walgreens (the “Asset Sale”). The Company intends to sell the remaining assets
      to several other national and regional pharmacy operators.





On
      March
      30, 2007, Familymeds Group, Inc.’s shareholders voted to approve the Asset Sale.
      Shareholders also voted to approve and adopt a plan of complete liquidation
      and
      dissolution of the Company and the transactions contemplated thereby pursuant
      to
      which the Company will be dissolved and liquidated




**Comparison
      of Operating Results for Continuing Operations for the Fiscal Years ended
      December 30, 2006, December 31, 2005 and January 1, 2005.**





We
      refer
      to prescription products as Rx products and to the remaining products, such
      as
      over-the-counter medications, home medical equipment and home health appliances,
      as non-Rx products. While non-Rx reflects a smaller percentage of our overall
      revenues, the gross margin for non-Rx products is higher. The Rx portion of
      the
      pharmacy business is dependent upon a number of third party customers that
      pay a
      portion or all of the Rx cost on behalf of the customers, “Third Party
      Customers.” Prescriptions generated by Third Party Customers represented
      approximately 92% of pharmacy’s Rx sales in the fiscal year ended December 30,
      2006 and 94% for the fiscal year ended December 31, 2005,
      respectively.





For
      financial statement presentation purposes, the Company has
      reported substantially all of the wholesale distribution business as
      discontinued operations.




***Net
      Revenues***





Net
      revenue performance is detailed below:




**For
                the Fiscal Year Ended****52
                weeks**
            
            **Change**
            
            **52
                weeks**
            
            **Change**
            
            **53
                weeks**
            
            **Change****2006**
            
            **%**
            
            **2005**
            
            **%**
            
            **2004**
            
            **%**Net
                revenues (in millions)
            
            $
            230.5
            
            
            6.7
            %
            $
            216.1
            
            
            (3.5
            )%
            $
            224.0
            
            
            2.5
            %Net
                revenues on a comparable 52 week basis (in millions) (1)
            
            
            230.5
            
            
            6.7
            %
            
            216.1
            
            
            (1.8
            )%
            
            220.0
            
            
            0.1
            %Rx
                % of store net revenues (2)
            
            
            93.9
            %
            
            
            
            
            93.8
            %
            
            
            
            
            93.8
            %Third
                party % of Rx net revenues
            
            
            92.2
            %
            
            
            
            
            93.8
            %
            
            
            
            
            94.8
            %Number
                of corporate stores
            
            
            74
            
            
            
            
            
            77
            
            
            
            
            
            77Average
                same store net revenue per store (in millions) (1)
            
            $
            3.1
            
            
            
            
            $
            2.8
            
            
            
            
            $
            2.9





*(1)*
            *The
                Company’s fiscal year is a 52 or 53 week period ending on Saturday nearest
                to December 31. Fiscal 2004 included 53 weeks. Fiscal 2006 and fiscal
                2005
                each included 52 weeks. To improve comparability, $4.0 million of
                additional revenue related to the 53**rd**week in fiscal 2004 was removed.*





*(2)*
            *Store
                net revenues are net of contractual allowances.*




28




**Fiscal 2006
                Compared to Fiscal 2005**
            
            **Fiscal 2005
                Compared to Fiscal 2004**Net
                revenues increases (decreases) are as follows (in
                millions):Net
                effect of store openings/closings(1)
            
            $
            1.9
            
            $
            (2.7
            )Prescription
                sales (2)
            
            
            3.0
            
            
            (2.7
            )Effect
                of 53 weeks in 2004 vs. 52 weeks in 2003 and 2005 (3)
            
            
            —
            
            
            (4.0
            )Non-Rx
                sales
            
            
            —
            
            
            (0.2
            )Physician
                distribution (4)
            
            
            9.6
            
            
            1.8Franchise
                royalties
            
            
            (0.1
            )
            
            (0.1
            )Net
                increase (decrease)
            
            $
            14.4
            
            $
            (7.9
            )





*(1)*
            *The
                net effect of store openings/closings represents the difference in
                revenues by eliminating stores that were not open during the full
                periods
                compared. We closed four stores during fiscal 2006 that accounted
                for $6.3
                million of net revenues and opened two new stores that added $3.0
                million
                of net revenues during the year. We closed seven stores during fiscal
                2004
                that accounted for $2.8 million of net revenue and opened two new
                stores
                during the year that added $0.2 million of net revenues.*





*(2)*
            *Prescription
                sales were negatively impacted during fiscal 2005 compared to fiscal
                2004
                due to the disruptions to our supply chain resulting from Hurricane
                Katrina as well as higher purchasing costs due to our inability to
                buy on
                a more credit worthy basis.*





*(3)*
            *The
                Company’s fiscal year is a 52 or 53 week period ending on Saturday nearest
                to December 31. Fiscal 2004, which ended on January 1, 2005, included
                53
                weeks. Fiscal 2006 and fiscal 2005, which ended on December 30, 2006
                and
                December 31, 2005, respectively, each included 52 weeks.*





*(4)*
            *Represents
                post-Merger revenues for the entire fiscal years 2005 and 2006 for
                the
                continuing portion of the drug distribution operations that relates
                to
                physician distribution.*




***Gross
      Margin***





Gross
      margin was $44.9 million or 19.5 % in fiscal 2006, a 52 week year. This compares
      to $42.4 million or 19.6 % in fiscal 2005, a 52 week year and $46.6 million
      or
      20.8% in fiscal 2004, a 53 week year. Fiscal 2006 reflects the adverse effect
      of
      the efforts of managed care organizations, pharmacy benefit managers and other
      third party payors to reduce their prescription costs. In recent years, our
      industry has undergone significant changes driven by various efforts to reduce
      costs. As employers and managed care organizations continue to focus on the
      costs of branded and specialty pharmaceuticals, we expect there will continue
      to
      be negative pressure on gross margins. In addition, gross margin percentage
      is
      expected to be negatively impacted because of the recent addition of Medicare
      Part D and other efforts by third party payors to reduce reimbursement rates.
      Information that helps explain our gross margin trend is detailed
      below:




**Fiscal
                2006**
              **Compared
                to**
              **Fiscal
                2005**
            
            **Fiscal
                2005**
              **Compared
                to**
              **Fiscal
                2004**Gross
                margin increases (decreases) are as follows (in millions):Pharmacy
                Operations:Net
                effect of store openings/closings (1)
            
            $
            0.2
            
            $
            (0.6
            )Franchise
                royalties
            
            
            (0.1
            )
            
            (0.1
            )Prescription
                gross margin (2)
            
            
            1.2
            
            
            (2.6
            )Non-Rx
                gross margin
            
            
            0.3
            
            
            (0.1
            )Effect
                of 53 weeks in 2004 vs. 52 weeks in 2003 and 2005 (3)
            
            
            —
            
            
            (0.9
            )Physician
                distribution business
            
            
            0.8
            
            
            0.1Net
                increase (decrease)
            
            $
            2.4
            
            $
            (4.2
            )




*(1)*
            *The
                net effect of store openings/closings represents the difference in
                gross
                margin by eliminating stores that were not open during the full periods
                compared.*




29




*(2)*
            *Prescription
                gross margins were negatively impacted during fiscal 2005 compared
                to
                fiscal 2004 due to the disruptions to our supply chain resulting
                from
                Hurricane Katrina as well as higher purchasing costs due to our inability
                to buy on a more credit worthy basis.*





*(3)*
            *The
                Company’s fiscal year is a 52 or 53 week period ending on Saturday nearest
                to December 31. Fiscal 2006 and fiscal 2005, which ended on December
                30,
                2006 and December 31, 2005, respectively, included 52 weeks. Fiscal
                2004,
                which ended on January 1, 2005, included 53 weeks.*





***Total
      Operating Expenses***





Operating
      expenses include selling, general and administrative (“SG&A”) expenses,
      depreciation and amortization expense, write-downs of goodwill and long-lived
      assets, and the gain or loss on disposal of fixed assets and intangible assets
      and restructuring expenses. Intangible assets include the amounts allocated
      to
      prescription files for prescriptions acquired in previous purchase business
      combinations of the pharmacy operations. A prescription file refers to the
      actual prescription maintained by a pharmacy for each prescription filled.
      Each
      prescription file has monetary value to a pharmacy because when pharmacies
      and/or prescription files are sold, the customers are more likely to leave
      their
      accounts with the purchaser than to transfer their business to a third-party
      pharmacy, as such the prescription base is thought of as a repeatable source
      of
      revenue. Accordingly, when pharmacies are sold, the number of prescription
      files
      is taken into consideration when determining the purchase price of the pharmacy.
      Intangible assets also include goodwill, trademarks, and authorized distributor
      licenses. Total operating expenses were $58.3 million or 25.3% of net revenues
      in fiscal 2006. This compares to $58.9 million or 27.3% of net revenues in
      fiscal 2005 and $50.2 million or 22.4% of net revenues in fiscal 2004.
      Information that helps explain our operating expense trend is detailed below:





**Fiscal
                2006**
              **Compared
                to**
              **Fiscal
                2005**
            
            **Fiscal
                2005**
              **Compared
                to**
              **Fiscal
                2004**Operating
                expenses increases (decreases) are as follows (in
                millions):Selling,
                general and administrative expenses(1)
            
            $
            (1.1
            )
            $
            8.1Depreciation
                and amortization expense(2)
            
            
            (1.1
            )
            
            (0.3
            )Impairments
                of goodwill and long-lived assets(3)
            
            
            3.1
            
            
            (0.3
            )Gain
                on disposal of fixed assets and intangible assets
            
            
            (1.5
            )
            
            1.4Net
                increase (decrease)
            
            $
            (0.6
            )
            $
            8.9





*(1)*
            *The
                increase in selling, general and administrative expenses in 2005
                mainly
                relates to the Merger consummated and includes $6.1 million of noncash
                stock compensation expense and increased fees and expenses of $1.7
                million
                attributable to costs associated with being a public company. The
                decrease
                in selling, general and administrative expenses during fiscal 2006
                is
                primarily due to a reduction in noncash stock compensation expense
                of $5.5
                million, offset by higher expenses in the physician distribution
                business
                of $1.1 million, and higher payroll, recruiting and benefit costs
                of $3.3
                million.*




30




*(2)*
            *Depreciation
                and amortization expense was approximately $3.4 million, $4.4 million
                and
                $4.8 million for fiscal 2006, 2005 and 2004,
                respectively.*





*(3)*
            *During
                fiscal 2006, we expensed approximately $3.1 million related to the
                impairment of goodwill, tradename and wholesale distributor contracts
                of
                the Familymeds Medical Supply business.**We
                have estimated that any proceeds which may be realized from sale
                of this
                business in connection with the liquidation of the Company will not
                be
                sufficient to recover these amounts.**During
                fiscal 2005 and 2004, we expensed approximately $0.0 million and
                $0.3
                million, respectively, related to the impairment of prescription
                file
                intangible assets and estimated lease obligations for sold stores.*





***Interest
      Expense***





Interest
      expense was $5.5 million, $5.9 million and $5.7 million for fiscal 2006, 2005
      and 2004, respectively. In connection with the Merger, Familymeds issued
      warrants to purchase 350,009 shares of Familymeds common stock at $26.10 per
      share to the former FMG shareholders, warrant holders and note holders. The
      warrants were allocated among the FMG shareholders, warrant holders and note
      holders in the same manner as the Familymeds common stock. Familymeds recorded
      noncash interest expense of approximately $1.7 million in fiscal 2004 related
      to
      the portion of the warrants issued to the former FMG note holders. The charge
      was based on the fair value of the warrants to purchase 70,433 shares at $26.10
      per share issued to the FMG noteholders, using a Black Scholes valuation as
      of
      the Merger date.





Familymeds
      recorded noncash interest expense of $1.6 million in 2006, consisting of $0.3
      million of amortization of the debt discount on the Deerfield loan, $0.3 million
      amortization of deferred financing fees and $1.0 million of interest expense
      paid in Familymeds common stock to AmerisourceBergen and Deerfield.




31




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





Other
      income (expense), net for the fiscal year ended December 30, 2006 included
      a
      gain on the extinguishment of the debt of $13.1 million. We extinguished this
      debt on June 29, 2006. There were no amounts related to the gain on
      extinguishment of this debt for the fiscal years ended December 31, 2005 or
      January 1, 2005, respectively.




***Income
      Taxes***





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





***Loss
      from Continuing Operations***




We
      incurred a loss from continuing operations of $5.9 million for the fiscal year
      ended December 30, 2006 versus $21.9 million for the fiscal year ended December
      31, 2005 and $8.6 million for the fiscal year ended January 1, 2005. The
      decrease in loss from continuing operations in fiscal year 2006 compared to
      fiscal year 2005 results are primarily related to the gain on the extinguishment
      of debt of $13.1 million, gross margin improvements of $2.4 million and reduced
      operating expenses of $0.6 million. The increase in the loss from continuing
      operations in fiscal year 2005 compared to fiscal year 2004 results are
      primarily from $6.1 million of noncash stock compensation expense attributable
      to the Merger, $1.7 million of expenses attributable to costs associated with
      being a public company, and a $4.2 million reduction in gross margin resulting
      primarily from the effect of one less week of operations in fiscal year 2005
      versus 2004 and overall reductions in revenue.





***Loss
      from Discontinued Operations***




The
      loss
      from discontinued operations of $1.3 million, $33.0 million and $31.3 million
      for the fiscal years ended December 30, 2006, December 31, 2005 and for the
      period November 12, 2004 (the Merger date) to January 1, 2005, respectively,
      represents the loss from operations of the discontinued operations of $0.3
      million, $5.7 million and $0.3 million, respectively, and loss on disposal
      of
      the discontinued operations of $1.0 million, $27.3 million and $31.0 million,
      respectively. The loss on disposal of discontinued operations includes goodwill
      and other intangible asset impairments of $0.0 million and $22.6 million and
      other exit losses primarily representing estimated losses on accounts
      receivable, inventory and vendor chargebacks, of $1.0 million and $4.7
      million, for fiscal years ended December 30, 2006, and December 31, 2005,
      respectively.





*N**et
      Loss Per Share Available to Common Shareholders*




Net
      loss
      per basic and diluted share available to common shareholders for the fiscal
      year
      ended December 30, 2006 was $1.04 compared to $19.00 for the fiscal year ended
      December 31, 2005 and $135.71 for the fiscal year ended January 1,
      2005.





Loss
      from
      continuing operations per basic and diluted share available to common
      shareholders for the fiscal year ended December 30, 2006 was $0.85, compared
      to
      losses from continuing operations per basic and diluted share available to
      common shareholders for the fiscal years ended December 31, 2005 and January
      1,
      2005 of $8.40 and $51.94, respectively. The loss from discontinued operations
      per basic and diluted fiscal year ended December 30, 2006, December 31, 2005
      and
      January 1, 2005 was $0.19 and $10.60 and $83.77, respectively.




32




***Inflation
      and Seasonality***





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





**LIQUIDITY
      AND CAPITAL RESOURCES**




We
      have
      financed our operations and have met our capital requirements primarily through
      private issuances of equity securities, convertible notes, bank borrowings,
      trade creditors and cash generated from operations.  Our principal sources
      of liquidity as of December 30, 2006, consisted of cash and cash equivalents
      of
      approximately $0.8 million along with approximately $0.6 million in availability
      under our $65.0 million revolving credit facility.





The
      Board
      of Directors approved the Asset Sale and the Plan of Complete Liquidation in
      part because we believe that our existing cash and amounts available under
      our
      senior credit facility and cash generated from operating activities may not
      be
      sufficient to meet our vendor terms and anticipated cash needs for the next
      12
      months.




If
      the
      Company does not complete the Asset Sale, then it will be required to raise
      additional financing to continue funding its operations. If our capital
      resources are insufficient to satisfy our liquidity requirements, we may seek
      to
      sell additional equity securities or debt securities or obtain other debt
      financing. The sale of additional equity securities or convertible debt
      securities would result in additional dilution to our shareholders. Additional
      debt would result in increased expenses and could result in covenants that
      would
      restrict our operations. We have explored obtaining additional financing and
      there is no assurance that financing will be available in amounts or on terms
      acceptable to us, if at all.





In
      the
      absence of such financing, the Company may not able to service its debts and
      may
      be required to continue to scale back or terminate operations and/or seek
      protection under applicable United States bankruptcy laws.




**Credit
      Facility**





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





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




33




The
      New
      Credit Facility includes an early termination fee of $0.7 million if paid in
      full before October 12, 2008. The New Credit Facility is secured by
      substantially all assets of the Company. As of December 30, 2006, $37.5 million
      was outstanding on the revolving line of credit and $0.6 million was available
      for additional borrowings, based on eligible receivables, inventory and
      prescription files.





In
      connection with the Asset Sale, Wells Fargo Retail Finance, LLC, as agent for
      the revolving credit lenders pursuant to the Loan and Security Agreement dated
      as of October 12, 2005 (as amended, modified, supplemented or restated and
      in
      effect from time to time, the “Loan Agreement”) among (i) Familymeds Group, Inc.
      (f/k/a Drugmax, Inc.), as Lead Borrower, (ii) the other Borrowers party thereto
      from time to time, (iii) the Revolving Credit Lenders party thereto from time
      to
      time, (iv) and Wells Fargo, has consented to the Asset Sale and the consummation
      of the sale, subject to various terms and conditions. Among those conditions,
      we
      agreed that all proceeds received by us from the sale shall be paid to Wells
      Fargo for application to the credit facility until all amounts due under the
      facility are paid in full and the Loan Agreement is terminated. Each such
      payment of proceeds applied to the credit facility shall permanently reduce
      the
      commitments in the amount of such payment.





**Retired
      Subordinated Note and Convertible Debenture**





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





As
      further described below, on June 29, 2006, the Company and ABDC entered into
      an
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10.0
      million.




**Note
      and Warrant Purchase Agreement**





On
      June
      29, 2006, we entered into a Note and Warrant Purchase Agreement and certain
      other agreements, each effective as of June 23, 2006, with Deerfield Special
      Situations Fund, L.P. (“Deerfield L.P.”) and Deerfield Special Situations Fund
      International, Limited (“Deerfield International”), pursuant to which Deerfield
      L.P. and Deerfield International (collectively, “Deerfield”) purchased two
      secured promissory notes in the aggregate principal amount of $10.0 million
      (one
      note in the principal amount of $3.3 million and the second note in the amount
      of $6.7 million collectively the “Notes”) and eight warrants to purchase an
      aggregate of 1.65 million shares of Familymeds Group, Inc. common stock (the
      “Warrants”), for an aggregate purchase price of $10.0 million.





The
      $10.0
      million purchase price for the Notes and Warrants was used entirely for an
      early
      repayment, settlement and termination of approximately $23.0 million in
      outstanding subordinated debt with Familymeds Group’s former supplier
      AmerisourceBergen Drug Corporation (“ABDC”). The subordinated debt with ABDC
      consisted of a subordinated convertible debenture in the original principal
      amount of $11.5 million and a subordinated promissory note in the original
      principal amount of $11.5 million. Both original debt instruments were 5-year
      agreements maturing in September 2010. In connection with the Deerfield
      transaction, Familymeds Group and ABDC entered into a payoff and mutual release
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10.0 million. Wells
      Fargo
      Retail Finance, LLC (“WFRF”), the Company’s senior lender, consented to
      Familymeds Group’s early repayment of the ABDC debt and waived any default under
      Familymeds Group’s credit facility with WFRF as a result of such repayment by
      entering into an amendment to such credit facility with Familymeds Group and
      its
      subsidiaries. We extinguished the ABDC Notes on June 29, 2006 which resulted
      in
      a gain on the extinguishment of $13.1 million.




34




Principal
      on each of the Notes is due and payable in successive quarterly installments
      each in the amount of $0.2 million and $0.3 million, respectively, beginning
      on
      September 1, 2006 and on each December 1, March 1, June 1 and September 1
      thereafter and continuing until June 23, 2011, on which date all outstanding
      principal and accrued and unpaid interest is due. The Notes bear interest at
      a
      rate equal to 2.5% for the first year, 5.0% for the second year, 10.0% for
      the
      third year, 15.0% for the fourth year and 17.5% for the fifth year. The Notes
      may be prepaid by the Company at anytime without penalty. Interest expense
      has
      been estimated over the five year period to be approximately $1.8
      million (excludes the effect of amortization of the debt discount of $2.5
      million discussed below) and due to the increasing interest rate on this
      debt, the Company records the average quarterly interest expense and records
      a
      corresponding asset or liability for the difference not currently payable each
      quarter. As of December 30, 2006, the Company has classified this liability
      as
      current as it expects to retire this obligation within 12 months of the balance
      sheet date.





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





On
      December 15, 2006, the Company and Deerfield agreed pursuant to an amendment
      to
      the Notes and an investor rights agreement, that in lieu of making the December
      1, 2006 principal payment in cash, the Company shall issue and deliver to
      Deerfield a number of shares of common stock, par value $0.001 per share, of
      Borrower equal to 269,059.





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




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





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





On
      June
      29, 2006, in accordance with Accounting Principles Board (“APB”) Opinion No. 14
“Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants,”
the Company allocated the proceeds received between the debt and the detachable
      warrants based upon the relative fair market values on the dates the proceeds
      were received. The net value allocated to the warrants was $2.5 million and
      was
      determined using the Black-Scholes option pricing formula. The $2.5 million
      has
      been recorded as debt discount and will be amortized over the life of the
      related debt using the effective interest method. The effective interest rate
      on
      the Notes, after giving effect to the amortization of the debt discount is
      approximately 17.0% annually.





35


**New
      Accounting Standards**





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




In
      September 2006, the SEC issued Staff Accounting Bulletin, or SAB, No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements.* SAB No. 108
      provides guidance on how prior year misstatements should be taken into
      consideration when quantifying misstatements in current year financial
      statements for purposes of determining whether the current year’s financial
      statements are materially misstated. SAB No. 108 is effective for
      fiscal years ending on or after November 15, 2006. The adoption of SAB No.
      108 did not have a material impact on our financial position or results of
      operations.





**Operating,
      Investing and Financing Activities:**




***Cash
      Inflows and Outflows***




During
      the fiscal year ended December 30, 2006, the net decrease in cash and cash
      equivalents was $5.8 million compared to a net increase of $4.4 million during
      the fiscal year ended December 31, 2005, respectively. As reported on our
      condensed consolidated statements of cash flows, our change in cash and cash
      equivalents during the fiscal years ended December 30, 2006 and December 31,
      2005 is summarized as follows:




**Fiscal
                Year Ended****Dollars
                in thousands**
            
            **December****30 ,**
              **2006**
            
            **December****31 ,**
              **2005**Net
                cash used by operating activities
            
            $
            (3,840
            )
            $
            (26,350
            )Net
                cash used by investing activities
            
            
            (1,218
            )
            
            (1,192
            )Net
                cash (used in)provided
                by financing activities
            
            
            (778
            )
            
            31,892Change
                in cash and cash equivalents
            
            $
            (5,836
            )
            $
            4,350


36




Details
      of our cash inflows and outflows are as follows during the fiscal years ended
      December 30, 2006 and December 31, 2005, respectively:




*Operating
      Activities:* During
      the fiscal year ended December 30, 2006 we used $3.8 million in cash and cash
      equivalents in operating activities as compared with $26.4 million used during
      the prior year. For the fiscal year ended December 30, 2006, this was comprised
      primarily of net losses of $7.2 million and non-cash charges totaling $4.8
      million partially offset by an increase in working capital of $8.2 million,
      the
      net change in operating assets and liabilities reflected on our condensed
      consolidated statements of cash flows. For the fiscal year ended December 31,
      2005, the use of cash consisted primarily of net losses of $54.9 million and
      a
      decrease in working capital of $7.3 million, the net change in operating assets
      and liabilities reflected on our condensed consolidated statements of cash
      flows, partially offset by non-cash items of $35.8 million. Components of our
      significant non-cash adjustments for the fiscal years ended December 30, 2006
      and December 31, 2005 are as follows:




**Non-cash
                Adjustments**
            
            **Fiscal
                year ended****December****30 ,****2006****(dollars in****thousands)**
            
            **Fiscal
                year ended****December
                31 ,****2005****(dollars in****thousands)**
            
            **Explanation
                of Non-cash Activity**Depreciation
                and amortization
            
            $
            3,366
            
            $
            4,413
            
            During
                fiscal year 2006 and 2005, consists of depreciation of property and
                equipment as well as amortization of intangibles.Non
                cash interest expense
            
            
            1,348
            
            
            1,008
            
            During
                fiscal year 2006 and 2005, interest expense related to ABDC and
                Deerfield notes payable in common stock along with deemed shortfall
                payments.Gain
                on extinguishment of debt
            
            
            (13,086
            )
            
            -
            
            During
                the second quarter of 2006, we retired the outstanding ABDC notes
                amounting to $23.0 million and issued a $10.0 million Note due to
                Deerfield that was used to retire the ABDC notes resulting in a gain
                on
                the extinguishment of our debt.Impairment
                of goodwill and long-lived assets
            
            
            3,103
            
            
            22,617
            
            During
                2006, we recorded impairment charges related to the write down of
                goodwill
                and other intangible assets associated with our Familymeds Medical
                Supply
                business as we do not expect to recover these amounts from future
                estimated cash flows. During 2005, we recorded impairment changes
                related
                to the write down of goodwill and other intangible assets associated
                with
                our discontinued business.Other
                non-cash items, net
            
            
            503
            
            
            7,809
            
            Other
                non-cash items include items such as adjustments to deferred financing
                fees, adjustments to our allowance for doubtful accounts, gains or
                losses
                on disposals of fixed assets and intangible assets and non-cash
                stock-based compensation.Total
                non-cash adjustments to net loss
            
            $
            (4,766
            )
            $
            35,847




*Investing
      Activities:* Cash
      used by investing activities was $1.2 million the fiscal years ended December
      30, 2006 and December 31, 2005. Specific investing activity the fiscal year
      ended December 30, 2006 is as follows:





·
            During
                the fiscal year ended December 30, 2006, we invested approximately
                $2.5
                million in pharmacy software, leasehold improvements, land and computer
                hardware. We incurred capital expenditures of $0.7 million which
                we have
                not paid for as of December 30, 2006.




37




·
            During
                the fiscal year ended December 30, 2006, we used cash of approximately
                $0.2 million to acquire the assets of an oncology based pharmacy
                located
                in central Florida.





·
            During
                the fiscal year ended December 30, 2006, we received cash of approximately
                $1.6 million from the sale of certain prescription assets from closed
                pharmacy locations.




*Financing
      Activities:* Net
      cash
      used in financing activities was $0.8 million during the fiscal year ended
      December 30, 2006, as compared with $31.9 million provided by financing
      activities in the fiscal year ended December 31, 2005. Specific financing
      activity during the fiscal years ended December 30, 2006 and December 31, 2005
      are as follows:





·
            During
                the fiscal year ended December 30, 2006, we did not receive any proceeds
                through the sale of our common stock. During the fiscal year ended
                December 31, 2005, we received $47.4 million, net of $3.7 million
                in fees
                from the issuance of our common stock in a private investment in
                public
                equity (“PIPE”) financing.





·
            During
                the fiscal year ended December 30, 2006, we used $1.2 million of
                our
                revolving credit facility to fund our operations, acquire pharmacy
                assets
                and to purchase capital expenditures. This compares to $3.4 million
                in
                fiscal 2005 to fund our operations along with our PIPE financing
                proceeds.





·
            During
                the fiscal year ended December 30, 2006, we made scheduled debt repayments
                of $11.9 million under our outstanding subordinated notes and notes
                payable and received proceeds of $10 million from issuance of the
                Deerfield notes payable. This compares to $1.9 million for scheduled
                debt
                repayments in the same period of
                2005.




·
            During
                the fiscal year ended December 30, 2006, we received proceeds of
                approximately $0.009 million from the issuance of common stock under
                our
                employee stock plans. This compares to $0.5 million for proceeds
                related
                to employee stock option exercises in the same period of
                2005.




·
            During
                the fiscal year ended December 30, 2006, we did not have any preferred
                stock outstanding as we used $17.0 million during the fiscal year
                ended
                December 31, 2005 to redeem all of our outstanding preferred
                stock.





The
      following is a summary of our corporate-owned store activity for the years
      presented:




**Fiscal
                Year****2006**
            
            **2005**
            
            **2004**Total
                stores (beginning of year)
            
            
            77
            
            
            77
            
            
            82New
                stores
            
            
            2
            
            
            1
            
            
            2Closed
                stores
            
            
            (5
            )
            
            (1
            )
            
            (7
            )Total
                stores (end of year)
            
            
            74
            
            
            77
            
            
            77




38




***Contractual
      Obligations***





The
      following table summarizes our contractual obligations as of December 30, 2006
      (amounts in thousands):





**Payments
                due by period (1)****Total**
            
            **Less
                than 1**
              **year**
            
            **1-3
                years**
            
            **3-5
                years**
            
            **More
                than 5**
              **years**Debt
                (2)
            
            $
            46,543
            
            $
            46,543
            
            $
            —
            
            $
            —
            
            $
            —Purchase
                obligations (3)
            
            
            150,000
            
            
            150,000
            
            
            —
            
            
            —
            
            
            —Operating
                leases(4)
            
            
            5,648
            
            
            2,042
            
            
            3,606
            
            
            —
            
            
            —Interest
                expense(5)
            
            
            984
            
            
            984
            
            
            —
            
            
            —
            
            
            —**Total**
            
            $
            203,175
            
            $
            199,569
            
            $
            3,606
            
            $
            —
            
            $
            —





*(1)*
            *The
                Company has begun to implement the Plan of Complete Liquidation and
                Dissolution ratified by its shareholders on March 30, 2007, pursuant
                to
                which the Company intends to liquidate its assets and satisfy its
                obligations. The Company anticipates that it will have sold substantially
                all of its assets by the end of the second quarter of 2007. However,
                the
                Company can make no assurances with regard to the timing of the
                liquidation (see “Risk
                Factors”).*





*(2)*
            *As
                of December 31, 2006, $37.5 million was outstanding on our New Credit
                Facility, $9.0 million was outstanding on the Deerfield notes payable
                and
                $0.1 million was outstanding on the promissory notes payable. As
                of
                December 30, 2006, the Company has classified its debt as current
                as it
                expects to retire these obligations within 12
                months.*





*(3)*
            *Purchase
                obligations represent the $150 million minimum purchase commitments
                determined on a 12 month basis required under our existing supply
                agreements.*





*(4)*
            *Operating
                leases relate primarily to our store locations and equipment. These
                amounts have not been adjusted for the effect of the sale of our
                assets
                and Plan of Complete Liquidation and Dissolution. However, we assume
                that
                these leases will be settled within the next three
                years.*





*(5)*
            *Estimated
                future interest expense for long-term debt, includes interest on
                the New
                Credit Facility. Interest on the New Credit Facility is based on
                the
                amounts outstanding and interest rate as of December 30, 2006.*




See
      “Debt,” “Leases” and “Commitments and Contingencies” in the accompanying notes
      to our consolidated financial statements for further information about the
      above
      items.





***Off-Balance
      Sheet Arrangements***





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





39


***Critical
      Accounting Policies and Estimates***





Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      (“MD&A”) contains a discussion of the Company’s consolidated financial
      statements, which have been prepared in accordance with accounting principles
      generally accepted in the United States. The preparation of these financial
      statements requires us to make estimates and assumptions that affect the
      reported amounts of assets and liabilities and the disclosure of contingent
      assets and liabilities at the date of the financial statements and the reported
      amounts of revenues and expenses during the reporting periods. On an on-going
      basis, we evaluate estimates and judgments, including the most significant
      judgments and estimate. We based our estimates and judgments on historical
      experience and on various other facts that are believed to be reasonable under
      the circumstances, the results of which form the basis for making judgments
      about the carrying values of assets and liabilities that are not readily
      apparent from other sources. Actual results may differ from these estimates
      under different assumptions or conditions. Our critical accounting policies
      include: assessing merger goodwill and identifiable intangible assets for
      impairment, assessing other long-lived assets for impairment, evaluating the
      adequacy of the allowance for doubtful accounts, and estimating for inventory
      loss reserves. The following represents accounting related to the going concern
      basis. On March 30, 2007, the date of shareholder approval of our Plan of
      Liquidation, the Company adopted the liquidation basis of accounting. Any
      adjustments as a result of such adoption can not be estimated at this
      time.




**Goodwill
      and Identifiable Intangible Assets - Merger Related**




The
      Merger resulted in $51.8 million of goodwill and $5.6 million of other
      intangible assets. The values assigned to goodwill and intangibles, as well
      as
      their related useful lives, are subject to judgment and estimation by the
      Company. Goodwill and identifiable intangible assets related to the Merger
      were
      determined based on the purchase price allocation. The valuation of the
      identifiable intangible assets acquired was based on the estimated cash flows
      related to those assets, while the initial value assigned to goodwill was the
      residual of the purchase price over the fair value of all identifiable assets
      acquired and liabilities assumed. Judgments were required to estimate future
      cash flows in order to determine the fair values of the identifiable intangible
      assets acquired as well as estimate the useful lives for the identifiable assets
      to be amortized over. Useful lives for identifiable intangibles are determined
      based on the expected future period of benefit of the asset, the assessment
      of
      which considers various characteristics of the asset, including historical
      cash
      flows.




After
      goodwill is initially recorded, annual impairment tests are required, or more
      frequently if impairment indicators are present. The amount of goodwill cannot
      exceed the excess of the fair value of the related reportable unit (which is
      based on the Company’s stock price) over the fair value of reporting units
      identifiable assets and liabilities. Downward movement in the Company’s common
      stock price has a material effect on the fair value of goodwill in future
      measurement periods.




During
      the third quarter of 2005, we determined that we would discontinue substantially
      all of the drug distribution operations acquired in the Merger.





We
      completed impairment tests of the goodwill and other intangibles related to
      the
      Merger which resulted in impairment charges of $3.1 million in fiscal 2006,
      $19.4 million in fiscal 2005 and $31.0 million in fiscal 2004. During fiscal
      2006, these charges are included in the loss from continuing operations. During
      fiscal 2005 and 2004, these charges are included in the loss from discontinued
      operations. During fiscal 2006, we recorded impairment charges of $1.4 million
      related to goodwill, $1.5 million related to wholesale distributor contracts
      and
      $0.2 million related to the tradename, respectively. Also during fiscal 2005,
      we
      recorded impairment charges of $3.2 million related to trademarks and customer
      list associated with the discontinued operations and is included in the loss
      form discontinued operations. Significant judgments and estimates were required
      in connection with the impairment test to determine the estimated future cash
      flows and fair value of the reporting unit. To the extent our estimates change
      in the future, further writedowns may occur. As of December 30, 2006, we had
      remaining goodwill of $0.0 million recorded and remaining other intangible
      assets of $0.0 million related to the Merger.




40




**Impairment
      of Other Long-lived Assets**





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





Our
      impairment loss calculations contain uncertainty since we must use judgment
      to
      estimate future sales, profitability and cash flows. When preparing these
      estimates, we consider historical results and current operating trends and
      our
      consolidated revenues, profitability and cash flow results and forecasts. These
      estimates can be affected by a number of factors including, but not limited
      to,
      general economic conditions, the cost of real estate, the continued efforts
      of
      third party customers to reduce their prescription drug costs, the continued
      efforts of competitors to gain market share and consumer spending patterns.
      If
      these projections change in the future, we may be required to write-down our
      long-lived assets. Long-lived assets evaluated for impairment include property
      and equipment as well as intangible assets, which as of December 30, 2006 were
      approximately $6.3 million and $1.3 million, respectively, and $5.0 million
      and
      $4.9 million, respectively, at December 31, 2005.





**Trade
      Receivables - Allowance for Doubtful Accounts**





At
      December 30, 2006 and December 31, 2005, trade receivables reflected
      approximately $19.7 million and $15.7 million, respectively, of amounts due
      from
      various insurance companies, governmental agencies and individual customers.
      Of
      these amounts, there was approximately $3.7 million and $2.8 million reserved
      as
      of December 30, 2006 and December 31, 2005, respectively, for a balance of
      net
      trade receivables of $16.0 million and $12.9 million, respectively. We use
      historical experience, market trends and other analytical data to estimate
      our
      allowance for doubtful accounts. Based upon these factors, the reserve at
      December 30, 2006 is considered adequate. Although we believe that the reserve
      estimate is reasonable, actual results could differ from our estimate, and
      such
      differences could be material. If the estimate is too low, we may incur higher
      bad debt expenses in the future resulting in lower net income or higher net
      losses. If the estimate is too high, we may experience lower bad debt expense
      in
      the future resulting in higher net income or lower net losses.





**Inventories**





Inventories
      consist of pharmaceuticals and other retail merchandise owned by us. Inventories
      are stated at the lower of cost (first-in, first-out method for pharmaceutical
      inventory and retail method for retail merchandise inventory) or market.
      Physical inventory counts are taken on a regular basis in each location to
      ensure that the amounts reflected in the consolidated financial statements
      are
      properly stated. We use historical data to estimate our inventory loss reserves
      and we have not made any material changes in the accounting methodology used
      to
      establish our inventory loss reserves during the past three years. If the
      estimate of inventory losses is too low we may incur higher cost of sales in
      the
      future resulting in lower net income or higher net losses. If the estimate
      of
      inventory losses incurred is too high, we may experience lower cost of sales
      in
      the future resulting in higher net income or lower net losses. Inventories
      as of
      December 30, 2006 and December 31, 2005 were approximately $25.0 million and
      $32.7 million, respectively, net of approximately $2.6 million and $2.1 million
      of inventory loss reserves, respectively. Any changes to the realization of
      this
      amount in future periods will be reflected in discontinued operations.




41




***Impact
      of Inflation and Changing Prices***





The
      consolidated financial statements and related data presented in this Form 10-K
      have been prepared in conformity with accounting principles generally accepted
      in the United States of America, which require the measurement of financial
      position and operating results in terms of historical dollars, without
      considering changes in the relative purchasing power of money over time due
      to
      inflation. We believe that inflation has not had a material impact on our
      results of operations during the three years ended December 30, 2006.





**Item
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.**





As
      of
      December 30, 2006, $37.5 million and $9.0 million were outstanding on our
      revolving credit facility and Deerfield Notes, respectively. These borrowings
      are at a variable rate of interest. Assuming $46.5 million was outstanding
      for a
      full year, a 1% change in interest rates would change our interest expense
      by
      $0.5 million annually.





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




42





**Item
      8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA** **FAMILYMEDS
      GROUP, INC. AND SUBSIDIARIES**




**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**




**Page**REPORT
                OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
            
            F-2CONSOLIDATED
                FINANCIAL STATEMENTS:Consolidated
                Balance Sheets as of December 30, 2006 and December 31,
                2005
            
            F-3Consolidated
                Statements of Operations for the Fiscal Years Ended December 30,
                2006,
                December 31, 2005 and January 1, 2005
            
            F-4Consolidated
                Statements of Changes in Stockholders’ (Deficit) Equity for the Fiscal
                Years Ended December 30, 2006, December 31, 2005 and January 1, 2005
            
            F-5Consolidated
                Statements of Cash Flows for the Fiscal Years Ended December 30,
                2006,
                December 31, 2005 and January 1, 2005
            
            F-6Notes
                to Consolidated Financial Statements
            
            F-7




F-1




REPORT
      OF
      INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To
      the
      Board of Directors and Stockholders of


Familymeds
      Group, Inc.


Farmington,
      Connecticut





We
      have
      audited the accompanying consolidated balance sheets of Familymeds Group, Inc.
      and subsidiaries (formerly DrugMax, Inc.) (the “Company”) as of December 30,
      2006 and December 31, 2005 and the related consolidated statements of
      operations, stockholders' (deficit) equity, and cash flows for each of the
      three
      years in the period ended December 30, 2006.  Our audits also included the
      consolidated financial statement schedule listed in the Index at Item 15. 
These consolidated financial statements and consolidated financial statement
      schedule are the responsibility of the Company's management.  Our
      responsibility is to express an opinion on the consolidated financial statements
      and consolidated financial statement schedule based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States).  Those standards require that
      we plan and perform the audit to obtain reasonable assurance about whether
      the
      financial statements are free of material misstatement.  The Company is not
      required to have, nor were we engaged to perform, an audit of its internal
      control over financial reporting.  Our audits included consideration of
      internal control over financial reporting as a basis for designing audit
      procedures that are appropriate in the circumstances, but not for the purpose
      of
      expressing an opinion on the effectiveness of the Company's internal control
      over financial reporting.  Accordingly, we express no such opinion. 
An audit also includes examining, on a test basis, evidence supporting the
      amounts and disclosures in the financial statements, assessing the accounting
      principles used and significant estimates made by management, as well as
      evaluating the overall financial statement presentation.  We believe that
      our audits provide a reasonable basis for our opinion.





In
      our
      opinion, such consolidated financial statements present fairly, in all material
      respects, the financial position of Familymeds Group, Inc. and subsidiaries
      as
      of December 30, 2006 and December 31, 2005, and the results of their operations
      and their cash flows for each of the three years in the period ended December
      30, 2006, in conformity with accounting principles generally accepted in the
      United States of America.  Also, in our opinion, such financial statement
      schedule, when considered in relation to the basic consolidated financial
      statements taken as a whole, present fairly in all material respects the
      information set forth therein.





As
      discussed in Note 2 to the consolidated financial statements, effective
      January 1, 2006, the Company adopted the fair value method of accounting
      for stock-based compensation as required by Statement of Financial Accounting
      Standards No. 123(R), *Share
      Based Payment* ,
      applying the modified prospective method.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As discussed in Note 1 to the
      consolidated financial statements, the Company's recurring losses, stockholders’
deficit and the approval by the Company’s stockholders of a plan of liquidation
      raise substantial doubt about the Company’s ability to continue as a
      going concern. Management's plans concerning these matters are also described
      in
      Note 1. The financial statements do not include any adjustments that might
      result from the outcome of these matters.




*/s/*Deloitte
                & Touche LLPHartford,
                ConnecticutApril
                16, 2007


F-2




**FAMILYMEDS
                  GROUP, INC. AND SUBSIDIARIES****(formerly
                  DRUGMAX, INC.)****CONSOLIDATED
                  BALANCE SHEETS****December
                  30, 2006 and December 31, 2005****(in
                  thousands, except share data)**
  **December
                  30, 2006**
              
              **December
                  31, 2005****ASSETS****Current
                  Assets:**Cash
                  and cash equivalents
              
              $
              845
              
              $
              6,681Trade
                  receivables, net of allowance for doubtful accounts of$3,720
                  and $2,777 in 2006 and 2005, respectively
              
              
              16,038
              
              
              12,855Inventories
              
              
              22,417
              
              
              30,631Prepaid
                  expenses and other current assets
              
              
              1,553
              
              
              2,487Total
                  current assets
              
              
              40,853
              
              
              52,654**Property
                  and Equipment**—Net
                  of accumulated depreciation and amortizationof
                  $14,502 and $13,080 in 2006 and 2005, respectively
              
              
              6,269
              
              
              4,959**Goodwill**
              
              
              -
              
              
              1,355**Other
                  Intangible Assets**—Net
                  of accumulated amortization of$20,657
                  and $17,674 in 2006 and 2005, respectively
              
              
              1,289
              
              
              4,852**Other
                  Noncurrent Assets**
              
              
              750
              
              
              207**Total
                  Assets**
              
              $
              49,161
              
              $
              64,027**LIABILITIES
                  AND STOCKHOLDERS’ DEFICIT****Current
                  Liabilities:**Notes
                  payable, net of discount of $2,247 in 2006
              
              $
              6,753
              
              $
              4,721Promissory
                  notes payable
              
              
              76
              
              
              915Revolving
                  credit facility
              
              
              37,467
              
              
              36,251Accounts
                  payable
              
              
              14,843
              
              
              9,014Accrued
                  expenses
              
              
              4,269
              
              
              6,100Other
                  liabilities
              
              
              59
              
              
              -Total
                  current liabilities
              
              
              63,467
              
              
              57,001**Notes
                  Payable**
              
              
              -
              
              
              18,184**Other
                  Long-Term Liabilities**
              
              
              -
              
              
              135**Total
                  Liabilities**
              
              
              63,467
              
              
              75,320**Commitments
                  and Contingencies****Stockholders’
                  Deficit:**Series
                  A convertible preferred stock, $1,000 par value, 500,000 authorized
                  and
                  none outstanding
              
              
              -
              
              
              -Common
                  stock, $.001 par value, 200,000,000 shares authorized; 6,962,821
                  and
                  6,574,044 shares issued and outstanding for 2006 and 2005,
                  respectively
              
              
              67
              
              
              66Additional
                  paid in capital
              
              
              230,949
              
              
              227,336Accumulated
                  deficit
              
              
              (245,322
              )
              
              (238,131
              )Unearned
                  compensation
              
              
              -
              
              
              (564
              )Total
                  stockholders’ deficit
              
              
              (14,306
              )
              
              (11,293
              )**Total
                  Liabilities and Stockholders' Deficit**
              
              $
              49,161
              
              $
              64,027
  See
        notes
        to consolidated financial statements
  F-3
  **FAMILYMEDS
                    GROUP, INC. AND SUBSIDIARIES****(formerly
                    DRUGMAX, INC.)****CONSOLIDATED
                    STATEMENTS OF OPERATIONS****Fiscal
                    Years ended December 30, 2006, December 31, 2005 and January
                    1,
                    2005****(in
                    thousands, except share and per share data)**
  **Fiscal
                    Years Ended****December
                    30, 2006**
                
                **December
                    31, 2005**
                
                **January
                    1, 2005**Net
                    revenues
                
                $
                230,524
                
                $
                216,103
                
                $
                223,962Cost
                    of sales
                
                
                185,667
                
                
                173,668
                
                
                177,348Gross
                    margin
                
                
                44,857
                
                
                42,435
                
                
                46,614Selling,
                    general and administrative expenses
                
                
                53,197
                
                
                54,291
                
                
                46,202Loss
                    (gain) on disposal of fixed assets and intangible assets
                
                
                (1,355
                )
                
                159
                
                
                (1,027
                )Depreciation
                    and amortization expense
                
                
                3,366
                
                
                4,412
                
                
                4,758Impairment
                    of goodwill and long-lived assets
                
                
                3,103
                
                
                -
                
                
                260Operating
                    loss
                
                
                (13,454
                )
                
                (16,427
                )
                
                (3,579
                )Other
                    income (expense):Gain
                    on extinguishment of debt
                
                
                13,086
                
                
                -
                
                
                -Interest
                    expense
                
                
                (5,525
                )
                
                (5,900
                )
                
                (5,654
                )Interest
                    income
                
                
                75
                
                
                84
                
                
                43Other
                    income (expense)
                
                
                (42
                )
                
                391
                
                
                605Total
                    other income (expense), net
                
                
                7,594
                
                
                (5,425
                )
                
                (5,006
                )Loss
                    from continuing operations
                
                
                (5,860
                )
                
                (21,852
                )
                
                (8,585
                )Loss
                    from discontinued operations
                
                
                (1,331
                )
                
                (33,005
                )
                
                (31,259
                )Net
                    loss
                
                
                (7,191
                )
                
                (54,857
                )
                
                (39,844
                )FMG
                    redeemable preferred stock dividends
                
                
                -
                
                
                -
                
                
                (10,665
                )DrugMax
                    preferred stock dividends
                
                
                -
                
                
                (4,301
                )
                
                (131
                )Net
                    loss available to common stockholders
                
                $
                (7,191
                )
                $
                (59,158
                )
                $
                (50,640
                )Basic
                    and diluted loss per common share:Loss
                    from continuing operations
                
                $
                (0.85
                )
                $
                (8.40
                )
                $
                (51.94
                )Loss
                    from discontinued operations
                
                
                (0.19
                )
                
                (10.60
                )
                
                (83.77
                )Net
                    loss available to common stockholders
                
                $
                (1.04
                )
                $
                (19.00
                )
                $
                (135.71
                )Weighted
                    average shares outstanding:Basic
                    and diluted
                
                
                6,903,942
                
                
                3,113,881
                
                
                373,149
  See
        notes
        to consolidated financial statements
  F-4
  **FAMILYMEDS
                      GROUP, INC. AND SUBSIDIARIES****(formerly
                      DRUGMAX, INC.)****CONSOLIDATED
                      STATEMENTS OF CHANGES IN STOCKHOLDERS’ (DEFICIT)
                      EQUITY****Fiscal
                      Years ended December 30, 2006, December 31, 2005 and January
                      1,
                      2005****(in
                      thousands, except share data)**
  **Common
                            Stock**
                        
                        **DrugMax
                            Series A Convertible**
                        
                        
                        
                        
                        
                        **Total****Additional**
                        
                        **Preferred**
                        
                        
                        
                        
                        
                        **Stockholders'****Paid
                            in**
                        
                        **Stock**
                        
                        **Accumulated**
                        
                        **Unearned**
                        
                        **(Deficit)****Shares**
                        
                        **Amount**
                        
                        **Capital**
                        
                        **Shares**
                        
                        **Amount**
                        
                        **Deficit**
                        
                        **Compensation**
                        
                        **Equity**BALANCE—December
                            28, 2003
                        
                        
                        128,632
                        
                        $
                        1
                        
                        $
                        15,284
                        
                        
                        -
                        
                        $
                        -
                        
                        $
                        (149,173
                        )
                        $
                        -
                        
                        $
                        (133,888
                        )Net
                            loss
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (39,844
                        )
                        
                        -
                        
                        
                        (39,844
                        )Dividends
                            accrued and accretion of issuance costs on FMG Series
                            A, B, D and E
                            Redeemable Convertible Preferred Stock through Merger
                            date
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (5,186
                        )
                        
                        -
                        
                        
                        (5,186
                        )Stock
                            compensation related to vesting and exercise of FMG stock
                            options
                        
                        
                        52,465
                        
                        
                        1
                        
                        
                        7
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (8
                        )
                        
                        -Dilution
                            of common shares
                        
                        
                        (181,356
                        )
                        
                        (2
                        )
                        
                        (15,291
                        )
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (15,293
                        )Conversion
                            of FMG notes payable, including accrued interest, into
                            Familymeds Group,
                            Inc. (formerly DrugMax) common stock
                        
                        
                        210,698
                        
                        
                        2
                        
                        
                        7,998
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (54
                        )
                        
                        -
                        
                        
                        7,946Conversion
                            of certain FMG Redeemable Preferred Stock to Familymeds
                            Group, Inc.
                            (formerly DrugMax) common stock and reversal of accrued
                            dividends not
                            converted
                        
                        
                        836,352
                        
                        
                        8
                        
                        
                        106,291
                        
                        
                        -
                        
                        
                        -
                        
                        
                        22,026
                        
                        
                        -
                        
                        
                        128,325Issuance
                            of warrants to note holders in connection with the Merger
                        
                        
                        -
                        
                        
                        -
                        
                        
                        1,655
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        1,655Dividends
                            related to warrants issued to former FMG preferred shareholders
                            in
                            connection with the Merger
                        
                        
                        -
                        
                        
                        -
                        
                        
                        5,480
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (5,480
                        )
                        
                        -
                        
                        
                        -Issuance
                            of common stock in connection with the Merger
                        
                        
                        819,665
                        
                        
                        8
                        
                        
                        44,550
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        44,558Granting
                            of restricted stock and stock options in connection with
                            the
                            Merger
                        
                        
                        65,605
                        
                        
                        1
                        
                        
                        7,186
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (7,187
                        )
                        
                        -Exercise
                            of stock options
                        
                        
                        16,047
                        
                        
                        -
                        
                        
                        296
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        296Other
                            stock compensation
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        1,346
                        
                        
                        1,346Issuance
                            of warrants in connection with promissory notes
                        
                        
                        -
                        
                        
                        -
                        
                        
                        171
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        171Issuance
                            of Series A Convertible Preferred Stock
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        17,000
                        
                        
                        15,868
                        
                        
                        -
                        
                        
                        -
                        
                        
                        15,868Issuance
                            of warrants in connection with Series A Convertible Preferred
                            Stock
                        
                        
                        -
                        
                        
                        -
                        
                        
                        1,872
                        
                        
                        -
                        
                        
                        (1,872
                        )
                        
                        -
                        
                        
                        -
                        
                        
                        -Dividends
                            accrued on Familymeds Group, Inc. (formerly DrugMax)
                            Series A Convertible
                            Preferred Stock
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        31
                        
                        
                        (130
                        )
                        
                        -
                        
                        
                        (99
                        )BALANCE—January
                            1, 2005
                        
                        
                        1,948,108
                        
                        
                        19
                        
                        
                        175,499
                        
                        
                        17,000
                        
                        
                        14,027
                        
                        
                        (177,841
                        )
                        
                        (5,849
                        )
                        
                        5,855Net
                            loss
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (54,857
                        )
                        
                        -
                        
                        
                        (54,857
                        )Issuance
                            of warrants to former FMG shareholders and note holders
                        
                        
                        -
                        
                        
                        -
                        
                        
                        45
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        45Issuance
                            of options to DrugMax employees and directors
                        
                        
                        -
                        
                        
                        -
                        
                        
                        59
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        59Exercise
                            of stock options
                        
                        
                        33,236
                        
                        
                        -
                        
                        
                        528
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        528Restricted
                            stock issued to DrugMax employees and directors
                        
                        
                        51,605
                        
                        
                        1
                        
                        
                        833
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (834
                        )
                        
                        -Forfeited
                            Merger-related restricted stock
                        
                        
                        (1,525
                        )
                        
                        -
                        
                        
                        (56
                        )
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (56
                        )Stock
                            compensation expense
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        6,119
                        
                        
                        6,119Amortization
                            of Familymeds Group, Inc. (formerly DrugMax) Series A
                            Convertible
                            Preferred Stock discount
                        
                        
                        -
                        
                        
                        -
                        
                        
                        656
                        
                        
                        -
                        
                        
                        1,560
                        
                        
                        (2,217
                        )
                        
                        -
                        
                        
                        (1
                        )Dividends
                            on Familymeds Group, Inc. (formerly DrugMax) Series A
                            Convertible
                            Preferred Stock
                        
                        
                        60,659
                        
                        
                        1
                        
                        
                        1,001
                        
                        
                        -
                        
                        
                        281
                        
                        
                        (1,240
                        )
                        
                        -
                        
                        
                        43Convertible
                            note interest payments made in common stock
                        
                        
                        23,552
                        
                        
                        -
                        
                        
                        597
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        597Proceeds
                            from sale of common stock, net of $3,730,000 in expense
                        
                        
                        4,409,343
                        
                        
                        44
                        
                        
                        47,330
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        47,374Redemption
                            of Preferred A Stock for cash and shares of Familymeds
                            Group, Inc.
                            (formerly DrugMax) common stock
                        
                        
                        48,807
                        
                        
                        1
                        
                        
                        844
                        
                        
                        (17,000
                        )
                        
                        (15,868
                        )
                        
                        (1,976
                        )
                        
                        -
                        
                        
                        (16,999
                        )BALANCE—December
                            31, 2005
                        
                        
                        6,573,785
                        
                        
                        66
                        
                        
                        227,336
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (238,131
                        )
                        
                        (564
                        )
                        
                        (11,293
                        )Adjustment
                            due to SFAS 123 (R)
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (564
                        )
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        564
                        
                        
                        -Net
                            loss
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        (7,191
                        )
                        
                        -
                        
                        
                        (7,191
                        )Stock
                            compensation expense
                        
                        
                        -
                        
                        
                        -
                        
                        
                        615
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        615Exercise
                            of stock options
                        
                        
                        1,521
                        
                        
                        -
                        
                        
                        9
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        9Issuance
                            of restricted stock to employees and directors
                        
                        
                        33,436
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -Convertible
                            note interest payments made in common stock
                        
                        
                        26,142
                        
                        
                        -
                        
                        
                        229
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        229Issuance
                            of warrants to subordinated debt holders
                        
                        
                        -
                        
                        
                        -
                        
                        
                        2,508
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        2,508Subordinated
                            note principal and interest payments made in common stock
                        
                        
                        327,937
                        
                        
                        1
                        
                        
                        816
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        -
                        
                        
                        817BALANCE—December
                            30, 2006
                        
                        
                        6,962,821
                        
                        $
                        67
                        
                        $
                        230,949
                        
                        
                        -
                        
                        $
                        -
                        
                        $
                        (245,322
                        )
                        $
                        -
                        
                        $
                        (14,306
                        )
 See
            notes
            to consolidated financial statements
 F-5
  **FAMILYMEDS
                  GROUP, INC. AND SUBSIDIARIES****(formerly
                  DRUGMAX, INC.)****CONSOLIDATED
                  STATEMENTS OF CASH FLOWS****Fiscal
                  Years ended December 30, 2006, December 31, 2005 and January 1,
                  2005****(in
                  thousands)**
  **Fiscal
                  Years Ended****December
                  30, 2006**
              
              **December
                  31, 2005**
              
              **January
                  1, 2005**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  loss
              
              $
              (7,191
              )
              $
              (54,857
              )
              $
              (39,844
              )Adjustments
                  to reconcile net loss to net cash provided by (used in) operating
                  activities:Depreciation
                  and amortization
              
              
              3,366
              
              
              4,413
              
              
              4,758Stock
                  compensation expense
              
              
              615
              
              
              6,119
              
              
              1,346Noncash
                  interest expense
              
              
              1,348
              
              
              1,008
              
              
              1,665Impairment
                  of goodwill and long-lived assets
              
              
              3,103
              
              
              22,617
              
              
              31,260Amortization
                  of deferred financing fees
              
              
              299
              
              
              257
              
              
              288Provision
                  for doubtful accounts
              
              
              943
              
              
              1,275
              
              
              342Gain
                  on extinguishment of debt
              
              
              (13,086
              )
              
              -
              
              
              -(Gain)
                  loss on disposal of fixed assets and intangible assets
              
              
              (1,355
              )
              
              159
              
              
              (1,027
              )Effect
                  of changes in operating assets and liabilities:Trade
                  receivables
              
              
              (4,126
              )
              
              6,440
              
              
              (241
              )Inventories
              
              
              8,458
              
              
              3,894
              
              
              (2,100
              )Prepaid
                  expenses and other current assets
              
              
              651
              
              
              (926
              )
              
              (1,970
              )Accounts
                  payable
              
              
              5,096
              
              
              (16,544
              )
              
              3,529Accrued
                  expenses
              
              
              (1,654
              )
              
              (654
              )
              
              1,984Other
              
              
              (307
              )
              
              449
              
              
              403Net
                  cash provided by (used in) operating activities
              
              
              (3,840
              )
              
              (26,350
              )
              
              393CASH
                  FLOWS FROM INVESTING ACTIVITIES:Purchases
                  of property and equipment
              
              
              (2,524
              )
              
              (1,747
              )
              
              (1,135
              )Purchases
                  of pharmacy assets
              
              
              (244
              )
              
              -
              
              
              -Proceeds
                  from sale of drug distribution business
              
              
              -
              
              
              405
              
              
              -Proceeds
                  from sale of pharmacy assets
              
              
              1,550
              
              
              150
              
              
              1,103Net
                  cash used in investing activities
              
              
              (1,218
              )
              
              (1,192
              )
              
              (32
              )CASH
                  FLOWS FROM FINANCING ACTIVITIES:Proceeds
                  from sale of common stock, net of $3,730 in expense
              
              
              -
              
              
              47,374
              
              
              -Proceeds
                  from (repayment of) revolving credit facility, net
              
              
              1,216
              
              
              3,381
              
              
              (8,530
              )Net
                  proceeds from Series A Convertible Preferred Stock
              
              
              -
              
              
              -
              
              
              15,868Repayment
                  of Series A Convertible Preferred Stock
              
              
              -
              
              
              (17,000
              )
              
              -Repayment
                  of term loan
              
              
              -
              
              
              -
              
              
              (4,000
              )Repayment
                  of promissory notes payable to ABDC
              
              
              (11,914
              )
              
              (1,369
              )
              
              (2,335
              )Repayment
                  of notes payable
              
              
              -
              
              
              (575
              )
              
              -Repayment
                  of obligations under capital leases
              
              
              -
              
              
              (30
              )
              
              (44
              )Payment
                  of deferred financing fees
              
              
              (89
              )
              
              (417
              )
              
              (592
              )Proceeds
                  from Deerfield notes payable
              
              
              10,000
              
              
              -
              
              
              -Proceeds
                  from exercise of stock options
              
              
              9
              
              
              528
              
              
              296Net
                  cash provided by (used in) financing activities
              
              
              (778
              )
              
              31,892
              
              
              663NET
                  INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
              
              
              (5,836
              )
              
              4,350
              
              
              1,024CASH
                  AND CASH EQUIVALENTS—Beginning of period
              
              
              6,681
              
              
              2,331
              
              
              1,307CASH
                  AND CASH EQUIVALENTS—End of period
              
              $
              845
              
              $
              6,681
              
              $
              2,331SUPPLEMENTAL
                  DISCLOSURES OF CASH FLOW INFORMATION:Cash
                  paid for interest
              
              $
              3,911
              
              $
              4,893
              
              $
              3,701Noncash
                  transactions—Subordinated
                  Convertible Debenture interest payments made in common
                  stock
              
              $
              229
              
              $
              597
              
              $
              -Payment
                  of Familymeds Group, Inc. (formerly DrugMax) Series A preferred
                  stockdividends
                  in common stock
              
              $
              -
              
              $
              1,002
              
              $
              -Increase
                  in Subordinated Convertible Debenture due to deemed payment
                  shortfall
              
              $
              -
              
              $
              481
              
              $
              -Note
                  receivable from sale of drug distribution business
              
              $
              -
              
              $
              250
              
              $
              -Conversion
                  of accounts payable to subordinated notes payable
              
              $
              -
              
              $
              23,000
              
              $
              -Conversion
                  of notes payable and accrued interest into Familymeds Group,
                  Inc.(formerly
                  DrugMax) Common Stock
              
              $
              -
              
              $
              -
              
              $
              7,946Exercise
                  of FMG Series E Preferred Stock warrants into FMG Series E Preferred
                  Stock
              
              $
              -
              
              $
              -
              
              $
              4,000Issuance
                  of Familymeds Group, Inc. (formerly DrugMax) common shares
                  inconnection
                  with Merger
              
              $
              -
              
              $
              -
              
              $
              44,558Dividends
                  relating to warrants issued to FMG preferred shareholders
              
              $
              -
              
              $
              -
              
              $
              5,479Interest
                  expense relating to warrants issued to note holders
              
              $
              -
              
              $
              -
              
              $
              1,655Issuance
                  of warrants to promissory note holders
              
              $
              -
              
              $
              -
              
              $
              171Issuance
                  of warrants to Series A Convertible Preferred Stockholders
              
              $
              -
              
              $
              -
              
              $
              1,872Retirement
                  of ABDC subordinated notes payable
              
              $
              13,089
              
              $
              -
              
              $
              -Principal
                  payment on subordinated notes payable to Deerfield made in common
                  stock
              
              $
              500
              
              $
              -
              
              $
              -Interest
                  payment on subordinated notes payable to Deerfield made in common
                  stock
              
              $
              317
              
              $
              -
              
              $
              -Capital
                  expenditures incurred but not yet paid
              
              $
              733
              
              $
              -
              
              $
              -
  See
        notes
        to condensed consolidated financial statements
  F-6




**FAMILYMEDS
      GROUP, INC. AND SUBSIDIARIES**




**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS - FISCAL YEARS ENDED DECEMBER 30, 1006,
      DECEMBER 31, 2005 AND JANUARY 1, 2005**




**1.**
            **ASSET
                SALE****,****PLAN
                OF COMPLETE LIQUIDATION AND DISSOLUTION,****BUSINESS, DISCONTINUED OPERATIONS AND GOING
                CONCERN**




Familymeds
      Group, Inc. (“Familymeds,” the “Company,” or “we” and other similar pronouns) is
      a pharmacy and drug distribution provider formed by the merger on November
      12,
      2004 of DrugMax, Inc. and Familymeds Group, Inc.  Familymeds Group, Inc.
      was formerly known as DrugMax, Inc. and on July 10, 2006, the Company amended
      its Articles of Incorporation to change its name from DrugMax, Inc. to
      Familymeds Group, Inc. As of December 30, 2006, we operated 77 Company-owned
      locations including 74 pharmacies, one health and beauty location, one
      non-pharmacy mail order center, and a drug distribution business primarily
      focused on the direct distribution of specialty pharmaceuticals to physicians,
      medical clinics and other health care providers known as Familymeds Medical
      Supply.  The Company also franchises 7 pharmacies.   The
      Company’s pharmacies are located in 13 states and operate under the Familymeds
      Pharmacy, Arrow Pharmacy & Nutrition Center, and Worksite Pharmacy SM brand
      names.




As
      of
      December 30, 2006, the Company had a net shareholders’ deficit of $14.3 million
      and had incurred net losses of $7.2 million, $54.9 million and $39.8 million
      for
      the years ended December 30, 2006, December 31, 2005, and January 1, 2005,
      respectively.





During
      the past two years, the Company has taken significant steps to improve its
      operating results, reduce costs and improve its financial performance. These
      include the sale of common stock for net proceeds of $47.4 million, the
      redemption of all of its outstanding Series A Preferred Stock, the refinancing
      of the senior credit facility with a new $65.0 million facility, which allowed
      for additional borrowing availability, and the sale and discontinuation of
      a
      majority of the Company’s full-line wholesale drug distribution operations,
      which had incurred significant losses.




Further,
      during the second quarter of 2006, the Company entered into a Note and Warrant
      Purchase Agreement and certain other agreements described below, each effective
      as of June 23, 2006, with Deerfield Special Situations Fund, L.P. and Deerfield
      Special Situations Fund International, Limited (collectively, “Deerfield”),
      pursuant to which Deerfield purchased two secured promissory notes in the
      aggregate principal amount of $10.0 million (one note in the principal amount
      of
      $3.3 million and the second note in the amount of $6.7 million, collectively
      the
“Notes”) and eight warrants to purchase an aggregate of 1.65 million shares of
      Company common stock (the “Warrants”), for an aggregate purchase price of $10.0
      million.  The $10.0 million purchase price for the Notes and Warrants was
      used entirely for an early repayment, settlement and termination of
      approximately $23.0 million in outstanding subordinated debt and accrued unpaid
      interest with the Company’s former supplier AmerisourceBergen Drug
      Corporation.




Also
      during the third and fourth quarters of 2006, the Company closed or sold
      underperforming stores and continued to evaluate its ongoing operations to
      improve results.  Despite these efforts, the Company continued to
      experience a reduction in gross margins due to the increased number of
      participants enrolled in Medicare Part D plans and the increased pressure by
      other third parties to reduce prescription reimbursement rates.




These
      negative pressures on gross margin coupled with the increasing demand for
      pharmacists, rising salary requirements, increasing health care costs and
      professional liability insurance costs, will continue to negatively impact
      the
      Company’s ability to become profitable.




F-7




During
      the 2nd half of 2006 the Company implemented selling and general administrative
      expense reduction measures, including a workforce reduction of 33 employees
      at
      the Company headquarters in Farmington, Connecticut in July 2006, directed
      at
      reducing costs and improving overall liquidity.




The
      continued gross margin pressure on prescription drug sales, among other factors,
      has created a more urgent need for a larger scaled enterprise for its clinic
      and
      Worksite Pharmacy business model. The Company exhaustively sought new capital;
      however, such financing opportunities were highly dilutive.




Familymeds
      strategic plan has been to seek long term sustainable profits by increasing
      sales through organic growth, continued focus on same store sales growth and
      expansion of new pharmacies in clinic and Worksite settings. However, in light
      of the factors noted above, the current competitive environment and the
      Company’s highly leveraged capital structure, the Board of Directors believed
      that the Company lacked the capital resources necessary in the long-term to
      compete effectively in its industry.  In an effort to maximize the value of
      the shareholders’ investment in the Company, the Board of Directors decided to
      examine certain financial and strategic alternatives to the Company remaining
      independent.




In
      October 2006, the Board of Directors retained JMP Securities LLC (“JMP
      Securities”) as its financial advisor to examine these alternatives and to
      contact certain potential strategic and financial partners with respect to
      a
      transaction with the Company.  With the Board of Directors frequent
      consultation and guidance throughout a process extending many months, management
      and JMP Securities considered a number of strategic alternatives for the Company
      and its business.  This included an analysis of the operating history and
      prospects for growth of the Company as a whole.




By
      December 2006, the Company received several written indications of interest
      and
      verbal expressions of continued interest.  The proposals were in the form
      of financing commitments, stock exchanges, and others in the form of asset
      purchases.




On
      February 7, 2007, our Board of Directors approved the Asset Purchase Agreement
      and the Plan of Complete Liquidation and Dissolution of the Company.  Its
      decision was based on a review of the Company’s past performance, projected
      future growth, ongoing liquidity constraints, vendor relations, industry
      outlook, and strategic alternatives.





***Asset
      Sale***





On
      February 14, 2007, Familymeds Group, Inc. together with its wholly owned
      subsidiaries Familymeds, Inc. and Arrow Prescription Corp., entered into an
      Asset Purchase Agreement with Walgreen Co., an Illinois corporation, Walgreen
      Eastern Co., Inc., a New York corporation (together with Walgreen Co.,
“Walgreens”), pursuant to which the Company will, subject to certain terms and
      conditions, sell up to 53 of our locations and related assets to Walgreens
      (the
“Asset Sale”). Of the 53 locations, 33 of the clinic and Worksite locations will
      remain open and continue to operate in place. As consideration for this sale,
      Walgreens will assume only certain of our liabilities, including certain
      automobile and certain real estate leases, and will pay us approximately $43.0
      million in addition to amounts to be paid for customer accounts receivable
      and
      inventories related to those locations. $3.0 million of the purchase price
      shall
      be placed into escrow until the earlier of one year from the closing date or
      the
      final distribution of assets to the Company’s shareholders or dissolution of
      Familymeds.





The
      Company intends to sell its remaining assets to several other national and
      regional pharmacy operators for cash and assumption of certain real estate
      leases, subject to closing physical inventory counts.





On
      March
      30, 2007, Familymeds Group, Inc.’s shareholders voted to approve the sale of a
      majority of pharmacy assets to Walgreen Co. and Walgreen Eastern Co. Inc.
      Shareholders also voted to approve and adopt a plan of complete liquidation
      and
      dissolution of the Company and the transactions contemplated thereby pursuant
      to
      which the Company will be dissolved and liquidated.





F-8





***Plan
      of Complete Liquidation and Dissolution***





As
      discussed above, Familymeds’ Board of Directors approved the proposed Plan of
      Complete Liquidation and Dissolution of Familymeds (referred to herein as the
      “Plan of Complete Liquidation and Dissolution”) on February 7, 2007, subject to
      the approval of its shareholders which was obtained at the Special Meeting
      held
      March 30, 2007.





The
      Plan
      of Complete Liquidation and Dissolution provides that upon its approval by
      its
      shareholders, the Board of Directors, without further action by the Company’s
      shareholders, may:




·
            dissolve
                Familymeds;




·
            liquidate
                the Company’s assets;




·
            pay,
                or provide for the payment of, any remaining, legally enforceable
                obligations of Familymeds; and




·
            distribute
                any remaining assets to the Company’s
                shareholders.





***Business-*** On
      March
      19, 2004, Familymeds Group, Inc. (“FMG”) entered into an Agreement and Plan of
      Merger which was amended on July 1, 2004 and on October 11, 2004 (as amended,
      the “Merger Agreement”) with DrugMax, Inc. (“DrugMax”). Under the terms of the
      Merger Agreement, on November 12, 2004, FMG merged into DrugMax, and DrugMax
      became the surviving corporation in the merger (the “Merger”). The Merger was
      treated as a purchase of DrugMax by FMG for accounting purposes. Accordingly,
      for periods prior to the Merger, the information contained herein is the
      historical information of FMG. On July 10, 2006, DrugMax changed its name back
      to Familymeds Group, Inc,




The
      results of operations acquired in the merger have been included in the Company’s
      consolidated statements of operations (primarily in discontinued operations
      as
      described below) since the date of acquisition. The excess of the purchase
      price
      over the estimated fair values of the underlying assets acquired and liabilities
      assumed of $50.8 million was allocated to goodwill. The allocation of the
      purchase price was finalized during the nine months ended October 1, 2005
      resulting in an increase of $1.0 million in goodwill. In connection with the
      Merger, the Company terminated certain DrugMax employees. Included in a
      restructuring liability as of the Merger date was a severance obligation of
      approximately $1.0 million. The total amount of the severance obligation was
      reduced by payments during 2006 to $0.3 million. Additionally, an accrued lease
      liability of $0.1 million was recorded related to an office location that is
      no
      longer used by the Company.




The
      purchase price of approximately $44.6 million represents the fair value ($37.8
      million) of the shares of the Company’s common stock retained by the existing
      common shareholders of Familymeds Group, Inc., the value ($5.2 million) of
      outstanding DrugMax options which vested in connection with the Merger and
      $1.6
      million of Merger costs.




In
      the
      Merger, the shareholders of FMG (along with certain FMG warrant holders and
      note
      holders) received an aggregate of 1,047,806 shares of the Company’s common stock
      along with warrants to purchase an additional 353,850 shares of the Company’s
      common stock. The exercise price of the warrants is $26.10 per share. In
      addition, in connection with the Merger, the Company issued an aggregate of
      65,605 shares of restricted common stock, along with options to purchase an
      additional 157,284 shares of common stock, to certain employees and directors
      of
      FMG who agreed to continue providing services post-Merger. The exercise price
      of
      the stock options is $5.70 per share. The noncash compensation charge recorded
      during the fiscal year ended December 31, 2005 and January 1, 2005 relating
      to
      the restricted stock and stock options related to the Merger was $5.8 million
      and $1.3 million, respectively, which was based on the provisions of the
      restricted stock and stock option agreements. During the fiscal year ended
      December 31, 2005, an additional 3,814 warrants were issued to former FMG
      shareholders. These additional warrants were valued at $0.05 million which
      was
      reflected as an adjustment to goodwill during the fiscal year ended December
      31,
      2005.




F-9




***Discontinued
      Operations*** -
      In
      September 2005, Hurricane Katrina resulted in the temporary closure of the
      warehouse facility located in St. Rose, Louisiana. The Company maintains
      insurance coverage, which provides for reimbursement from losses resulting
      from
      property damage, loss of product and losses from business interruption. The
      Company estimates approximately $0.2 million of inventory was damaged during
      the
      hurricane and incurred approximately $0.8 million of incremental costs related
      to closing the facility and relocating the inventory and operations to the
      Company’s New Castle facility. Additionally, provisions for bad debts of $0.5
      million were recorded related to estimated losses resulting from customers
      whose
      businesses were affected by the hurricane and the related unamortized customer
      list asset of $0.5 million was also written off. These costs were expensed
      and
      included in loss from discontinued operations in the consolidated statement
      of
      operations for the year ended December 31, 2005. The Company is attempting
      to
      recover these costs through insurance claims. No amounts have been recorded
      related to the expected recovery from insurance and the Company is still
      pursuing reimbursement efforts.





During
      the third quarter of 2005, the Company determined that it would sell certain
      assets of its wholesale drug distribution business and discontinue a significant
      portion of the operations for the year ended December 31, 2005 conducted out
      of
      the New Castle, Pennsylvania facility. The Company continued to purchase
      pharmaceuticals utilizing the authorized distributor agreements and distribute
      pharmaceuticals directly to physicians, medical clinics and other health care
      providers. Revenues for this portion of the drug distribution operations were
      $2.3 million for the year ended December 31, 2005 and are included in continuing
      operations.




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





The
      original lease (dated December 30, 2003) (the “Original Lease”) provided for a
      term of 15 years, expiring December 30, 2018, and monthly lease payments of
      $0.017 million.  When the Original Lease was executed, Becan and Valley
      North entered into a Consent, Subordination and Assumption Agreement (the
“Guarantee”) with the Pennsylvania Industrial Development Authority (“PIDA”) and
      Regional Industrial Development Corporation of Southwest Pennsylvania (“RIDC”)
      dated December 30, 2003, pursuant to which, among other things, Becan and Valley
      Drug Company (Valley North”), jointly and severally, assumed all obligations of
      RIDC to make payments and discharge all obligations expenses, costs and
      liabilities of RIDC in connection with the PIDA note (the “PIDA Note”). 
The PIDA Note is also secured by the Original Lease and the property.




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




F-10




Further,
      as part of the discontinuance of substantially all of the drug distribution
      business, the Company recorded a goodwill impairment charge of $19.4 million
      during the year ended December 31, 2005. The Company also recorded a goodwill
      impairment charge of $31.0 million during the year ended January 1, 2005. The
      Company has estimated that any proceeds which may be realized from sale of
      this
      business in connection with the liquidation of the Company will not be
      sufficient to recover the remaining goodwill as of December 30, 2006.
      Accordingly, we have recorded an impairment charge of approximately $1.4 million
      in the consolidated statement of operations for the year ended December 30,
      2006.





Net
      revenues related to the discontinued operations were $0.0 million, $103.6
      million and $15.3 million for the fiscal years ended December 30, 2006, December
      31, 2005 and for the period November 12, 2004 (the Merger date) to January
      1,
      2005, respectively.  The loss from discontinued operations was $1.3
      million, $33.0 million and $31.3 million the fiscal years ended December 30,
      2006, December 31, 2005 and for the period November 12, 2004 (the Merger date)
      to January 1, 2005, respectively. During the third quarter 2006, the Company
      received notification of a tax assessment from a state tax authority relating
      to
      the Company’s discontinued operations.  The Company has accrued $0.2
      million of estimated income taxes relating to this matter which is
      reflected as a component of discontinued operations.




***Going
      Concern*** —
The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As of December 30, 2006, the
      Company had a net shareholders' deficit of $14.3 million, has incurred net
      losses of $7.2 million, $54.9 million and $39.8 million for the years ended
      December 30, 2006, December 31, 2005 and January 1, 2005 and in March 2007
      the
      Company’s shareholders approved a plan of liquidation and dissolution of the
      Company. These matters raise substantial doubt about the Company's ability
      to
      continue as a going concern.




**2.**
            **BUSINESS
                AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





***Business*** —
As
      of
      December 30, 2006, the Company operated 74 pharmacies, including one home health
      center and one non-pharmacy mail order center, in 13 states under the Arrow
      Pharmacy & Nutrition Center, Familymeds Pharmacy, and Worksite
      Pharmacy SM brand
      names.





***Fiscal
      Periods*** —The
      Company reports on a 52-53 week fiscal year. Fiscal years 2006 and 2005 include
      52 weeks, while fiscal year 2004 includes 53 weeks.





***Principles
      of Consolidation*** —The
      consolidated financial statements include the accounts of the Company and its
      wholly-owned subsidiaries. All significant intercompany transactions have been
      eliminated in consolidation.





***Use
      of Estimates*** —The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America requires management to make
      estimates and assumptions that affect the reported amounts of assets and
      liabilities and the disclosure of contingent assets and liabilities as of the
      date of the financial statements and the reported amounts of income and expenses
      during the reporting periods. Actual results could differ from those estimates.
      Management’s estimates relate primarily to assigning values and lives to
      intangible assets acquired in connection with the Merger, estimating impairments
      of long-lived assets and estimating the allowance for doubtful accounts and
      inventory reserves.




F-11




***Revenue
      Recognition*** —Revenues
      from pharmacy operations are comprised of both pharmacy sales in Company-owned
      locations and royalty revenues from franchised pharmacies. Revenues from
      pharmacy sales, net of contractual allowances from third-party payors, are
      recognized at the time of sale. The Company participates in various third-party
      provider networks and state Medicaid programs. Under a majority of these
      networks, revenue is adjudicated at the time of sale. However, for certain
      third-party providers and state Medicaid programs, revenue is reported at the
      net realizable amount and adjusted in future periods as final settlements are
      determined. Revenues from franchised pharmacies are based on a flat fee per
      location or a percentage of the revenues of the franchised pharmacy and are
      recognized in the period in which revenues are earned. The Company recognizes
      revenues from the mail order and e-commerce operations when products are shipped
      to customers, net of discounts. Revenues for the drug distribution operations
      are recognized when goods are shipped and title or risk of loss resides with
      unaffiliated customers or when services are provided. The Company has no sales
      incentive or rebate programs with its customers. Revenue is recorded net of
      sales returns and allowances.





***Vendor
      Rebates, Allowances and Chargebacks-*** Rebates
      and allowances are recorded as a component of cost of goods sold in the period
      they are received from the vendor or manufacturer unless such rebates and
      allowances are reasonably estimable at the end of a reporting period. The
      Company records chargeback credits due from its vendors in the period when
      the
      sale is made to the customer which is eligible for contract pricing from the
      manufacturer.





***Cash
      and Cash Equivalents*** —The
      Company considers investments with original maturities of three months or less
      to be cash equivalents.





***Inventories*** —Inventories
      consist of pharmaceuticals and other retail merchandise. Inventories are stated
      at the lower of cost (first-in, first-out method for pharmaceutical inventory
      and retail method for retail merchandise inventory) or market. Inventories
      are
      monitored for out of date or damaged products. Inventories are recorded net
      of a
      reserve for obsolescence of approximately $2.6 million and $2.1 million at
      December 30, 2006 and December 31, 2005, respectively. The drug distribution
      operations accept return of product from its customers for product which is
      resaleable, in unopened containers and expires six months or more from the
      return date.





***Property
      and Equipment*** —Property
      and equipment is stated at cost less accumulated depreciation and amortization.
      Depreciation and amortization are computed using the straight-line method over
      the useful lives of the assets with a mid-month convention being applied to
      the
      first year assets are placed into service. Furniture and fixtures, computer
      equipment and software, excluding website software costs, are depreciated over
      useful lives of five years. Capitalized website software costs are amortized
      over three years. Leasehold improvements and equipment purchased under capital
      leases are amortized over the shorter of the useful life of the asset or the
      lease term. When fixed assets are retired or sold, the asset cost and related
      accumulated depreciation and amortization are eliminated and any resulting
      gain
      or loss is included in the consolidated statements of operations.





***Leases
      and Deferred Rent Payable-*** The
      Company leases pharmacy, distribution, administrative, marketing and customer
      service facilities. Leases are accounted for under the provisions of SFAS No.
      13, *Accounting
      for Leases* ,
      as
      amended, which requires that leases be evaluated and classified as operating
      or
      capital leases for financial reporting purposes. The lease term used for lease
      evaluation includes option periods only in instances in which the exercise
      of
      the option period can be reasonably assured and failure to exercise such options
      would result in an economic penalty.




F-12




For
      leases that contain rent escalations, the Company records the total rent payable
      during the lease term, as determined above, on a straight-line basis over the
      term of the lease and records the difference between the rents paid and the
      straight-line rent as a deferred rent payable. As of December 30, 2006 and
      December 31, 2005, a liability of approximately $0.1 million, was recorded
      related to deferred rent payable.





***Impairment
      of Long-Lived Assets*** —The
      Company reviews long-lived assets, including property plant and equipment and
      intangible assets, to be held and used for impairment whenever events or changes
      in circumstances indicate that the carrying amount of an asset may not be
      recoverable. If the sum of the undiscounted expected future cash flows is less
      than the carrying amount of the related assets, the Company recognizes an
      impairment loss. Impairment losses are measured as the amount by which the
      carrying amount of the assets, including related intangible assets, exceeds
      the
      future cash flows for the assets. For purposes of recognizing and measuring
      impairment of long-lived assets, the Company evaluates assets at the store
      level
      for pharmacy operations. For purposes of measuring goodwill impairment, the
      drug
      distribution operations and pharmacy operations are considered separate
      reporting units.





***Goodwill*** —Goodwill
      represents the excess of acquisition cost over the fair value of the net assets
      acquired as a result of the Merger. Goodwill is not amortized, but is subject
      to
      impairment testing annually, or more frequently if events and circumstances
      indicate there may be impairment.





***Other
      Intangible Assets*** —Prescription
      file intangible assets were recorded at fair value in connection with store
      acquisitions. The Company amortizes prescription files on a straight-line basis
      over an estimated useful life of seven years. Authorized distributor licenses,
      trademarks and patents and a customer list were recorded in connection with
      the
      Merger. Authorized distributor licenses relate to contractual and
      non-contractual relationships with pharmaceutical manufacturers allowing direct
      access to purchase their products. These contracts are amortized on a
      straight-line basis over an estimated life of 15 years. Trademarks and patents
      are amortized on a straight-line basis over their estimated life of 15 years.
      The customer list was amortized on a straight-line basis over an estimated
      life
      of five years. Noncompete agreements relate to agreements with former
      storeowners who sold their pharmacies to the Company. These agreements are
      amortized on a straight-line basis over the lives of the agreements, generally
      two to five years. Royalty rights relate to the purchase of certain franchise
      license agreements and are amortized on a straight-line basis over an estimated
      life of 20 years





Deferred
      financing costs are amortized as interest expense on an effective yield basis
      over the terms of the related debt. Amortization of approximately $0.3 million,
      $0.3 million and $0.3 million, for the fiscal years ended December 30, 2006,
      December 31, 2005 and January 1, 2005, respectively, was recorded as interest
      expense in the accompanying consolidated statements of operations.





***Store
      Opening and Closing Costs*** —Store
      opening costs are charged directly to expense when incurred, including rent
      expense during construction periods. When the Company makes a decision to close
      a store, the unrecoverable costs, including remaining lease obligations (net
      of
      estimated sublease rental income commencing in fiscal 2003 upon adoption of
      SFAS
      No. 146, *Accounting
      for Costs Associated with Exit or Disposal Activities* ),
      are
      charged to expense. SFAS No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets,* was
      adopted by the Company in fiscal 2003. SFAS No. 144 requires the results of
      operations of a component entity that is classified as held for sale or that
      has
      been disposed of to be reported as discontinued operations in the statement
      of
      operations if certain conditions are met. These conditions include commitment
      to
      a plan of disposal after the effective date of this statement, elimination
      of
      the operations and cash flows of the component entity from the ongoing
      operations of the company and no significant continuing involvement in the
      operations of the component entity after the disposal transaction.





***Concentration
      of Credit Risk*** —The
      Company’s receivables for the pharmacy operations are principally from
      third-party insurance plans and state Medicaid programs (collectively,
“Third-Party Customers”). The largest individual Third-Party Customer accounted
      for approximately 11%, 13% and 12% of the Company’s net revenues for the years
      ended December 30, 2006, December 31, 2005 and January 1, 2005, respectively.
      There is no other customer that represents over 10% of the Company’s net
      revenues for these periods. Total gross trade receivables for this customer
      were
      $1.3 million, $1.8 million and $0.7 million, as of December 30, 2006, December
      31, 2005 and January 1, 2005, respectively.




F-13




***Advertising*** —Advertising
      costs are charged to expense as incurred and were approximately $0.9 million,
      $1.2 million and $1.3 million for the fiscal years ended December 30, 2006,
      December 31, 2005 and January 1, 2005, respectively.





***Shipping
      and Handling Costs*** —Outbound
      shipping and handling costs are included in selling, general and administrative
      expenses in the accompanying consolidated statements of operations. Shipping
      and
      handling costs were approximately $1.3 million, $1.6 million and $1.3 million
      for the fiscal years ended December 30, 2006, December 31, 2005 and January
      1,
      2005, respectively.





***Income
      Taxes*** —The
      Company accounts for income taxes according to the provisions of SFAS No. 109, *Accounting
      for Income Taxes* .
      Under
      the asset and liability method, deferred tax assets and liabilities are
      recognized for the future tax effects attributable to operating loss
      carryforwards and to differences between the financial statement and tax bases
      of assets and liabilities and are measured using the enacted tax rates and
      laws
      that are expected to be in effect when the differences are expected to be
      reversed. Valuation allowances are established for deferred tax assets when
      realization is not likely.





***Per
      Share Information*** —The
      computations of basic and diluted loss per common share are based upon the
      weighted average number of common shares outstanding and potentially dilutive
      securities. Potentially dilutive securities include in-the-money stock options
      and in-the-money warrants of restricted stock. All options and warrants to
      purchase shares of common stock were not included in any computations of diluted
      net loss per common share, because inclusion of such shares would have been
      anti-dilutive.




***Segment*** —The
      Company operated as one business segment for all periods presented.





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




On
      January 1, 2006, the Company adopted SFAS No. 123(R) using a modified
      prospective method resulting in the recognition of share-based compensation
      expense of $0.6 million. Prior period amounts have not been restated. Under
      this
      application, the Company is required to record compensation expense for all
      awards granted after the date of adoption and for the unvested portion of
      previously granted awards that remain outstanding at the date of
      adoption.




Prior
      to
      January 1, 2006, and the adoption of FAS123(R), the Company applied Accounting
      Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (“Opinion 25”), and its related interpretations in accounting for employee stock
      compensation and Emerging Issues Task Force (“EITF”) 96-18, *Accounting
      for Equity Instruments That Are Issued to Other Than Employees for Acquiring,
      or
      in Conjunction with Selling, Goods or Services* ,
      to
      account for options issued to nonemployees. Forfeitures are accounted for in
      the
      period the options are actually forfeited. Had compensation cost for the
      Company’s stock-based compensation plans been determined based on the fair value
      at the grant dates for awards consistent with the method of SFAS No. 123, *Accounting
      for Stock-Based Compensation* ,
      the
      Company’s net loss would have changed to the pro forma amounts indicated below:





**Fiscal
                Year Ended****December
                31,**
            
            **January****1,****2005**
            
            **2005**Net
                loss available to common shareholders, as reported
            
            $
            (59,158
            )
            $
            (50,640
            )Add:
                Actual stock-based employee compensation expense
            
            
            6,118
            
            
            1,346Less:
                Pro forma stock-based employee contribution expense
            
            
            (6,580
            )
            
            (1,033
            )Effect
                of stock-based employee compensation expense determined under fair
                method
                valuation for all awards
            
            
            (462
            )
            
            313Pro
                forma net loss available to common shareholders
            
            $
            (59,620
            )
            $
            (50,327
            )Basic
                and diluted net loss available to common shareholder per
                share:As
                reported
            
            $
            (19.00
            )
            $
            (135.71
            )Pro
                forma
            
            $
            (19.15
            )
            $
            (134.90
            )




F-14




The
      fair
      value of each option grant has been for SFAS No. 123 purposes on the date of
      grant using the Black Scholes pricing model with the following
      assumptions:





**Fiscal
                Year Ended****December
                31,****2005**
            
            **January 1,**
              **2005**Risk-free
                interest rate
            
            
            3.42%
                - 4.52
            %
            
            3.54%
                - 4.22
            %Expected
                life
            
            
            3
                years
            
            
            3
                yearsVolatility
            
            
            58
            %
            
            48
            %Dividend
                yield
            
            
            —
            %
            
            —
            %Weighted
                average fair value of each option granted
            
            $
            1.77
            
            $
            3.50




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




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




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




F-15




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




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





**3.**
            **NEW
                ACCOUNTING PRONOUNCEMENTS**





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




In
      September 2006, the SEC issued Staff Accounting Bulletin, or SAB, No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements.* SAB No. 108
      provides guidance on how prior year misstatements should be taken into
      consideration when quantifying misstatements in current year financial
      statements for purposes of determining whether the current year’s financial
      statements are materially misstated. SAB No. 108 is effective for
      fiscal years ending on or after November 15, 2006. The adoption of SAB No.
      108 did not have a material impact on the Company’s financial position or
      results of operations.




**4.**
            **IMPAIRMENTS
                OF GOODWILL AND LONG-LIVED ASSETS**





During
      the fiscal years ended December 30, 2006, December 31, 2005 and January 1,
      2005,
      the Company recorded goodwill impairment charges of $1.4 million, $19.4 and
      $31.0 million, respectively relating to Familymeds Medical Supply business
      and
      discontinued operations. During the fiscal year ended December 30, 2006, the
      Company recorded an impairment charge of $1.7 million related to trademarks
      for
      $0.2 million and related to the wholesale distributor contracts for $1.5 million
      associated with the Familymeds Medical Supply business. The 2006 charges are
      included in continuing operations in the accompanying consolidated statements
      of
      operations. In addition, during the fiscal year ended December 31, 2005, the
      Company recorded an impairment charge of $3.2 million related to trademarks
      for
      $2.7 million and the customer list for $0.5 million associated with the
      discontinued business. The 2005 charges are included in discontinued operations
      in the accompanying consolidated statements of operations.





During
      the fiscal years ended December 30, 2006, December 31, 2005 and January 1,
      2005,
      the Company approved the closure of four, one and seven underperforming stores,
      respectively, and as a result, no impairments of long-lived assets were recorded
      in connection with the disposal of the related prescription file intangible
      assets and equipment for these locations as they were fully amortized at the
      time of disposal. Additionally, net lease obligations related to these stores
      of
      approximately $0.0 million, $0.0 million and $0.2 million were accrued,
      respectively and are included in write-downs of long-lived assets. During the
      fiscal years ended December 30, 2006, December 31, 2005 and January 1, 2005,
      the
      Company had favorable settlements on lease obligations of approximately $0.0
      million, $0.0 million and $0.1 million, respectively. Revenues for stores closed
      were $6.3 million, $0.8 million, and $1.7 million for the fiscal years ended
      December 30, 2006, December 31, 2005 and January 1, 2005, respectively. The
      operating income (loss) for the stores closed was $0.1 million, ($0.2) million
      and ($0.4) million for the fiscal years ended December 30, 2006, December 31,
      2005 and January 1, 2005, respectively. The Company also recorded impairment
      charges for prescription file intangible assets and property and equipment
      of
      approximately $0.0 million, $0.0 million and $0.3 million relating to
      underperforming and relocated stores during the fiscal years ended December
      31,
      2005, January 1, 2005, and December 27, 2003.




F-16




**5.**
            **PROPERTY
                AND EQUIPMENT**





Property
      and equipment consists of (amounts in thousands):





**December
                30,**
              **2006**
            
            **December
                31,**
              **2005**Land
            
            $
            393
            
            $
            —Computer
                equipment and software
            
            
            9,900
            
            
            8,983Furniture,
                fixtures and equipment
            
            
            5,850
            
            
            4,634Leasehold
                improvements
            
            
            4,401
            
            
            3,892Equipment
                under capital lease obligations
            
            
            177
            
            
            177Construction
                in progress
            
            
            50
            
            
            353Total
            
            
            20,771
            
            
            18,039Less
                accumulated depreciation and amortization
            
            
            (14,502
            )
            
            (13,080
            )Property
                and equipment, net
            
            $
            6,269
            
            $
            4,959





Depreciation
      and amortization expense of the Company’s property and equipment was
      approximately $1.8 million, $1.8 million and $2.2 million for the fiscal years
      ended December 30, 2006, December 31, 2005 and January 1, 2005, respectively.





**6.**
            **GOODWILL**





The
      changes in the carrying value of goodwill for the fiscal years ended December
      30, 2006 and December 31, 2005 are as follows (amounts in thousands):





**Fiscal
                Year Ended**
              **December
                30,**
              **2006**
            
            **Fiscal
                Year Ended**
              **December
                31,**
              **2005**Goodwill,
                beginning of fiscal year
            
            $
            1,355
            
            $
            19,813Adjustments
                to Goodwill:Additional
                contract costs relating to the Merger
            
            
            —
            
            
            936Merger
                expenses, including warrants issued to FMG shareholders related to
                the
                Merger
            
            
            —
            
            
            131Other
            
            
            
            
            
            (104
            )Total
                Adjustments to Goodwill
            
            
            —
            
            
            964Goodwill
                impairment charge
            
            
            (1,355
            )
            
            (19,422
            )Goodwill,
                end of fiscal year
            
            $
            —
            
            $
            1,355





F-17


The
      Merger required the Company to enter into an agreement with a former officer
      and
      director which requires payments in excess of market value over a three year
      period. The incremental costs of approximately $1.0 million over the term of
      the
      agreement were recorded as goodwill.  As of December 30, 2006, the
      remaining goodwill of $1.4 million relating to the Familymeds Medical Supply
      business (the ongoing business of direct distribution of pharmaceuticals to
      physicians, medical clinics and other healthcare providers) was written off
      in
      connection with the required annual impairment tests. The Company has estimated
      that any proceeds which may be realized from sale of this business in connection
      with the liquidation of the Company will not be sufficient to recover this
      amount.





**7.**
            **OTHER
                INTANGIBLE ASSETS**





Other
      intangible assets consist of (amounts in thousands):





**December
                30, 2006**
            
            **December
                31, 2005****Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**
            
            **Gross**
              **Carrying**
              **Amount**
            
            **Accumulated**
              **Amortization**Prescription
                files
            
            $
            17,475
            
            $
            (17,008
            )
            $
            18,130
            
            $
            (16,255
            )Trademarks
                and copyrights
            
            
            818
            
            
            (612
            )
            
            818
            
            
            (332
            )Wholesale
                distributor contracts
            
            
            1,800
            
            
            (1,800
            )
            
            1,800
            
            
            (135
            )Noncompete
                agreements
            
            
            869
            
            
            (868
            )
            
            883
            
            
            (882
            )Deferred
                financing costs
            
            
            984
            
            
            (369
            )
            
            895
            
            
            (70
            )$
            21,946
            
            $
            (20,657
            )
            $
            22,526
            
            $
            (17,674
            )




During
      fiscal year ended December 30, 2006, the Company recorded $1.7 million of
      impairment charges for trademarks of $0.2 million and the wholesale distributor
      contracts of $1.5 million related to Familymeds Medical Supply, respectively.
      The Company has estimated that any proceeds which may be realized from sale
      of
      this business in connection with the liquidation of the Company will not be
      sufficient to recover this amount. These charges have been recorded as
      impairments of goodwill and long-lived assets in the loss from continuing
      operations within the accompanying consolidated statements of
      operations.





The
      weighted average amortization period for intangible assets is approximately
      4.0
      years as of December 30, 2006. Included in the loss from continuing operations
      is amortization expense related to other intangible assets of approximately
      $1.6
      million, $2.6 million and $2.6 million for the fiscal years ended December
      30,
      2006, December 31, 2005 and January 1, 2005, respectively.





Estimated
      future amortization expense for the succeeding five years is as follows (amounts
      in thousands):





**Fiscal
                Year Ending**
            
            **Amount**2007
            
            $
            6722008
            
            
            3352009
            
            
            972010
            
            
            342011
            
            
            25




F-18


**8.**
            **DEBT**





Debt
      consists of the following (amounts in thousands):





**December****30,
                2006**
            
            **December****31,**
              **2005**Revolving
                credit facility
            
            $
            37,467
            
            $
            36,251Promissory
                notes payable
            
            
            76
            
            
            915Subordinated
                notes payable, net of discount of $2,247
            
            
            6,753
            
            
            —Subordinated
                notes payable
            
            
            —
            
            
            22,905Total
            
            $
            44,296
            
            $
            60,071





***Credit
      Facility***





On
      October 12, 2005, the Company entered into a Loan and Security Agreement with
      Wells Fargo Retail Finance, LLC (“WFRF”), pursuant to which WFRF will provide
      the Company with a senior secured revolving credit facility up to $65.0 million
      (the “New Credit Facility”). On that same date the Company terminated its $65.0
      million Amended and Restated Credit Agreement with General Electric Capital
      Corporation (“GECC”) and in connection therewith repaid all outstanding amounts
      due under the credit facility to GECC along with a $0.5 million termination
      fee.
      The $65.0 million of maximum availability under the New Credit Facility is
      reduced by a $7.0 million reserve. Available credit is based on eligible
      receivables, inventory and prescription files, as defined in and determined
      pursuant to the agreement, and may be subject to reserves as determined by
      the
      lender from time to time. Interest on the revolving line of credit is calculated
      at the prime index rate plus an applicable prime margin (as defined in the
      agreement), unless the Company or the lender chooses to convert the loan to
      a
      LIBOR-based loan. In each case, interest is adjusted quarterly. The applicable
      prime index margin as of December 30, 2006 was 8.25%. As of December 30,
      2006, the interest rate, including applicable margin, used to calculate
      accrued interest was 8.5%. Interest is payable monthly.





The
      New
      Credit Facility includes usual and customary events of default (subject to
      applicable grace periods) for facilities of this nature and provides that,
      upon
      the occurrence of an event of default, payment of all amounts payable under
      the
      New Credit Facility may be accelerated and/or the lenders’ commitments may be
      terminated. In addition, upon the occurrence of certain insolvency or bankruptcy
      related events of default, all amounts payable under the New Credit Facility
      shall automatically become immediately due and payable, and the lenders’
commitments shall automatically terminate. The New Credit Facility does not
      include any financial covenants.





The
      New
      Credit Facility includes an early termination fee of $0.7 million if paid in
      full before October 12, 2008. The New Credit Facility is secured by
      substantially all assets of the Company. As of December 30, 2006, $37.5 million
      was outstanding on the revolving line of credit and $1.0 million was available
      for additional borrowings, based on eligible receivables, inventory and
      prescription files.





In
      connection with the Walgreens’ Asset Sale, Wells Fargo Retail Finance, LLC, as
      agent for the revolving credit lenders pursuant to the Loan and Security
      Agreement dated as of October 12, 2005 (as amended, modified, supplemented
      or
      restated and in effect from time to time, the “Loan Agreement”) among (i)
      Familymeds Group, Inc. (f/k/a Drugmax, Inc.), as Lead Borrower, (ii) the other
      Borrowers party thereto from time to time, (iii) the Revolving Credit Lenders
      party thereto from time to time, (iv) and Wells Fargo, has consented to the
      Asset Sale and the consummation of the sale, subject to various terms and
      conditions. Among those conditions, we agreed that all proceeds received by
      us
      from the sale shall be paid to Wells Fargo for application to the credit
      facility until all amounts due under the facility are paid in full and the
      Loan
      Agreement is terminated. Each such payment of proceeds applied to the credit
      facility shall permanently reduce the commitments in the amount of such payment.




F-19





***Retired
      Subordinated Note and Convertible Debenture***





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





As
      further described below, on June 29, 2006, the Company and ABDC entered into
      an
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10.0
      million.




***Note
      and Warrant Purchase Agreement***





On
      June
      29, 2006, the Company entered into a Note and Warrant Purchase Agreement and
      certain other agreements, each effective as of June 23, 2006, with Deerfield
      Special Situations Fund, L.P. (“Deerfield L.P.”) and Deerfield Special
      Situations Fund International, Limited (“Deerfield International”), pursuant to
      which Deerfield L.P. and Deerfield International (collectively, “Deerfield”)
      purchased two secured promissory notes in the aggregate principal amount of
      $10.0 million (one note in the principal amount of $3.3 million and the second
      note in the amount of $6.7 million collectively the “Notes”) and eight warrants
      to purchase an aggregate of 1.65 million shares of Familymeds Group, Inc. common
      stock (the “Warrants”), for an aggregate purchase price of $10.0 million.





The
      $10.0
      million purchase price for the Notes and Warrants was used entirely for an
      early
      repayment, settlement and termination of approximately $23.0 million in
      outstanding subordinated debt with Familymeds Group’s former supplier
      AmerisourceBergen Drug Corporation (“ABDC”). The subordinated debt with ABDC
      consisted of a subordinated convertible debenture in the original principal
      amount of $11.5 million and a subordinated promissory note in the original
      principal amount of $11.5 million. Both original debt instruments were 5-year
      agreements maturing in September 2010. In connection with the Deerfield
      transaction, Familymeds Group and ABDC entered into a payoff and mutual release
      agreement pursuant to which the parties agreed to settle and retire both
      existing debt instruments for a lump sum repayment of $10.0 million. Wells
      Fargo
      Retail Finance, LLC (“WFRF”), the Company’s senior lender, consented to
      Familymeds Group’s early repayment of the ABDC debt and waived any default under
      Familymeds Group’s credit facility with WFRF as a result of such repayment by
      entering into an amendment to such credit facility with Familymeds Group and
      its
      subsidiaries. . The Company extinguished the ABDC Notes on June 29, 2006 which
      resulted in a gain on the extinguishment of $13.1 million.





Principal
      on each of the Notes is due and payable in successive quarterly installments
      each in the amount of $0.17 million and $0.33 million, respectively, beginning
      on September 1, 2006 and on each December 1, March 1, June 1 and September
      1
      thereafter and continuing until June 23, 2011, on which date all outstanding
      principal and accrued and unpaid interest is due. The Notes bear interest at
      a
      rate equal to 2.5% for the first year, 5.0% for the second year, 10.0% for
      the
      third year, 15.0% for the fourth year and 17.5% for the fifth year. The Notes
      may be prepaid by the Company at anytime without penalty. Interest expense
      has
      been estimated over the five year period to be approximately $1.8
      million (excludes the effect of amortization of the debt discount of $2.5
      million discussed below) and due to the increasing interest rate on this
      debt, the Company records the average quarterly interest expense and record
      a
      corresponding asset or liability for the difference not currently payable each
      quarter. As of December 30, 2006, the Company has classified this liability
      as
      current as it expects to retire this obligation within 12 months of the balance
      sheet date.




F-20





In
      lieu
      of making any interest payments in cash during the first and second year of
      the
      Notes, the Company may issue and deliver to Deerfield shares of Company common
      stock.  Pursuant to an amendment in October 2006, such shares shall be
      issued annually and Deerfield shall not be able to transfer or sell such shares
      until such time as the quarterly interest payment represented by those shares
      shall become due.  During the fourth quarter of 2006, 58,878 shares of
      common stock were issued to Deerfield representing the first year’s interest of
      approximately $0.2 million.





On
      December 15, 2006, the Company and Deerfield agreed pursuant to an amendment
      to
      the Notes and an investor rights agreement, that in lieu of making the December
      1, 2006 principal payment in cash, the Company shall issue and deliver to
      Deerfield a number of shares of common stock, par value $0.001 per share, of
      Borrower equal to 269,059.





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




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





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





On
      June
      29, 2006, in accordance with Accounting Principles Board (“APB”) Opinion No. 14
“Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants,”
the Company allocated the proceeds received between the debt and the detachable
      warrants based upon the relative fair market values on the dates the proceeds
      were received. The net value allocated to the warrants was $2.5 million and
      was
      determined using the Black-Scholes option pricing formula. The $2.5 million
      has
      been recorded as debt discount and will be amortized over the life of the
      related debt using the effective interest method. The effective interest rate
      on
      the Notes, after giving effect to the amortization of the debt discount is
      approximately 17.0% annually.





**9.**
            **CAPITAL
                STOCK**





***Common
      Stock*** —The
      number of authorized shares of common stock was increased from 24 million to
      45
      million shares on November 12, 2004. In connection with the Merger, the
      shareholders of FMG (along with certain FMG warrant holders and note holders)
      received an aggregate of 1,047,806 shares of Familymeds common stock. On
      September 7, 2005, shareholders of the Company approved an amendment to
      increase the Company’s authorized shares of common stock from 45 million to 100
      million. Then, on September 27, 2005, the Company’s authorized shares of
      common stock increased from 100 million to 200 million. Authorized common stock
      consists of 200 million shares of common stock, $.001 par value as of December
      30, 2006 and December 31, 2005.




F-21





On
      August
      27, 2003, the Company adopted the Drugmax, Inc. 2003 Restricted Stock
      Plan (“the Restricted Stock Plan”). Prior to the Merger, the
      Company had not issued any restricted shares under the Restricted Stock
      Plan. On November, 12, 2004, the number of shares authorized under the
      Restricted Stock Plan was increased from 150,000 shares to 350,000 shares.
      In
      connection with the Merger, the Company issued an aggregate of 65,605 shares
      of
      the Company’s restricted common stock to certain employees and directors of
      FMG. The restricted stock was scheduled to vest on March 25, 2005 or upon such
      time as a registration statement is declared effective. On March 23, 2005,
      certain of the restricted stock agreements were amended to change the vesting
      to
      June 15, 2005 or upon such time as a registration statement is declared
      effective by the SEC. The compensation charge recorded during the years ended
      December 31, 2005 and January 1, 2005 relating to the restricted stock was
      $2.1
      million and $0.6 million, respectively, which was based on the vesting
      provisions of the original restricted stock agreements.





During
      fiscal years ended December 30, 2006 and December 31, 2005, the Company issued
      33,436 and 51,605 shares of restricted stock to directors and employees,
      respectively. The shares issued to directors vested one-third upon the date
      of
      grant and one-third on each anniversary thereof. The employee shares vest
      two-thirds upon the first anniversary of the grant and one-third upon the second
      anniversary of the grant. Compensation expense related to these shares of $0.4
      million and $0.3 million was recorded during the fiscal years ended December
      30,
      2006 and December 31, 2005, respectively.





***Preferred
      Stock*** —
The
      number of authorized shares was increased from two million to five million
      preferred shares at the annual meeting on November 12, 2004, of which 17,000
      shares have been designated as Series A Convertible Preferred Stock. On December
      2, 2004, for an aggregate purchase price of $17 million, the Company sold to
      certain qualified institutional buyers and accredited investors an aggregate
      of
      17,000 shares of Series A convertible redeemable preferred stock (the “Series
      A”). These shares were convertible into an aggregate of 459,459 shares of the
      Company’s common stock, based upon an initial conversion price of $37.00 per
      share. However, in an amendment to the certificate of designation, on July
      7,
      2005, the conversion price was reduced from $37.00 per share to $28.00 per
      share
      and the Series A stock became convertible into an aggregate of 607,143 shares
      of
      Familymeds common stock. In addition, the investors received warrants to
      purchase an aggregate of 137,837 shares of Familymeds common stock. The exercise
      price of the warrants was $42.50 per share upon issuance. The exercise price
      was
      reduced to $10.90 upon the redemption of the Series A. The warrants are
      exercisable into common stock and expire on the fifth anniversary of the
      closing. The fair value of the warrants was originally estimated at $1.9 million
      based on Black Scholes valuation. The modification of the warrant exercise
      price
      resulted in an increase in the fair value of the warrants of $0.7 million to
      $2.5 million which is being recorded as additional preferred stock dividends
      over the ten-year estimated life of the Familymeds Series A convertible
      redeemable preferred stock. In connection with the redemption of the Series
      A
      convertible preferred stock, on October 3, 2005, the unamortized discount
      was fully amortized and recorded as an increase to the accumulated deficit
      in the consolidated statement of changes in shareholders’ (deficit)
      equity.





The
      Company filed a registration on Form S-3 to register the resale of the shares
      of
      common stock issuable upon the conversion of the Series A stock and the exercise
      of the warrants. The Company was required to maintain the registration effective
      until all of such shares have been sold or may be sold without volume
      restrictions pursuant to rule 144. The Form S-3 was declared effective by the
      SEC on January 19, 2005. The Company’s agreement with the preferred shareholders
      contained a provision to the effect that if the registration statement ceased
      for any reason to remain continuously effective or the holders were not
      permitted to utilize the prospectus therein to resell such registrable
      securities for 10 consecutive calendar days but no more than an aggregate of
      15
      calendar days during any 12-month period (the “Event Date”), then in addition to
      any other rights the holders may have, the Company shall pay to each holder
      an
      amount in cash equal to 2% of the aggregate purchase price paid by such holder
      as partial liquidated damages. Such amounts were to be payable on the Event
      Date
      and on each monthly anniversary of the Event Date until such time as the
      registration statement became effective or until the holders are permitted
      to
      utilize the prospectus to resell securities.




F-22





Effective
      April 20, 2005, the Company suspended sales under the previously filed
      registration statement to resell such securities. Under the terms of the Series
      A, the investors were entitled to liquidated damages until such time as the
      registration statement became effective. On July 7, 2005, the Company amended
      the certificate of designation to reduce the conversion price of the Series
      A
      from $37.00 to $28.00 per share. In exchange, investors representing 95% of
      the
      Series A shareholders agreed to waive liquidated damages under the registration
      rights agreement through the date of the amendment and to amend the registration
      rights agreement to require the filing of a registration statement covering
      the
      registrable securities by July 8, 2005 and to require the effectiveness of
      such
      registration statement to be no later than October 1, 2005. On July 7, 2005,
      the
      Company filed a registration statement on Form S-1. The SEC declared the Form
      S-1 effective on August 10, 2005. The amount of the liquidated damages owed
      as
      of July 2, 2005, $1.0 million, substantially all of which was waived by the
      shareholders, was recorded as additional Familymeds preferred stock dividends
      for the three months ended July 2, 2005. A total of $1.1 million was accrued
      through July 7, 2005 related to liquidated damages and reversed during the
      three
      months ended October 1, 2005. The revised conversion price does not represent
      a
      beneficial conversion feature.





The
      Series A contained an increasing-rate dividend as follows: 7% per annum until
      the fourth anniversary; 9% per annum from the fourth until the fifth
      anniversary; 11% per annum from the fifth until the sixth anniversary and 14%
      per annum thereafter. In accordance with SEC Staff Accounting Bulletin Topic
      5, *Miscellaneous
      Accounting* ,
      Section
      Q, the Company has recorded dividends in amounts equal to a consistent effective
      rate over the life of the preferred stock.





On
      October 3, 2005, the Company redeemed the Series A convertible redeemable
      preferred stock for cash of $17.0 million and 48,807 shares of common stock
      valued at $0.8 million. The common stock issued is reflected as an additional
      dividend on the Series A convertible redeemable preferred
      stock.





***FMG
      Redeemable Convertible Preferred Stock*** —
Prior
      to the Merger, FMG had outstanding Series A, B, C, D and E Preferred Stock.
      In
      connection with the Merger, the Company issued 836,353 shares of its common
      stock to certain FMG preferred shareholders which were allocated to FMG’s
      preferred shareholders based on liquidation preferences. Based on the
      ten-day-weighted stock price of $37.969 as of November 12, 2004, the FMG Series
      E shareholders received Company common stock equal to their full liquidation
      preference, the FMG Series C preferred shareholders and FMG Series D preferred
      shareholders received Familymeds stock equal to approximately 7% of their
      liquidation preferences and the FMG Series A preferred shareholders, FMG Series
      B preferred shareholders and FMG common shareholders received no consideration
      for their shares.





The
      Company also issued warrants to purchase 350,009 shares of the Company’s common
      stock at $26.10 per share to the former FMG shareholders and note holders.
      The
      warrants were allocated among the FMG shareholders, note holders in the same
      manner as the Familymeds common stock and warrants to purchase 195,069 shares
      were allocated to former FMG preferred shareholders. The fair value of the
      warrants issued to the former FMG preferred shareholders of $5.5 million based
      on a Black Scholes valuation was recorded as a preferred stock dividend prior
      to
      the Merger.





Following
      is a summary of FMG liquidation preferences and the shares received by FMG
      note
      holders and preferred shareholders in the Merger:





**Familymeds**
              **Common
                Shares**
              **Received**
            
            **Liquidation**
              **Value
                as of**
              **Merger
                Date**
            
            **Carrying
                Value as**
              **of
                Merger Date**Noteholders,
                including accrued interest
            
            
            210,698
            
            $
            8,000
            
            $
            8,000Series
                E Preferred Shareholders, after warrant exercise
            
            
            697,471
            
            
            26,482
            
            
            17,860Series
                D Preferred Shareholders
            
            
            95,273
            
            
            3,617
            
            
            54,619Series
                C Preferred Shareholders
            
            
            43,609
            
            
            1,656
            
            
            25,000Series
                B Preferred Shareholders
            
            
            —
            
            
            —
            
            
            14,688Series
                A Preferred Shareholders
            
            
            —
            
            
            —
            
            
            8,159Total
            
            
            1,047,051
            
            $
            39,755
            
            $
            128,326




F-23





Dividends
      on FMG preferred stock were accrued through the Merger date. Following is a
      summary of the terms and conditions of the FMG preferred stock prior to the
      Merger:





FMG
      Series E Redeemable Convertible Preferred Stock—On June 22, 2001, FMG issued to
      existing investors 988,441 shares of Series E Redeemable Convertible Preferred
      Stock (“FMG Series E Preferred Stock”) at a purchase price of $9.87 per share
      for aggregate proceeds of $9.8 million. In connection with this transaction,
      FMG
      incurred $0.2 million of professional fees and closing costs, which were offset
      against the proceeds. The carrying amount of the FMG Series E Preferred Stock
      was increased by periodic accretion, using the effective interest method, with
      charges to accumulated deficit. For the fiscal year ended January 1, 2005,
      $0.04
      million, of expenses were accreted. The Series E Preferred Stock accrued
      dividends at 8% per annum, was senior to all other classes of stock, had certain
      special voting rights and had an initial liquidation value of $9.87 per share.
      In exchange for the commitment and funding of the Notes, FMG issued certain
      note
      holders warrants to purchase 438,249 shares of FMG Series E Preferred Stock
      at
      an exercise price of $9.87 per share. The fair value of the warrants as of
      the
      date of issuance was $0.05 million using the Black-Scholes model. These warrants
      were exercised into 438,249 shares of FMG Series E Preferred Stock on a cashless
      basis prior to the Merger.





FMG
      Series E Preferred Stock was senior to all other Series of preferred stock
      and
      had to have 100% of their liquidation preference satisfied prior to distribution
      to the other Series of preferred stock. As of the Merger, November 12, 2004,
      Series E was convertible into common stock at $148.10 per share. The Series
      E
      Preferred Stock accrued dividends at 8% per annum, and had certain special
      voting rights. Upon a liquidation event, Series E preferred shareholders were
      entitled to receive the greater of the value of two times the liquidated value
      plus accrued dividends or the amount received on an “as converted” basis. The
      holders had the right to require the Company to redeem the Series E Preferred
      Stock in August 2005.




FMG
      Series D Redeemable Convertible Preferred Stock—In July 2000, FMG issued to an
      investor group 1,542,188 shares of Series D Redeemable Convertible Preferred
      Stock (“FMG Series D Preferred Stock”), with a par value of $0.01 at a purchase
      price of $18.37 per share for gross proceeds of $28.3 million. In connection
      with this transaction, FMG incurred approximately $1.8 million of professional
      fees and closing costs, which were offset against the proceeds. The carrying
      amount of the FMG Series D Preferred Stock was increased by periodic accretion,
      using the effective interest method, with charges to accumulated deficit. For
      the fiscal years ended January 1, 2005, $0.3 million, of expenses were accreted,
      respectively.





In
      connection with the FMG Series D Preferred Stock issuance, $10.0 million of
      convertible promissory notes issued in March 2000 were converted into FMG Series
      D Preferred Stock in fiscal 2000 at $17.45 per share. Upon conversion, the
      note
      holders received 573,017 shares of FMG Series D Preferred Stock and exercised
      the nondetachable warrants for an additional 102,564 shares of FMG Series D
      Preferred Stock at a price of $9.75 per share for $1.0 million.





The
      Series D Preferred Stock was convertible into common stock at any time and
      would
      automatically convert into common stock upon the closing of an initial public
      offering with gross proceeds of at least $30.0 million. The FMG Series D
      Preferred Stock accrued dividends at 8% per annum, had certain special voting
      rights and had an initial liquidation value of $18.37 per share. Due to the
      absence of certain events, including an underwritten public offering of FMG’s
      stock, not occurring within 18 months, the FMG Series D Preferred Stock
      shareholders’ conversion price was adjusted. The adjusted conversion price
      entitled such shareholder to the number of common shares issuable upon
      conversion of the Series D. The change in the conversion ratio had no accounting
      implications since the conversion terms did not represent a beneficial
      conversion feature. Additionally, in the event of an underwritten public
      offering, dividends would become payable in cash. Upon liquidation or
      redemption, the Series D Preferred Stock shareholders were entitled to the
      liquidation value, including any unpaid dividends. The holders of FMG Series
      D
      Preferred Stock had the right to require the Company to redeem the stock in
      August 2005. FMG Series D and C Preferred Stock were senior to FMG Series B
      and
      A Preferred Stock, but were subordinate to FMG Series E Preferred Stock. Series
      D and C shared pari passu after satisfaction of the Series E in connection
      with
      the Merger.




F-24





FMG
      Series C Convertible Preferred Stock—On May 14, 1999, FMG issued to an investor
      group 2,564,102 shares of Series C Convertible Preferred Stock (“FMG Series C
      Preferred Stock”), with a par value of $0.01 at a purchase price of $9.75 per
      share for aggregate proceeds of $25.0 million. In connection with this
      transaction FMG incurred $0.3 million of professional fees and closing costs,
      which were offset against the proceeds. The FMG Series C Preferred Stock
      shareholders were entitled to convert each share of FMG Series C Preferred
      Stock
      into that number of fully paid and non-assessable shares of common stock as
      is
      determined by dividing the initial conversion price of $14.63 by the conversion
      price in effect at the time of conversion. The conversion rate was subject
      to
      adjustment for the effects of dilution. The FMG Series C Preferred Stock
      shareholders were entitled to certain special voting rights, preferential
      liquidation rights (initial liquidation value of $9.75 per share) and
      anti-dilutive provisions. Dividends did not accrue on the Series C Preferred
      Stock.





FMG
      Series B Redeemable Convertible Preferred Stock—On June 8, 1998, FMG issued to
      an investor group 2,042,105 shares of Series B Redeemable Convertible Preferred
      Stock (“FMG Series B Preferred Stock”), with a par value of $0.01 at a purchase
      price of $4.75 per share for aggregate proceeds of $9.7 million. In connection
      with this transaction, FMG incurred approximately $0.2 million of professional
      fees and closing costs, which were offset against the proceeds. The carrying
      amount of the FMG Series B Preferred Stock was increased by periodic accretion,
      using the effective interest method, with charges to accumulated deficit. For
      the fiscal year ended January 1, 2005 $0.03 million of expenses were accreted.
      The FMG Series B Preferred Stock accrued dividends at an annual rate of 8%
      of
      liquidation value, as defined, with an initial liquidation value of $4.75 per
      share. Concurrent with the FMG Series C Convertible Preferred Stock issuance,
      the conversion price of the FMG Series B Preferred Stock was adjusted to $7.83
      per share and the existing 2,042,105 FMG Series B Preferred Stock shares were
      exchanged for 1,858,239 shares of FMG Series B Preferred Stock with a
      liquidation value of $5.22 per share, plus unpaid dividends.





The
      FMG
      Series B Preferred Stock shareholders were entitled to convert each share of
      FMG
      Series B Preferred Stock into that number of fully-paid and non-assessable
      shares of common stock determined by dividing the initial conversion price
      of
      $7.83 by the conversion price in effect at the time of conversion. The
      conversion rate was subject to adjustment for the effects of dilution.
      Additionally, the Company had the option to convert each share of Series B
      Preferred Stock into common stock upon the occurrence of an initial public
      offering with aggregate gross proceeds to the Company of at least $15.0 million
      and at a price per share of at least three times the then conversion price.
      Upon
      such conversion, all accrued dividends will be canceled. The holders of Series
      B
      Preferred Stock, subject to the consent of both the Series C and Series D
      Preferred Stock shareholders, also have the right to require the Company to
      redeem 25% of the Series B Preferred Stock outstanding immediately prior to
      the
      fifth anniversary of the Series B Preferred Stock issuance and on the sixth,
      seventh and eighth anniversaries. The Series B Preferred Stock shareholders
      were
      entitled to certain special voting rights, registration rights and anti-dilutive
      provisions.





FMG
      Series B and A were subordinate to all other Series of FMG preferred stock.
      If a
      liquidation amount remained after all other FMG preferred shareholders were
      100%
      satisfied, Series B and A would have shared pari passu up to the amount of
      their
      respective liquidation preferences.





FMG
      Series A Redeemable Convertible Preferred Stock—On December 18, 1996, FMG issued
      to an investor group 900,000 shares of Series A Redeemable Convertible Preferred
      Stock (“FMG Series A Preferred Stock”) with a par value of $0.01 at a purchase
      price of $5.55 per share for aggregate proceeds of approximately $5.0 million.
      In connection with this transaction, FMG incurred approximately $0.2 million
      of
      professional fees and closing costs, which were offset against the proceeds.
      The
      carrying amount of the FMG Series A Preferred Stock was increased by periodic
      accretion, using the effective interest method, with charges to accumulated
      deficit. Conversion and dividend features are calculated for FMG Series A
      Preferred Stock in the same manner as the FMG Series B Preferred Stock with
      the
      exception of the following:


·
              FMG
                  Series A Preferred Stock initial conversion price was $8.33 per
                  share; and




F-25


·
            FMG
                Series A Preferred Stock liquidation value was adjusted from $5.55
                per
                share to $5.69 per share in conjunction with the FMG Series B Preferred
                Stock issuance.





To
      redeem
      a FMG Series A Preferred Stock shareholder in 1998, the Company purchased
      468,406 shares of FMG Series A Preferred Stock for $1,749,337. Voting rights,
      redemption rights, registration rights and anti-dilutive provisions were
      identical to Series B Preferred Stock shares.





***FMG
      Common Stock*** -Immediately prior to the Merger there were 248,565 voting and non-voting common
      shares of FMG issued and outstanding.




F-26




**10.**
            **EMPLOYEE
                BENEFITS**





The
      Company has three 401(k) defined contribution plans that cover eligible
      full-time employees that existed prior to the Merger for Familymeds employees.
      During fiscal 2006, 2005 and 2004, Familymeds, Inc. contributed 50% of an
      employee’s pre-tax contribution up to a maximum of 4% of an employee’s eligible
      compensation to the Familymeds Plan. During the fiscal years ended December
      30,
      2006, December 31, 2005 and January 1, 2005, the Company contributed
      approximately $0.2 million, $0.2 million and $0.3 million, respectively, to
      the
      Familymeds Plan.





Company
      contributions to the primary Familymeds 401(k) Plans are discretionary. The
      Company made no contributions to the Familymeds 401(k) Plan for the period
      subsequent to the Merger.





**11.**
            **INCOME
                TAXES**





The
      Company incurred net operating losses for the fiscal years ended December 30,
      2006, December 31, 2005 and January 1, 2005. Accordingly, no benefit for income
      taxes has been recorded due to uncertainty of realization.





The
      components of deferred income tax assets (liabilities) at December 30, 2006
      and
      December 31, 2005 are as follows (amounts in
      thousands):




**December
                30,**
              **2006**
            
            **December
                31,**
              **2005**Deferred
                Tax Assets (Liabilities)Trade
                receivables
            
            $
            1,431
            
            $
            1,188Inventories
            
            
            1,226
            
            
            502Accrued
                expenses
            
            
            62
            
            
            453Property
                and equipment
            
            
            (65
            )
            
            16Intangible
                assets
            
            
            15,920
            
            
            9,472Tax
                effect of net operating loss carryforwards
            
            
            58,185
            
            
            56,425Stock
                options
            
            
            2,438
            
            
            2,443Other
            
            
            65
            
            
            160Total
            
            
            79,262
            
            
            70,659Valuation
                allowance
            
            
            (79,262
            )
            
            (70,659
            )Total,
                net
            
            $
            -
            
            $
            -




A
      valuation allowance has been established for the full amount of the net deferred
      tax asset as of December 30, 2006 and December 31, 2005 which, based upon
      available evidence, will likely not be realized.





Following
      is a reconciliation of the statutory income tax rate to the effective income
      tax
      rate for the fiscal years ended December 30, 2006, December 31, 2005 and January
      1, 2005:




**Fiscal
                Year Ended****December
                30, 2006**
            
            **December
                31, 2005**
            
            **January
                1, 2005**Statutory
                rate
            
            
            (34
            )%
            
            (34
            )%
            
            (34
            )%State
                income tax rate benefit, net of federal effect
            
            
            (5
            )%
            
            (5
            )%
            
            (5
            )%Change
                in valuation allowance
            
            
            39
            %
            
            39
            %
            
            39
            %Effective
                tax rate
            
            
            —
            %
            
            —
            %
            
            —
            %





F-27




At
      December 30, 2006, the Company had net operating loss carryforwards (“NOL’s”)
      for federal and state income tax purposes of approximately $149 million and
      $90
      million, respectively, that are available, other than as described below, to
      offset future taxable income and expire from 2016 through 2026. As a result
      of
      changes in the Company’s ownership, usage of the Company’s NOL’s is limited. As
      of December 30, 2006, approximately $142 million of the federal NOL carryforward
      is subject to a usage limitation of approximately $2.2 million per year. The
      amount of NOL’s that may not be available for usage prior to expiration due to
      NOL usage limitations is approximately $96 million.




**12.**
            **STOCK
                OPTIONS**





As
      of
      January 1, 1998, FMG adopted its 1998 Non-Qualified Stock Option Plan. The
      plan
      was amended July 1, 1999, and the FMG’s 1999 Non-Qualified Stock Option Plan
      (“the FMG 1999 Non-Qualified Stock Option Plan”) was adopted. The majority of
      options issued under the FMG 1999 Non-Qualified Stock Option Plan vested evenly
      over a three-year period and expired after five years. On April 25, 2000, FMG
      adopted its 2000 Stock Option Plan (“the FMG 2000 Plan”). Options were granted
      under the FMG 2000 Plan to employees, directors or consultants. Immediately
      prior to the Merger, FMG vested all outstanding stock options that had not
      terminated by their own terms prior to the Merger and issued one share of FMG
      non-voting common stock for each such outstanding FMG option on a one-for-one
      basis resulting in the issuance of 52,465 common shares. A compensation charge
      of $0.8 million was recorded during the fiscal year ended January 1, 2005
      related to the exchange which represented to estimated fair value of the shares
      issued. Accordingly, at the time of the Merger, no options to purchase FMG
      common stock remained outstanding.





On
      August
      13, 1999, the Company adopted its 1999 Incentive and Non-Statutory Stock Option
      Plan (the “DrugMax 1999 Plan”). On June 5, 2002, the first amendment to the
      DrugMax 1999 Plan was adopted. In connection with the Merger, on November 12,
      2004, the number of shares authorized under the DrugMax 1999 Plan was increased
      from 200,000 to 600,000 shares. Prior to the Merger, options were granted under
      the DrugMax 1999 Plan to employees and directors of FMG. As a result of the
      Merger on November 12, 2004, all of such options immediately vested.





In
      connection with the Merger, the Company issued options to purchase 157,284
      shares of the Company’s common stock at $5.70 per share to certain employees and
      directors of FMG that remained employees and directors of the Company after
      the
      Merger. The options vested immediately and became exercisable on January 4,
      2006. A compensation charge was recorded over the period the options become
      exercisable. Accordingly, $0.0 million, $4.2 million and $0.5 million of stock
      compensation expense was recorded during the years ended December 30, 2006, December
      31, 2005 and January 1, 2005, respectively, related to the options issued in
      connection with the Merger that had exercise prices less than their fair value.





During
      fiscal years ended December 30 2006 and December 31, 2005, 75,125 and 161,358
      stock options were granted to directors and employees of the Company,
      respectively. The majority of these grants vest evenly over three
      years.


F-28


The
      following table summarizes information about our stock option plans for
      the year ended December 30, 2006.




**Outstanding****Number
                of Shares**
            
            **Weighted
                Average Exercise Price**
            
            **Weighted
                Average Remaining Contractual Life**
            
            **Weighted
                Average Fair Value**Shares
                under option at December 31, 2005
            
            
            377,084
            
            $
            17.66
            
            
            7.8
            
            $
            24.36Granted
                2006
            
            
            75,125
            
            $
            7.67
            
            
            
            
            $
            4.24Forfeited
                2006
            
            
            (59,781
            )
            $
            45.01
            
            
            
            
            $
            38.81Exercised
                2006
            
            
            (1,521
            )
            $
            5.70
            
            
            
            
            $
            34.80Shares
                under option at December 30, 2006
            
            
            390,907
            
            $
            11.61
            
            
            8.1
            
            $
            18.24Shares
                exercisable at December 30, 2006
            
            
            284,013
            
            $
            12.08
            
            
            7.9
            
            $
            23.27




**Options
                Outstanding**
            ****
            ****
            **Options
                  Exercisable**
            ********
            ****
            ****
            **Number**
                    **Outstanding at**
                    **December
                      30,**
                    **2006**
            
            ****
            **Weighted**
                      **Average**
                      **Remaining**
                      **Contractual**
                      **Life
                        (Years**)
            ****
            ****
            **Weighted**
                    **Average**
                    **Exercise**
                    **Price**
            ****
            ****
            **Number**
                    **Exercisable at**
                    **December 30,**
                    **2006**
            ****
            ****
            **Weighted**
                      **Average**
                      **Remaining**
                      **Contractual**
                      **Life
                        (Years**)
            ****
            ****
            **Weighted**
                    **Average**
                    **Exercise**
                    **Price**$5.70
                to $10.00
            
            
            221,357
            
            
            8.3
            
            $
            6.00
            
            
            162,732
            
            
            7.9
            
            $
            5.76$10.50
                to $13.90
            
            
            99,500
            
            
            8.8
            
            $
            13.15
            
            
            61,499
            
            
            8.7
            
            $
            13.24$14.00
                to $130.00
            
            
            70,050
            
            
            6.4
            
            $
            27.13
            
            
            59,782
            
            
            6.8
            
            $
            28.09390,907
            
            
            
            
            
            
            
            
            284,013





As
      of
      December 30, 2006, there was $0.2 million of total unrecognized compensation
      cost related to stock options. These costs are expected to be recognized over
      a
      weighted average period of 1.1 years. The total fair value of stock awards
      granted was $0.3 million during the year ended December 30, 2006. Cash received
      from stock option exercises for the year ended December 30, 2006 was $0.009
      million. There are no income tax benefits from share based arrangements.




F-29




The
      following table summarizes information about restricted stock awards issued
      under the 2003 Restricted Stock Plan for the year ended December 30,
      2006:





**Non-vested
                shares****Number
                of Shares**
            
            **Weighted
                Average Fair Market Value**Non-vested
                shares at December 31, 2005
            
            
            44,403
            
            $
            15.65Granted
                2006
            
            
            33,436
            
            $
            6.58Forfeited
                2006
            
            
            -
            
            
            -Vested
                2006
            
            
            (35,014
            )
            $
            13.34Non-vested
                shares at December 30, 2006
            
            
            42,825
            
            $
            10.46





As
      of
      December 30, 2006, there was $0.4 million of total unrecognized compensation
      costs related to restricted stock awards. These costs are expected to be
      recognized over a weighted average period of 1.0 year. At December 30, 2006,
      an
      aggregate of 0.4 million shares of common stock remained available for future
      grants under our stock plans, which cover restricted stock awards and stock
      options. We issue shares to satisfy stock option exercises and restricted stock
      awards.





**13.**
            **RELATED
                PARTY TRANSACTIONS**





The
      Arrow
      Employee Benefit Trust (the “Trust”) was created to purchase group medical
      insurance for FMG, franchisees and certain affiliates. Use of the Trust was
      terminated effective May 17, 2004.




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





The
      original lease (dated December 30, 2003) (the “Original Lease”) provided for a
      term of 15 years, expiring December 30, 2018, and monthly lease payments of
      $0.017 million.  When the Original Lease was executed, Becan and Valley
      North entered into a Consent, Subordination and Assumption Agreement (the
“Guarantee”) with the Pennsylvania Industrial Development Authority (“PIDA”) and
      Regional Industrial Development Corporation of Southwest Pennsylvania (“RIDC”)
      dated December 30, 2003, pursuant to which, among other things, Becan and Valley
      Drug Company (Valley North”), jointly and severally, assumed all obligations of
      RIDC to make payments and discharge all obligations expenses, costs and
      liabilities of RIDC in connection with the PIDA note (the “PIDA Note”). 
The PIDA Note is also secured by the Original Lease and the property.




F-30




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





In
      January 2004, prior to the Merger, the Company executed a second commercial
      lease agreement (the “Second Lease”) with an entity controlled by certain
      directors and officers of the Company at the time, including Mr. Jugal K.
      Taneja, a current director. The Second Lease is for an initial period of fifteen
      years with a base monthly lease payment of $0.017 million. During the fiscal
      year ended December 31, 2005, the Company recorded rent expense of $0.2 million
      related to the Second Lease. This lease was terminated in accordance with the
      terms therein on October 18, 2006.





**14.**
            **COMMITMENTS
                AND CONTINGENCIES**





***Operating
      Leases*** —The
      Company leases its headquarter office space under an operating lease expiring
      in
      2007 with a renewal option through 2012. The Company also leases space for
      its
      pharmacies, distribution centers, vehicles, furniture and fixtures and office
      equipment under various operating leases. Certain leases include renewal
      options. Rent expense on these operating leases was approximately $3.1 million,
      $3.5 million and $3.4 million for the fiscal years ended December 30, 2006,
      December 31, 2005 and January 1, 2005, respectively.





Minimum
      lease payments under these leases are as follows, excluding renewal options
      (amounts in thousands):





**Fiscal
                Years**2007
            
            $
            2.02008
            
            
            1.42009
            
            
            1.02010
            
            
            0.42011
            
            
            0.3Thereafter
            
            
            0.5Total
            
            $
            5.6




F-31


***Legal
      Matters-*** On
      November 12, 2003, Phil & Kathy’s, Inc. d/b/a Alliance Distributors
      (“Alliance”) served a complaint against the Company seeking to recover the
      non-payment of open invoices approximating $2.0 million based upon an alleged
      breach of contract for the sale of pharmaceuticals. On December 18, 2003, the
      Company filed an answer and counterclaim. The counterclaim seeks to recover
      lost
      profits and other damages relating to the sale of twenty allegedly counterfeit
      bottles of Lipitor by Alliance to the Company, which the Company later sold
      to
      QK Healthcare, Inc. (“QK”). Alleging that the Lipitor was counterfeit, QK later
      sued the Company for breach of contract, violations of the implied warranty
      of
      merchantability and fraud. Accordingly, the Company’s subsidiary, Valley, also
      filed a separate action against Alliance for breach of an indemnification
      agreement related to the sale of the twenty bottles of Lipitor that precipitated
      a lawsuit against Valley by QK in New York. At March 31, 2005, the amount that
      the Company recorded as a trade payable balance due Alliance on the above was
      approximately $1.5 million. Under an indemnification agreement with Alliance,
      pursuant to which Alliance is required to indemnify the Company for all losses,
      expenses and damages sustained by the Company as a result of product sold to
      the
      Company by Alliance, and the Company’s right to offset its losses, expenses and
      damages against any amounts due to Alliance, the Company reduced the payable
      to
      Alliance by the cost of the faulty Lipitor sold to the Company by Alliance
      plus
      the settlement and litigation expenses incurred by the Company directly as
      a
      result of the Lipitor, or an aggregate of $0.5 million. The Company has recorded
      the foregoing trade payable of $1.5 million as of December 30, 2006 and believes
      this estimate is reasonable based on the information it has at this time;
      however, the Company cannot reasonably estimate the total future possible loss
      that it will sustain as a result of the Alliance complaint or the possible
      recovery through its counterclaim or Valley’s consolidated action. The parties
      have already exchanged written discovery.  The parties attempted to mediate
      this matter during the month of January 2006. A motion for Summary Judgment
      was
      filed by the plaintiffs and they were granted a partial judgment. The parties
      are awaiting disposition on the motion for clarification of summary judgment.
      The court has set no trial date.





From
      time
      to time, the Company may become involved in additional litigation arising in
      the
      ordinary course of the Company’s business. In the opinion of management, after
      consultation with counsel, the disposition of these matters arising in the
      normal course of business is not likely to have a material adverse effect,
      individually or in the aggregate, on the Company’s financial position or results
      of operations.





**15.**
            **QUARTERLY
                FINANCIAL INFORMATION (UNAUDITED)**





**Three
                Months Ended****April
                2,**
            
            **July
                1,**
            
            **September
                30,**
            
            **December 30,****2006**
            
            **2006**
            
            **2006**
            
            **2006*****Dollars
                in thousands, except per share amounts*****Fiscal
                2006:**Net
                revenues
            
            $
            56,040
            
            $
            60,743
            
            $
            57,915
            
            $
            55,826Gross
                margin
            
            
            10,915
            
            
            11,873
            
            
            11,383
            
            
            10,686Operating
                loss
            
            
            (2,910
            )
            
            (3,470
            )
            
            (1,523
            )
            
            (5,551
            )Gain
                on extinguishment of debt
            
            
            —
            
            
            13,086
            
            
            —
            
            
            —Income
                (loss) from continuing operations
            
            
            (4,237
            )
            
            8,241
            
            
            (2,927
            )
            
            (6,937
            )Income
                (loss) from discontinued operations (1)
            
            
            181
            
            
            (403
            )
            
            (144
            )
            
            (965
            )Net
                income (loss)
            
            
            (4,056
            )
            
            7,838
            
            
            (3,071
            )
            
            (7,902
            )Net
                loss available to common shareholders
            
            
            (4,056
            )
            
            7,838
            
            
            (3,071
            )
            
            (7,902
            )**BASIC
                INCOME (LOSS) PER COMMON SHARE:**Income
                (loss) from continuing operations available to common
                shareholders
            
            $
            (0.64
            )
            $
            1.25
            
            $
            (0.44
            )
            $
            (1.03
            )Income
                (loss) from discontinued operations (1)
            
            
            0.03
            
            
            (0.06
            )
            
            (0.02
            )
            
            (0.14
            )Net
                income (loss) available to common shareholders
            
            $
            (0.61
            )
            $
            1.19
            
            $
            (0.46
            )
            $
            (1.17
            )**DILUTED
                INCOME (LOSS) PER COMMON SHARE:**Income
                (loss) from continuing operations available to common
                shareholders
            
            $
            (0.64
            )
            $
            1.24
            
            $
            (0.44
            )
            $
            (1.03
            )Income
                (loss) from discontinued operations (1)
            
            
            0.03
            
            
            (0.06
            )
            
            (0.02
            )
            
            (0.14
            )Net
                income (loss) available to common shareholders
            
            $
            (0.61
            )
            $
            1.18
            
            $
            (0.46
            )
            $
            (1.17
            )**WEIGHTED
                AVERAGE SHARES OUTSTANDING:**Basic
                (reflects 1 for 10 reverse stock split)
            
            
            6,587
            
            
            6,606
            
            
            6,623
            
            
            6,703Diluted
                (reflects 1 for 10 reverse stock split)
            
            
            6,587
            
            
            6,633
            
            
            6,623
            
            
            6,703Dividends
                per common share
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —





F-32




**Three
                Months Ended****April
                2,**
            
            **July
                2,**
            
            **October
                1,**
            
            **December 31,****2005**
            
            **2005**
            
            **2005**
            
            **2005*****Dollars
                in thousands, except per share amounts*****Fiscal
                2005:**Net
                revenues
            
            $
            57,201
            
            $
            54,715
            
            $
            51,755
            
            $
            52,432Gross
                margin
            
            
            11,943
            
            
            11,033
            
            
            9,877
            
            
            9,582Operating
                loss
            
            
            (3,202
            )
            
            (4,107
            )
            
            (4,656
            )
            
            (4,462
            )Loss
                from continuing operations
            
            
            (3,770
            )
            
            (5,421
            )
            
            (6,342
            )
            
            (6,319
            )Loss
                from discontinued operations (1)
            
            
            (1,226
            )
            
            (1,744
            )
            
            (8,193
            )
            
            (21,842
            )Net
                loss
            
            
            (4,996
            )
            
            (7,165
            )
            
            (14,535
            )
            
            (28,161
            )Net
                loss available to common shareholders
            
            
            (5,627
            )
            
            (8,788
            )
            
            (14,134
            )
            
            (30,609
            )Net
                loss per share available to common shareholders, basic and
                diluted
            
            $
            (2.86
            )
            $
            (4.41
            )
            $
            (7.05
            )
            $
            (4.71
            )Shares
                used in basic and diluted loss per share (reflects 1 for 10 reverse
                stock
                split)
            
            
            1,965
            
            
            1,992
            
            
            2,005
            
            
            6,503Dividends
                per common share
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            —




(1)
            During
                the third quarter of 2005, the Company determined that it would
                discontinue substantially all of the drug distribution operations
                acquired
                in the Merger on November 12, 2004. Accordingly, these operations
                are
                reflected as discontinued for financial statement purposes for all
                periods
                presented since the date acquired. The loss from discontinued operations
                for the three months ended January 1, 2005 includes a goodwill impairment
                charge of $31.0 million. The loss from discontinued operations for
                the
                three months ended October 1, 2005 includes $5.3 million of estimated
                losses primarily related to accounts receivable and other asset
                impairments. The loss from discontinued operations for the three
                months
                ended December 31, 2005 includes a goodwill impairment charge of
                $19.4
                million and other exit losses, primarily representing estimated
                losses on accounts receivable, inventory and vendor chargebacks, of
                $1.6 million.




**16.**
            **SUBSEQUENT
                EVENTS**





In
      connection with the Agreement, on February 14, 2007, Wells Fargo Retail Finance,
      LLC, as agent for the revolving credit lenders pursuant to The Loan and Security
      Agreement dated as of October 12, 2005 (as amended, modified, supplemented
      or
      restated and in effect from time to time, the “Loan Agreement”) among (i)
      Familymeds Group, Inc. (f/k/a Drugmax, Inc.), as Lead Borrower, (ii) the other
      Borrowers party thereto from time to time, (iii) the Revolving Credit Lenders
      party thereto from time to time, (iv) and Wells Fargo Retail Finance, LLC,
      as
      Agent for the Revolving Credit Lenders, consented to the entering into the
      Agreement by the Sellers and consummating the sale, subject to various terms
      and
      conditions. Among those conditions, the Company agreed that all proceeds
      received by the Sellers shall be paid to the Agent for application to the credit
      facility until all amounts due under the facility are paid in full and the
      Loan
      Agreement is terminated. Each such payment of proceeds applied to the credit
      facility shall permanently reduce the commitments in the amount of such payment.


F-33




**Item
      9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE.**





None.





**Item
      9A. CONTROLS AND PROCEDURES**




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




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




43





**Item 9B.
      OTHER INFORMATION**




No
      events
      have occurred which would require disclosure under this Item.




44


**PART
      III**




**Item
      10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Management—Directors and Executive Officers” in
      our Form 10-K/A, which the Company expects to file with the Securities and
      Exchange Commission on or before April 30, 2007.





**Item
      11. EXECUTIVE COMPENSATION.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Management—Compensation of Executive Officers
      and Directors” in our Form 10-K/A, which we expect to file with the Securities
      and Exchange Commission on or before April 30, 2007.





**Item
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      SHAREHOLDER MATTERS.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Management—Security Ownership of Management and
      Others and Related Shareholder Matters” in our Form 10-K/A, which we expect to
      file with the Securities and Exchange Commission on or before April 30, 2007.





**Item
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.**





The
      information required by this Item is incorporated herein by reference to the
      information under the headings “Certain Relationships and Related Transactions”
in our Form 10-K/A, which we expect to file with the Securities and Exchange
      Commission on or before April 30, 2007.





**Item
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.**





The
      information required by this Item is incorporated herein by reference to the
      information under the heading “Principal Accountant Fees and Services” in our
      Form 10-K/A, which we expect to file with the Securities and Exchange Commission
      on or before April 30, 2007.




45




**PART
      IV**





**Item
      15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K**





(a)
            Documents
                filed as part of this report:





1.
            Consolidated
                Financial Statements and Report of Deloitte & Touche LLP





The
      consolidated financial statements included in Part II, Item 8 of this Annual
      Report on Form 10-K are filed as part of this Report.





2.
            Financial
                Statement Schedule.





Schedule
      II- Valuation and Qualifying Accounts for the fiscal years ending December
      30,
      2006, December 31, 2005 and January 1, 2005.




46




**SCHEDULE
      II**


**VALUATION
      AND QUALIFYING ACCOUNTS**


**FOR
      THE FISCAL YEARS ENDED** **DECEMBER
      30, 2006, DECEMBER 31, 2005 AND JANUARY 1, 2005.**





Balance,
                beginning
                  of
            
            Charged
                    to
                  cost
                    and
            
            
            
            Balance
                from
            
            
            
            Balance
                at(Amounts
                in thousands)
            
            Year
            
            expenses
            
            
            
            Merger
            
            Deductions
            
            End
                of yearAllowance
                for Doubtful Accounts:Fiscal
                year ended December 30, 2006
            
            $
            2,777
            
            $
            1,573
            
            
            (1
            )
            $
            —
            
            $
            (630
            )
            $
            3,720Fiscal
                year ended December 31, 2005
            
            
            3,896
            
            
            1,275
            
            
            (2
            )
            
            —
            
            
            (2,394
            )
            
            2,777Fiscal
                year ended January 1, 2005
            
            
            1,718
            
            
            342
            
            
            
            
            
            2,183
            
            
            (347
            )
            
            3,896Inventory
                Reserve:Fiscal
                year ended December 30, 2006
            
            $
            2,109
            
            $
            1,447
            
            
            (3
            )
            $
            —
            
            $
            (924
            )
            $
            2,632Fiscal
                year ended December 31, 2005
            
            
            903
            
            
            3,091
            
            
            (4
            )
            
            —
            
            
            (1,885
            )
            
            2,109Fiscal
                year ended January 1, 2005
            
            
            1,046
            
            
            659
            
            
            
            
            
            286
            
            
            (1,088
            )
            
            903Valuation
                Allowance for Deferred Tax Asset:Fiscal
                year ended December 30, 2006
            
            $
            70,659
            
            $
            8,603
            
            
            
            
            $
            —
            
            $
            —
            
            $
            79,262Fiscal
                year ended December 31, 2005
            
            
            50,124
            
            
            20,535
            
            
            
            
            
            —
            
            
            —
            
            
            70,659Fiscal
                year ended January 1, 2005
            
            
            46,529
            
            
            3,595
            
            
            
            
            
            —
            
            
            —
            
            
            50,124




*(1)
      Includes $1.0 million related to discontinued operations.*




*(2)
      Includes $1.1 million related to discontinued operations.*




*(3)
      Includes $0.5 million related to discontinued operations.*




*(4)
      Includes $1.4 million related to discontinued operations.*





**3.
      Exhibits**




2.1
            Agreement
                and Plan of Merger between Drugmax, Inc. and Familymeds Group, Inc.
                dated
                March 19, 2004, as amended. (5)2.2
            First
                Amendment to Agreement and plan of Merger between Drugmax, Inc. and
                Familymeds Group, Inc., dated July 1, 2004. (13)




47




2.3
                Second
                    Amendment to Agreement and plan of Merger between Drugmax, Inc.
                    and Family
                    Meds Group, Inc., dated October 11, 2004. (7)2.4
                Asset
                    Purchase Agreement between Valley Drug Company and Rochester
                    Drug
                    Cooperative dated December 22, 2005 (11)3.1
                Amended
                    and Restated Articles of Incorporation of Drugmax, Inc. filed
                    November 12,
                    2005. (8)3.2
                Amended
                    and Restated Bylaws, dated February 24, 2005. (13)3.3
                Certificate
                    of Designation, creating Series A Preferred Stock (9)3.4
                Amendment
                    to Certificate of Amendment relating to Series A Preferred Stock
                    (15)4.1
                Specimen
                    of Stock Certificate. (1)10.1
                Employment
                    Agreement by and between DrugMax, Inc. and Edgardo A. Mercadante
                    dated as
                    of March 31, 2006 (19)10.2
                Employment
                    Agreement by and between Drugmax, Inc. and Jugal K. Taneja dated
                    as of
                    December 12, 2004 (14)10.3
                Employment
                    Agreement by and between Familymeds Group, Inc. and James E.
                    Searson dated
                    August 14, 2006 (20)10.4
                Employment
                    Agreement by and between Familymeds Group, Inc. and James A.
                    Bologa dated
                    March 30, 2006 (21)10.5
                Employment
                    Agreement, as amended by and between Familymeds, Inc. and James
                    Beaumariage effective as May 29, 1998. (22)10.6
                Employment
                    Agreement, as amended by and between Familymeds, Inc. and Allison
                    D.
                    Kiene, effective as of September 9, 2002 (23)10.7
                Familymeds.com,
                    Inc. 1999 Incentive and Non-Statutory Stock Option Plan.
                    (1)10.8
                Amendment
                    No. 1 to Drugmax, Inc. 1999 Incentive and Non-Statutory Stock
                    Option Plan,
                    dated June 5, 2002. (2)10.9
                Loan
                    and Security Agreement between Familymeds and Wells Fargo Retail
                    Finance,
                    LLC dated October 12, 2005 (18)10.10
                Drugmax,
                    Inc. 2003 Restricted Stock Plan dated August 27, 2003.
                    (4)10.11
                Commercial
                    Lease between Becan Development LLC and Valley Drug Company,
                    dated January
                    1, 2004. (6)
  48
 10.12
                Amendment
                    No. 1 to Lease between Becan Development LLC and Valley Drug
                    Company,
                    dated December 22, 2005 (11)10.13
                Sublease
                    between Valley Drug Company, Rochester Drug Company and Becan
                    Development,
                    LLC dated December 27, 2005 (11)10.14
                Commercial
                    Lease between River Road Real Estate, LLC and Drugmax, Inc. dated
                    October
                    18, 2001.(6)10.15
                Supply
                    Agreement between Familymeds Group, Inc. and McKesson Corporation
                    dated
                    February 2, 2007. (24)10.16
                Form
                    of Securities Purchase Agreement among Drugmax, Inc. and various
                    Investors, dated as of September 23, 2005 (16)10.17
                Form
                    of Securities Purchase Agreement among Drugmax, Inc. and various
                    Investors, dated as of September 26, 2005 (16)10.18
                Form
                    of Common Stock Purchase Warrant issued in connection with Securities
                    Purchase Agreement dated as of September 23, 2005 (17)10.19
                Form
                    of Common Stock Purchase Warrant issued in connection with Securities
                    Purchase Agreement dated as of September 26, 2005 (17)10.20
                Form
                    of Registration Rights Agreement executed in connection with
                    Securities
                    Purchase Agreement dated as of September 23, 2005 (17)10.21
                Form
                    of Registration Rights Agreement executed in connection with
                    Securities
                    Purchase Agreement dated as of September 26, 2005 (17)10.22
                Asset
                    Purchase Agreement dated as February 14, 2007 by and among Walgreen
                    Co.,
                    Walgreen Eastern Co., Inc., Familymeds Group, Inc., Familymeds,
                    Inc. and
                    Arrow Prescription Leasing Corp.(25)10.23
                Note
                    and Warrant Purchase Agreement by and among Familymeds Group,
                    Inc.
                    (formerly known as DrugMax, Inc.) and Deerfield Special Situations
                    Fund,
                    L.P. and Deerfield Special Situations Fund International, Limited
                    dated as
                    of June 23, 2006.(20)10.24
                Form
                    of Common Stock Purchase Warrant issued in connection with Note
                    and
                    Purchase Warrant Agreement dated as of June 23, 2006.
                    (20)10.25
                Investor
                    Rights Agreement executed in connection with Note and Purchase
                    Warrant
                    Agreement dated as of June 23, 2006. (20)10.26
                Security
                    Agreement by and among Familymeds Group, Inc. (formerly known
                    as DrugMax,
                    Inc.) and Deerfield Special Situations Fund, L.P. and Deerfield
                    Special
                    Situations Fund International, Limited dated as of June 23,
                    2006.(20)
  49
  10.27
                Form
                    of Secured Promissory Note issued in connection with Note and
                    Warrant
                    Purchase Agreement dated as of June 23,
                    2006.(20)
 10.28
                  First
                      Amendment to Deerfield Promissory Note and Investor Rights
                      Agreement dated
                      as of October 11, 2006(26)10.29
                  Second
                      Amendment to Deerfield Promissory Note and Investor Rights
                      Agreement dated
                      as of December 14,
                      2006.*





21.0
            Subsidiaries
                of Familymeds Group, Inc.(13)23.0
            Consent
                of Deloitte & Touche LLP.31.1
            Certification
                of Principal Executive Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002. *31.2
            Certification
                of Principal Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002. *32.1
            Certification
                Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002. *32.2
            Certification
                Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section
                906 of
                the Sarbanes-Oxley Act of 2002. *





*
            Filed
                herewith.





(1)
            Incorporated
                by reference to Familymeds’ Form 10-KSB/A, filed July 14, 2000, File No.
                0-24362.





(2)
            Incorporated
                by reference to Familymeds’ Form 10-KSB, filed July 1, 2002.





(3)
            Incorporated
                by reference to Familymeds’ Form 10-K/A, filed July 29, 2003.





(4)
            Incorporated
                by reference to Familymeds’ Definitive Proxy Statement filed September 8,
                2003.





(5)
            Incorporated
                by reference to Familymeds’ Form 10-K, filed July 14, 2004.





(6)
            Incorporated
                by reference to Familymeds’ Form 10-K/A, filed October 1, 2004.





(7)
            Incorporated
                by reference to Familymeds’ Definitive Proxy Statement filed October 12,
                2004.




50


(8)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed November 18, 2004.
                Incorporated by reference to Familymeds’ Form 10-K, filed July 14, 2004.
                Incorporated by reference to Familymeds’ Form 8-K, filed November 18,
                2004.





(9)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed December 8, 2004.(10)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed December 15, 2004.(11)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed February 21,
                2005.





(12)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed March 25, 2005.(13)
            Incorporated
                by reference to Familymeds’ Form 10-K, filed April 19,
                2005.(14)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed on June 13,
                2005.(15)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed on July, 7,
                2005.(16)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed September 27,
                2005.(17)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed October 5,
                2005.(18)
            Incorporated
                by reference to Familymeds’ Form S-1, filed November 2,
                2005.




(19)
            Incorporated
                by reference to Familymeds’ Form 10-K, filed March 31
                2006.(20)
            Incorporated
                by reference to Familymeds’ Form 10-Q, filed August 15,
                2006.(21)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed March 31
                2006.(22)
            Incorporated
                by reference to Familymeds’ Form 10-K/A, filed May 5,
                2005.(23)
            Incorporated
                by reference to Familymeds’ Form 10-K/A, filed May 1,
                2006.(24)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed February 28,
                2007.(25)
            Incorporated
                by reference to Familymeds’ Form 8-K, filed February 21,
                2007.(26)
            Incorporated
                by reference to Familymeds’ Form S-3, filed October 18,
                2006.





51




**SIGNATURES**




Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.




**FAMILYMEDS
                GROUP, INC.**Date: April
                16, 2007
            By:
            /s/*Edgardo
                Mercadante*Edgardo
                Mercadante, President, Chief Executive Officer and Chairman of the
                Board






Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant in the
      capacities and on the dates indicated.




**Signatures**
            
            **Title**
            
            **Date***/s/
                Edgardo A. Mercadante*
            
            Chairman
                of the Board, President, Chief Executive Officer and Director (Principal
                Executive Officer)
            
            April
                16, 2007Edgardo
                A. Mercadante*/s/
                James A. Bologa*
            
            Senior
                Vice President, Chief Financial Officer (Principal Financial and
                Accounting Officer)
            
            April
                16, 2007James
                A. Bologa*/s/
                James E. Searson*
            
            Senior
                Vice President, Chief Operating Officer, and Director
            
            April
                16, 2007James
                E. Searson*/s/
                Philip P. Gerbino*
            
            Director
            
            April
                16, 2007Philip
                P. Gerbino*/s/
                Peter J. Grua*
            
            Director
            
            April
                16, 2007Peter
                J. Grua*/s/
                Mark T. Majeske*
            
            Director
            
            April
                16, 2007Mark
                T. Majeske**
            
            Director
            
            April
                16, 2007Jugal
                K. Taneja*/s/
                Laura L. Witt*
            
            Director
            
            April
                16, 2007Laura
                L. Witt





52