Galaxy Nutritional Foods (GXY) 10-Q 2009 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

________________________________________________________________________________

(Mark One)

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

For the quarterly period ended December 31, 2008

OR

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

For the transition period from_______ to ______

Commission File Number 1-15345

GALAXY NUTRITIONAL FOODS, INC.

(Exact name of registrant as specified in its charter)

Delaware	25-1391475
(State or other jurisdiction of	(IRS Employer Identification No.)
incorporation or organization)

6280 Hazeltine National Drive	32822
Orlando, Florida	(Zip Code)
(Address of principal executive offices)

1-407-855-5500

(Registrant’s telephone number, including area code)

5955 T.G. Lee Blvd, Suite 201

Orlando, Florida 32822

(Former address, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ                                No ¨

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

Large accelerated filer  ¨                                                                      Accelerated filer  ¨                                   Non-accelerated filer  ¨Smaller reporting company  þ

(Do not check if a smaller

reporting company)

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

Yes ¨                                No þ

On February 10, 2009, there were 27,051,294 shares of common stock, $.01 par value per share, outstanding.

 GALAXY NUTRITIONAL FOODS, INC.

Index to Form 10-Q

For the Quarter Ended December 31, 2008

				Page No.
PART I.			FINANCIAL INFORMATION
	Item 1.	Financial Statements
			Balance Sheets	1
			Statements of Income	2
			Statement of Stockholders’ Equity (Deficit)	3
			Statements of Cash Flows	4
			Notes to Financial Statements	5
	Item 2.	Management's Discussion and Analysis of Financial Condition
		and Results of Operations		14
	Item 4T.	Controls and Procedures		23
PART II.		OTHER INFORMATION
	Item 1A.	Risk Factors		24
	Item 5.	Other Information		26
	Item 6.	Exhibits		27
SIGNATURES				30

PART I.  FINANCIAL INFORMATION

GALAXY NUTRITIONAL FOODS, INC.

Balance Sheets

			DECEMBER 31,			MARCH 31,
	Notes		2008			2008
			(Unaudited)
ASSETS		2
CURRENT ASSETS:
Cash			$	2,901,079		$	1,893,425
Trade receivables, net				2,172,812			2,516,496
Inventories, net				163,667			116,902
Prepaid expenses and other				186,752			95,906
Total current assets				5,424,310			4,622,729
PROPERTY AND EQUIPMENT, NET				51,504			65,671
OTHER ASSETS				49,385			68,463
TOTAL			$	5,525,199		$	4,756,863
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
CURRENT LIABILITIES:
Secured borrowings		2	$	--		$	--
Accounts payable				1,801,681			1,393,810
Accrued and other current liabilities				393,858			1,028,049
Accrued employment contracts		3		2,154			282,599
Related party note payable		1,2		--			2,685,104
Total current liabilities				2,197,693			5,389,562
COMMITMENTS AND CONTINGENCIES		4		--			--
STOCKHOLDERS’ EQUITY (DEFICIT):
Common stock				270,513			171,100
Additional paid-in capital				73,488,033			70,167,149
Accumulated deficit				(70,431,040	)		(70,970,948	)
Total stockholders’ equity (deficit)				3,327,506			(632,699	)
TOTAL			$	5,525,199		$	4,756,863

See accompanying notes to financial statements

1

GALAXY NUTRITIONAL FOODS, INC.

Statements of Income

(UNAUDITED)

			THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,
	Notes		2008			2007			2008			2007
Net Sales			$	6,261,613		$	6,446,099		$	18,413,893		$	18,763,360
Cost of Goods Sold				4,310,492			4,145,200			12,514,672			11,346,406
GROSS MARGIN				1,951,121			2,300,899			5,899,221			7,416,954
OPERATING EXPENSES:
Selling				770,199			871,797			2,300,375			2,702,038
Delivery				265,134			263,923			758,191			772,786
General and administrative				550,944			672,530			1,800,850			1,883,647
Employment contract expense-general and administrative		3		--			--			--			346,447
Research and development				75,409			86,511			218,685			249,506
Loss on disposal of assets				--			512			--			512
Total operating expenses				1,661,686			1,895,273			5,078,101			5,954,936
INCOME FROM OPERATIONS				289,435			405,626			821,120			1,462,018
INTEREST EXPENSE, NET				(65,356	)		(110,261	)		(281,212	)		(343,313	)
INCOME BEFORE TAXES				224,079			295,365			539,908			1,118,705
INCOME TAX EXPENSE				--			--			--			(12,000	)
NET INCOME			$	224,079		$	295,365		$	539,908		$	1,106,705
BASIC NET INCOME PER COMMON SHARE		6	$	0.01		$	0.02		$	0.03		$	0.06
DILUTED NET INCOME PER COMMON SHARE		6	$	0.01		$	0.01		$	0.03		$	0.05

See accompanying notes to financial statements.

2

GALAXY NUTRITIONAL FOODS, INC.

Statement of Stockholders’ Equity (Deficit)

Nine Months Ended December 31, 2008

(UNAUDITED)

			Common Stock
	Notes		Shares		Par Value		Additional Paid-In Capital			Accumulated Deficit			Total
Balance at March 31, 2008				17,110,016	$	171,100	$	70,167,149		$	(70,970,948	)	$	(632,699	)
Conversion of related party note into common stock		2		9,941,278		99,413		3,380,034			--			3,479,447
Costs associated with issuance of common stock		2		--		--		(59,150	)		--			(59,150	)
Net income				--		--		--			539,908			539,908
Balance at December 31, 2008				27,051,294	$	270,513	$	73,488,033		$	(70,431,040	)	$	3,327,506

See accompanying notes to financial statements

3

GALAXY NUTRITIONAL FOODS, INC.

Statements of Cash Flows

(UNAUDITED)

Nine Months Ended December 31,	Notes		2008			2007
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES:		7
Net Income			$	539,908		$	1,106,705
Adjustments to reconcile net income to net cash from (used in) operating activities:
Depreciation and amortization				33,950			33,308
Amortization of debt discount and financing costs				19,078			36,117
Provision for future credits and doubtful accounts on trade receivables				(387,233	)		(632,500	)
Inventory reserve				(31,533	)		5,615
Loss on disposal of assets				--			512
(Increase) decrease in:
Trade receivables				730,917			703,643
Inventories				(15,232	)		271,259
Prepaid expenses and other				(90,846	)		(3,007	)
Increase (decrease) in:
Accounts payable				407,871			(308,204	)
Accrued and other liabilities				(120,293	)		(79,443	)
NET CASH FROM OPERATING ACTIVITIES				1,086,587			1,134,005
CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES:
Purchase of property and equipment				(19,783	)		(14,345	)
NET CASH USED IN INVESTING ACTIVITIES				(19,783	)		(14,345	)
CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES:
Net payments on secured borrowings				--			(556,886	)
Costs associated with issuance of common stock		2		(59,150	)		--
NET CASH USED IN FINANCING ACTIVITIES				(59,150	)		(556,886	)
NET INCREASE IN CASH		7		1,007,654			562,774
CASH, BEGINNING OF PERIOD				1,893,425			879,487
CASH, END OF PERIOD			$	2,901,079		$	1,442,261

See accompanying notes to financial statements.

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GALAXY NUTRITIONAL FOODS, INC.

Notes to Financial Statements

(UNAUDITED)

(1)           Summary of Significant Accounting Policies

The unaudited financial statements have been prepared by Galaxy Nutritional Foods, Inc. (the “Company”), in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and applicable rules and regulations of the Securities and Exchange Commission.  The accompanying financial statements contain all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of such financial statements.  Certain information and disclosures normally included in the financial statements prepared in accordance with GAAP have been omitted under such rules and regulations although the Company believes that the disclosures are adequate to make the information presented not misleading.  The March 31, 2008 balance sheet data was derived from the audited financial statements, but does not include all disclosures required by GAAP.  These unaudited financial statements should be read in conjunction with the financial statements and notes included on Form 10-K for the fiscal year ended March 31, 2008.  Interim results of operations for the three and nine months ended December 31, 2008 may not necessarily be indicative of the results to be expected for the full year.

Nature of Business and Going Concern

The Company develops and internationally markets plant-based cheese alternatives, organic dairy and other organic and natural food products to grocery and natural foods retailers, mass merchandisers and food service accounts. Galaxy Nutritional Foods Veggie®, the leading brand in the grocery cheese alternative category and the Company’s top selling product group, is primarily merchandised in the produce section and provides calcium and protein without cholesterol, saturated fat or trans-fat. Other popular brands include: Galaxy Nutritional Foods Rice®, Veggy®, Vegan®, Rice Vegan®, and Wholesome Valley Organic®. Galaxy Nutritional Foods, Inc. is dedicated to developing nutritious and delicious food products made with high quality natural ingredients that exceed the expectations of today’s health conscious consumers. The Company is also committed to reducing its environmental impact as part of its Eat Green for Body & Earth™ program that offsets carbon emissions associated with product shipping and emphasizes the use of organic ingredients.  The Company headquarters are located in Orlando, Florida, and its common stock is quoted on the OTC Bulletin Board under the symbol “GXYF.”

Schreiber Foods, Inc., a Wisconsin corporation (“Schreiber”), manufactures and distributes substantially all of the Company’s products in accordance with a Supply Agreement that was signed on June 30, 2005 (See Note 4).  Schreiber uses the Company’s formulas and processes to manufacture products for the Company’s customers.  The prices for such products are based on cost plus a processing fee as determined by the parties from time to time.

As of March 31, 2008, the Company’s ability to continue as a going concern depended upon successfully refinancing or obtaining sufficient cash resources to pay its Convertible Note and accrued interest thereon (see Note 2) and obtaining positive cash flow from operations to sustain normal business operations.

On November 18, 2008, the Company, Mr. Frederick A. DeLuca and Galaxy Partners, L.L.C., a Minnesota limited liability company (“Galaxy Partners”) entered into a Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to Galaxy Partners his 3,869,842 shares of the Company’s common stock and assigned to Galaxy Partners all of his right, title and interest in and to the Convertible Note. In connection with the Purchase Agreement and in accordance with the terms of the Convertible Note, Galaxy Partners converted all of the outstanding principal and accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278 shares of the Company’s common stock. As a result of the Purchase Agreement and conversion of the Convertible Note into 9,941,278 shares, Galaxy Partners acquired an aggregate of 13,811,120 shares of the Company’s common stock and consequently became the majority stockholder, owning approximately 51.1% of the 27,051,294 issued and outstanding shares of the Company’s common stock.  As a result of the conversion of the Convertible Note, the strength of the Company’s balance sheet greatly improved with no further debt obligations and stockholders’ equity greater than $3 million.  Therefore, management does not believe there currently is any remaining issue with the Company’s ability to operate as a going concern in the near future.

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Revenue Recognition

Sales are recognized upon shipment of products to customers.  The Company offers a right of return policy on certain products sold to certain retail customers in the conventional grocery stores and mass merchandising industry.  If the product is not sold during its shelf life, the Company will allow a credit for the unsold merchandise.  Since the shelf life of the Company’s products ranges from 4 months to one year, the Company historically averages less than 2% of gross sales in credits for unsold product. The Company’s reserve on accounts receivable takes these potential future credits into consideration.  Certain expenses such as returns, slotting fees, rebates, coupons and other discounts are accounted for as a reduction to Revenues.

Non-Cash Compensation Related to Stock-Based Transactions

Statement of Financial Accounting Standard (“FAS”) No. 123 (revised 2004), “Share-Based Payment,” (“FAS No. 123R”) requires companies to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period.

FAS No. 123R applies to new awards and to awards modified, repurchased, or cancelled after the effective date, as well as to the unvested portion of awards outstanding as of the effective date. The Company uses the Black-Scholes option-pricing model to value its new stock option grants under FAS No. 123R. FAS No. 123R also requires the Company to estimate forfeitures in calculating the expense related to stock-based compensation. Additionally, FAS No. 123R requires the Company to reflect cash flows resulting from excess tax benefits related to those options as a cash inflow from financing activities rather than as a reduction of taxes paid.

There were no issuances of stock awards or vesting of prior unvested stock awards during the three and nine months ended December 31, 2008 and 2007.  Therefore, there were no assumptions under the Black-Scholes option-pricing model and no stock-based compensation expense during the three and nine months ended December 31, 2008 and 2007.

Net Income per Common Share

Basic net income per common share is computed by dividing net income by the weighted average shares outstanding. Diluted net income per common share is computed by dividing adjusted net income by the weighted average shares outstanding plus potential common shares which would arise from the exercise of stock options and warrants using the treasury stock method and conversion of convertible debt using the if-converted method.

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 disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expense during the reporting period.  The Company’s significant estimates include the allowance for trade receivables, inventory reserves, valuation of deferred taxes and valuation of non-cash compensation related to stock-based transactions.  Actual results could differ from these estimates.

Segment Information

The Company does not identify separate operating segments for management reporting purposes.  The results of operations are the basis on which management evaluates operations and makes business decisions.   The Company sells to customers throughout the United States and 10 other countries.

Recent Accounting Pronouncements

In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13,” (“FSP FAS 157-1”).  FSP FAS 157-1 amends FAS No. 157 to remove certain leasing transactions from its scope and is effective upon the initial adoption of FAS No. 157 which the Company adopted beginning April 1, 2008.  Additionally in February 2008, FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157,” which amends FAS No. 157 by delaying its effective date by one year for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis.  Accordingly, the Company will begin applying fair value measurements for all non-financial assets and non-financial liabilities on April 1, 2009.

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In May 2008, FASB issued FSP APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”). This FSP specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years, and is applied retrospectively to all periods presented. The Company is currently evaluating the impact of adopting FSP APB 14-1 on its results of operations and financial position.

In June 2008, FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” The FSP concluded that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities under FASB No. 128, “Earnings per Share,” and should be included in the computation of earnings per share under the two-class method. The two-class method is an earnings allocation formula used to determine earnings per share for each class of common stock according to dividends declared and participation rights in undistributed earnings. FSP EITF 03-6-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, and is applied retrospectively to all periods presented.  The Company does not expect that the adoption of this FSP will have a material impact on its results of operations or financial position.

In June 2008, the FASB’s Emerging Issues Task Force reached a consensus regarding EITF Issue No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (EITF 07-5). EITF 07-5 outlines a two-step approach to evaluate the instrument’s contingent exercise provisions, if any, and to evaluate the instrument’s settlement provisions when determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock. EITF 07-5 is effective for fiscal years beginning after December 15, 2008 and must be applied to outstanding instruments as of the beginning of the fiscal year of adoption as a cumulative-effect adjustment to the opening balance of retained earnings. Early adoption is not permitted. The Company is currently evaluating the impact of adopting EITF 07-5 on its results of operations and financial position.

The Recent Accounting Pronouncements should be read in conjunction with the pronouncements included in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2008.

Income Taxes

The Company follows the provisions of the FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109,” (“FIN 48”).  FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The Company has not recognized a liability as a result of the implementation of FIN 48.  A reconciliation of the beginning and ending amount of unrecognized tax benefits has not been provided since there is no unrecognized benefit as of the date of adoption.  The Company has not recognized interest expense or penalties as a result of the implementation of FIN 48.  If there were an unrecognized tax benefit, the Company would recognize interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses.  The Company files income tax returns in the U.S. federal jurisdiction and in various states.

Deferred income taxes are recognized for the tax consequences of temporary differences between the financial reporting bases and the tax bases of the Company’s assets and liabilities in accordance with FAS No. 109, “Accounting for Income Taxes.” Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.  Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.

Financial Instruments

In April 2008, the Company adopted FAS No. 157, “Fair Value Measurements,” (“FAS No. 157”) to value its financial assets and liabilities. The adoption of FAS No. 157 did not have a significant impact on the Company’s results of operations, financial position or cash flows.  FAS No. 157 defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements.  FAS No. 157 defines fair value as the exchange price that would be paid by an external party for an asset or liability (exit price).  FAS No. 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  Three levels of inputs may be used to measure fair value:

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·   Level 1 – Active market provides quoted prices for identical assets or liabilities;

·   Level 2 – Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable with market data; and

·   Level 3 – Unobservable inputs that are supported by little or no market activity, therefore requiring an entity to develop its own assumptions about the assumptions that market participants would use in pricing.

Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of December 31, 2008. The Company uses the market approach to measure fair value for its Level 1 financial assets and liabilities.  The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.  The respective carrying value of certain on-balance-sheet financial instruments approximated their fair values.  These financial instruments which include cash, trade receivables, secured borrowings, related party note payable, accounts payable and accrued liabilities are valued using Level 1 inputs and are immediately available without market risk to principal.  Fair values were assumed to approximate carrying values for these financial instruments since they are short term in nature and their carrying amounts approximate fair values or they are receivable or payable on demand.  The Company does not have other financial assets that would be characterized as Level 2 or Level 3 assets.

FAS No. 157 is effective for non-financial assets and liabilities for the Company’s fiscal year beginning April 1, 2009.  The Company is currently assessing the impact of this pronouncement as it relates to non-financial assets and liabilities.

(2)           Secured Borrowings and Related Party Note Payable

Secured Borrowings

On June 23, 2006, the Company entered into a Receivables Purchase Agreement with Commercial Finance Division, a subsidiary of Textron Financial Corporation (“Commercial Finance”), whereby Commercial Finance provides financing to the Company through advances against certain trade receivable invoices due to the Company (the “Commercial Finance Agreement”).  The Commercial Finance Agreement is secured by the Company’s accounts receivable and all other assets.  Generally, subject to a maximum principal amount of $3,500,000 which can be borrowed under the Commercial Finance Agreement, the amount available for borrowing is equal to 85% of the Company’s eligible accounts receivable invoices less a dilution reserve and any required fixed dollar reserves.  The dilution and fixed dollar reserves are currently set at 7% and $100,000, respectively.  Advances under the Commercial Finance Agreement bear interest at a variable rate equal to the prime rate plus 1.5% per annum (4.75% on December 31, 2008).  However, the Commercial Finance Agreement requires a $4,500 minimum monthly interest charge to be assessed.   The Company is also obligated to pay a $1,500 monthly service fee.

The initial term of the Commercial Finance Agreement ends on June 23, 2009 and may renew automatically for consecutive twelve-month terms unless terminated sooner.  The Commercial Finance Agreement may be accelerated in the event of certain defaults by the Company including among other things, a default in the Company’s payment and/or performance of any obligation to Commercial Finance or any other financial institution, creditor, or bank; and any change in the conditions, financial or otherwise, of the Company which reasonably causes Commercial Finance to deem itself insecure.  In such an event, interest on the Company’s borrowings would accrue at the greater of twelve percent per annum or the variable rate of prime plus 1.5% and the Company would be liable for an early termination premium of 1% on the maximum principal amount available under the Commercial Finance Agreement.  Although the Company had approximately $1.5 million available to draw pursuant to this Commercial Finance Agreement as of December 31, 2008, there were no amounts advanced, because the Company did not need additional cash on such date.

In accordance with FAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Debt,” the Company accounts for the Commercial Finance Agreement as a current liability since it is a full-recourse agreement and the Company maintains effective control over the accounts receivable.

Related Party Note Payable

Pursuant to a Note Purchase Agreement dated July 19, 2006, as amended on March 14, 2007, the Company issued an unsecured convertible note for $2,685,104 (the “Convertible Note”) to Mr. Frederick A. DeLuca.  The proceeds from the Convertible Note were used to repay or refinance several notes totaling $2.4 million that matured on June 15, 2006 and a $285,104 registration rights penalty owed to Mr. DeLuca. The Convertible Note accrued interest at 12.5% per annum and matured on October 19, 2008.  No interest or principal payments were required under the Convertible Note until its maturity.  Principal, together with any accrued and unpaid interest, on the Convertible Note was convertible at any time prior to payment into shares of the Company’s common stock at a conversion price of $0.35 per share.  The

8

closing market price of the Company’s common stock as quoted on the OTC Bulletin Board on July 19, 2006 was $0.28.  As additional consideration for making the loan, the Company issued Mr. DeLuca a warrant (the “Warrant”) to purchase up to 200,000 shares of the Company’s common stock at an exercise price equal to $0.35 per share.  The Warrant is fully vested and can be exercised on or before the expiration date of July 19, 2009.  In July 2006, the Company recorded the $18,000 fair value of the Warrant as a discount to debt that was amortized from July 2006 through October 2007.

The Company recorded interest expense related to the Convertible Note in the amount of $45,684 and $216,300 in the three and nine months ended December 31, 2008, respectively and  $85,774 and $256,390 in the three and nine months ended December 31, 2007, respectively.   Additionally, the Company amortized $1,289 and $7,960 of debt discount to interest expense in the three and nine months ended December 31, 2007, respectively.

On November 18, 2008, the Company, Mr. DeLuca and Galaxy Partners entered into a Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to Galaxy Partners his 3,869,842 shares of the Company’s common stock and assigned to Galaxy Partners all of his right, title and interest in and to the Convertible Note. In connection with the Purchase Agreement and in accordance with the terms of the Convertible Note, Galaxy Partners converted all of the outstanding principal and accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278 shares of the Company’s common stock.  The Company recorded $59,150 of stock issuance costs related to these transactions to additional paid in capital in the three months ended December 31, 2008.

 (3)           Related Party Transactions

Change in Control

As a result of the Purchase Agreement and conversion of the Convertible Note into 9,941,278 shares described in Note 2, Galaxy Partners acquired an aggregate of 13,811,120 shares of the Company’s common stock and consequently became the majority stockholder, owning approximately 51.1% of the 27,051,294 issued and outstanding shares of the Company’s common stock.  Galaxy Partners is comprised of seven members.  In consideration of the conversion of the Convertible Note, the Company agreed to expand the size of its Board from 4 to 7 members and elected three of the seven members of Galaxy Partners to the Board - David B. Johnson, Timothy S. Krieger and Michael D. Slyce.  Mr. Krieger holds a 40% individual ownership in Galaxy Partners. Mr. Johnson and Mr. Slyce each hold a 7.5% individual ownership in Galaxy Partners.  As the sole Governor/Director and CEO of Galaxy Partners, Mr. Krieger has the sole voting authority over all the 13,811,120 shares held by Galaxy Partners.

In connection with the Purchase Agreement, Galaxy Partners obtained financing in the amount of $5,500,000 (the “Financing”) from Robert O. Schachter, who is one of the seven members of Galaxy Partners.  Pursuant to the terms of the Financing, the membership interests of Galaxy Partners owned by the majority of the remaining members of Galaxy Partners, including those owned by Messrs. Johnson, Krieger and Slyce, were pledged to Mr. Schachter.  In the event of default under the Financing, Mr. Schachter would be entitled to foreclose on the pledged interests, in which event Mr. Schachter would then indirectly own a majority of the Company’s common stock, which would constitute a further change in control of the Company.

Consulting Agreement between Galaxy Partners and the Chairman of the Board

Effective November 18, 2008 with the closing of the Purchase Agreement and upon waiving his rights under the 2007 Stay, Severance and Sales Bonus Plan (see Note 4), David H. Lipka, Chairman of the Board, entered into a Consulting Agreement with Galaxy Partners and Fairway Dairy and Ingredients LLC, an affiliate of Galaxy Partners (“Fairway”).  Under the Consulting Agreement, and in view of Galaxy Partner’s substantial investment in the Company, Mr. Lipka has been engaged as an independent consultant of Galaxy Partners to serve for three years as, and in the capacity of, an adviser and consultant to the management of Galaxy Partners and Fairway.  In exchange for his services, Mr. Lipka is to receive aggregate consideration of $500,000, $300,000 of which was paid by Galaxy Partners upon the execution of the Purchase Agreement.  The Company is not a party to the Consulting Agreement and has no obligations under it.

Michael E. Broll

Effective with the signing of the Purchase Agreement on November 18, 2008, Mr. Broll entered into an amendment to his employment agreement with the Company, whereby he would continue as its Chief Executive Officer and Board member through March 31, 2009.  Mr. Broll also serves as President of the Company.  In the event that the parties do not enter into a new employment arrangement, then upon receipt of Mr. Broll’s resignation as the Company’s Chief Executive Officer and from the Company’s Board of Directors on March 31, 2009, in consideration of his staying with the Company during the transition period subsequent to the change of control in the Company and in recognition of his waiver of his rights under the 2007 Stay, Severance and Sales Bonus Plan (see Note 4), the Company will pay Mr.

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Broll compensation of $20,000 per month for 25 consecutive months beginning on April 1, 2009 less any applicable federal and/or state taxes.

Angelo S. Morini

In a Second Amended and Restated Employment Agreement effective October 13, 2003, Angelo S. Morini, the Company’s Founder, resigned from his positions with the Company as Vice Chairman and President and he is no longer involved in the daily operations of the Company.   Mr. Morini remained a director of the Company until his resignation on March 8, 2007.  The agreement was for a five-year period beginning October 13, 2003 and provides for an annual base salary of $300,000, plus standard health insurance benefits, club dues and an auto allowance.

Because Mr. Morini was no longer performing ongoing services for the Company, the Company accrued and expensed the five-year cost of this agreement in October 2003.  The total estimated cost expensed and accrued under this agreement in October 2003 was $1,830,329 and it was paid in full through nearly equal monthly installments ending in October 2008.

Christopher Morini

On June 1, 2007, Christopher E. Morini resigned from his position as Vice President of New Business Development.  In accordance with the Separation and General Release Agreement which became effective on June 9, 2007, between the Company and Mr. C. Morini, the Company accrued $346,447 for wages, health insurance benefits and payroll taxes and expensed them under Employment Contract Expense - General and Administrative in the Company’s Statement of Income in June 2007.  After an initial lump sum payment of approximately $100,087, the remaining obligation is being paid out in bi-weekly installments through February 2009.  As of December 31, 2008, $2,154 remained unpaid but accrued as a current liability.

(4)           Commitments and Contingencies

Supply Agreement

Schreiber manufactures and distributes substantially all of the Company’s products in accordance with a Supply Agreement that was signed on June 30, 2005 and amended on November 3, 2006 and March 17, 2008.  Schreiber uses the Company’s formulas and processes to manufacture products for the Company’s customers.  The prices for such products are based on cost plus a processing fee as determined by the parties from time to time.  The major terms of the Supply Agreement are as follows:

·   The Initial Term of the Supply Agreement is a period of fifteen years from June 30, 2005 to June 30, 2020.

·    Schreiber may terminate the Supply Agreement prior to the end of the Initial Term, without penalty, upon provision of written notice to the Company issued at least six (6) months prior to such proposed termination date.  In such an event, the Company will use its commercially reasonable efforts to transition production of its products to a new supplier.  In the event the Company is unable to transition production for one or more of its products within such six (6) month period, upon the Company’s request, Schreiber will continue to provide such products to the Company, under the terms of the Supply Agreement, for an additional six (6) months after the date that would otherwise have been the effective date of such termination.

·   The Company may terminate the Supply Agreement prior to the end of the Initial Term, without penalty, upon provision of written notice to Schreiber issued at least six (6) months prior to such proposed termination date, provided that the effective date for such termination by the Company shall not be prior to December 31, 2012, unless a change of control of the Company shall have occurred, in which case the effective date for such termination by the Company shall not be prior to December 31, 2010.  As a result of the change in control in November 2008 (Note 3), the date is now set at December 31, 2010.

·   Schreiber may increase the processing fee component of the price once in any twelve-month period to reflect changes in labor and benefits, materials, utilities and energy.  If the proposed price exceeds the price at which the Company can obtain such item (either on its own or through another private labeling source), then the Company may elect such alternative source for such item.

·   The Company may be required to pay a termination fee to Schreiber should it terminate the Supply Agreement prior to March 17, 2011.  The termination fee would total $5,100,000 if the Company terminates the Supply Agreement prior to March 17, 2009, $3,400,000 if the Company terminates the Supply Agreement prior to March 17, 2010 and $1,700,000 if the Company terminates the Supply Agreement prior to March 17, 2011.  If the termination of the agreement is a result of a breach or termination by Schreiber, no termination fee would be due.  In addition, if there is a change of control in either the Company or Schreiber, the Company can terminate the agreement and no termination fee will be due unless the change of control results from the sale of the Company for a purchase price in excess of $50 million.

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        As a result of the change in control in November 2008 (Note 3), the Company is no longer subject to the termination fee described above.

Stay, Severance, Sales Bonus Plan

On December 10, 2007, the Company adopted a Stay Bonus, Severance Bonus and Sales Bonus Plan (the “Plan”) to provide incentives and protections to certain key executives and directors pursuant to a “Company Sale” (as defined), which generally includes an acquisition of at least 60% of the Company’s outstanding equity securities or acquisition of all or substantially all of the Company’s assets prior to September 1, 2009.  The Plan provides for a stay bonus pool up to $475,000 to be paid following the Company’s receipt of a definitive purchase offer (as defined in the Plan) upon the earlier of the consummation of a sale of the Company pursuant to such purchase offer or the termination of the purchase offer (other than as a result of a breach by the Company).  The stay bonus pool is to be paid $125,000 to David H. Lipka, the Company’s Chairman, and $100,000 to Michael E. Broll, the Company’s Chief Executive Officer.  The remaining $250,000 of the stay bonus pool is currently unallocated and may be granted to other key executives at the discretion of Messrs Lipka and Broll.  The Plan also provides for a severance bonus of $125,000 to be paid to David H. Lipka and $100,000 to be paid to Michael E. Broll in the event their positions are terminated other than for Cause (as defined in the Plan) or they resign within one year after the consummation of a sale of the Company.  Finally, the Plan provides for a sales bonus pool to be determined based on a range of selling prices.  The sales bonus pool will range from a minimum of $250,000 if the sale is in excess of a specified minimum sales target and will increase up to a maximum of 1.8% of the total sales price.  The sales bonus pool will be allocated 55.5% to David H. Lipka and 44.5% to Michael E. Broll upon the consummation of a sale of the Company. The Plan was approved unanimously by the Board of Directors and separately by the two independent members of the Board.

The Purchase Agreement entered into on November 18, 2008 (Note 2) did not trigger a change in control as defined in the Plan. However, effective November 18, 2008 with the closing of the Purchase Agreement, Mr. Lipka agreed to waive his rights under the Plan (Note 3).  In accordance with the amendment to his employment agreement on November 18, 2008, Mr. Broll also agreed to waive his rights under the Plan if he does not continue his employment with the Company after March 31, 2009 (Note 3).

Litigation

The Company is currently a party to certain legal proceedings, claims, disputes and litigation arising in the ordinary course of business. The Company currently believes that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse affect on the Company's financial position, results of operations or cash flows. However, because of the nature and inherent uncertainties of litigation, should the outcome of these actions be unfavorable, the Company's business, financial condition, results of operations and cash flows could be materially and adversely affected.

In June 2007, a civil action lawsuit was filed in Allegheny County, Pennsylvania by Shawn Fuhr and his wife, Raquel Fuhr against All-Fill Corporation, Schreiber Foods, Inc., Galaxy Nutritional Foods, Inc. and others.  Mr. Fuhr was seeking damages against the defendants for injuries he sustained while cleaning a machine that was manufactured by All-Fill, originally purchased and used by Galaxy Nutritional Foods and then ultimately sold by Schreiber to his employer, Castle Cheese, Inc.  On September 20, 2008, the parties reached a settlement agreement totaling $3,362,500, of which $2,612,500 was apportioned to Galaxy.  Zurich North America Insurance, the Company’s insurance company, presided over all litigation matters and paid all litigation expenses and settlement claims directly.  Therefore, there was no affect on operations or the Company’s financial statements as a result of this claim.

 (5) Non-Cash Compensation Related to Stock-Based Transactions

Effective April 1, 2006, FAS No. 123R applies to new awards and to awards modified, repurchased, or cancelled after the effective date, as well as to the unvested portion of awards outstanding as of the effective date. The Company uses the Black-Scholes option-pricing model to value its new stock option grants under FAS No. 123R.

Compensation cost arising from nonvested stock granted to employees and from non-employee stock awards is recognized as expense using the graded vesting attribution method over the vesting period. As of March 31, 2008, there was no remaining unrecognized compensation cost related to nonvested stock, and there were no stock-based transactions during the three and nine months ended December 31, 2008 and 2007. Therefore, there was no stock-based compensation expense nor any unrecognized compensation cost related to nonvested stock for the three and nine months ended December 31, 2008 and 2007.

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The following table summarizes the Company’s plan and non-plan stock options outstanding as of December 31, 2008, as well as activity during the nine months then ended:

	Shares		Weighted-  Average  Exercise Price		Weighted-  Average  Remaining Contractual Term in Years	Aggregate Intrinsic Value
Outstanding at March 31, 2008	3,642,963		$	2.72
Granted	—			—
Exercised	—			—
Forfeited or expired	(215,144	)		3.21
Outstanding at  December 31, 2008	3,427,819		$	2.69	1.7	$	-0-
Exercisable at December 31, 2008	3,427,819		$	2.69	1.7	$	-0-

There were no options granted and thus no weighted-average fair value computed on options during the three and nine months ended December 31, 2008 and 2007.  At December 31, 2008, the aggregate intrinsic value of options outstanding and options exercisable was zero, because the market value of the underlying stock was below the average exercise price of all options. The closing price of the Company’s common stock on December 31, 2008 as quoted on the OTC Bulletin Board was $0.20 per share.  There were no options exercised during the three and nine months ended December 31, 2008 and 2007 and therefore, no intrinsic value or cash received from option exercises.

 (6)           Earnings Per Share

The following is a reconciliation of basic net income per share to diluted net income per share:

	Three Months Ended December 31,				Nine Months Ended December 31,
	2008		2007		2008		2007
Net income - basic	$	224,079	$	295,365	$	539,908	$	1,106,705
Plus interest on convertible related party note payable		--		85,774		--		256,390
Net income - diluted	$	224,079	$	381,139	$	539,908	$	1,363,095
Weighted average shares outstanding – basic		21,756,483		17,110,016		18,664,470		17,110,016
Potential shares issued upon conversion of  related party note payable		--		8,835,803		--		8,348,329
Potential shares “in-the-money” under stock option and warrant agreements		--		--		--		740,000
Less:  Shares assumed repurchased under the treasury stock method		--		--		--		(662,069	)
Weighted average shares outstanding –diluted		21,756,483		25,945,819		18,664,470		25,536,276
Basic net income per common share	$	0.01	$	0.02	$	0.03	$	0.06
Diluted net income per common share	$	0.01	$	0.01	$	0.03	$	0.05

Options for 3,597,394 and 3,627,406 shares and warrants for 617,442 and 952,058 shares have not been included in the computation of diluted net income per common share for the three and nine months ended December 31, 2008, respectively, as their effects were antidilutive.  Options for 4,352,124 and 4,150,420 shares and warrants for 1,158,001 and 997,662 shares have not been included in the computation of diluted net income per common share for three and nine months ended December 31, 2007, respectively, as their effects were antidilutive.

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(7)           Supplemental Cash Flow Information

For purposes of the statement of cash flows, all highly liquid investments with a maturity date of three months or less are considered to be cash equivalents.

Nine Months Ended December 31,	2008		2007
Non-cash financing and investing activities:
Accrued interest converted into common stock	$	794,343	$	--
Related party note payable converted into common stock		2,685,104		--
Cash paid for:
Interest	$	45,834	$	50,805

(8)           Economic Dependence and Segment Information

Pursuant to the Supply Agreement with Schreiber, the Company purchased approximately 99% and 98% of its total raw material purchases from Schreiber for the three and nine months ended December 31, 2008, respectively, and approximately 100% and 99% of its total raw material purchases from Schreiber for the three and nine months ended December 31, 2007, respectively.

For the three months ended December 31, 2008 and 2007, the Company’s gross sales were $6,551,093 and $6,888,900, respectively. For the nine months ended December 31, 2008 and 2007, the Company’s gross sales were $19,109,219 and $20,317,013, respectively.

The Company had one customer that accounted for approximately 19% and 17% of gross sales for the three and nine months ended December 31, 2008, respectively.  The Company had one customer that accounted for approximately 16% of gross sales for the three and nine months ended December 31, 2007.  There were no customers whose balance outstanding was greater than 10% of accounts receivable as of December 31, 2008 or 2007.

The Company has one operating segment and sells to customers throughout the United States, Puerto Rico, and the U.S. controlled Virgin Islands (together considered the United States) and 10 foreign countries.  Gross sales derived from foreign countries were approximately $677,000 and $999,000, representing 10% and 15% of gross sales for the three months ended December 31, 2008 and 2007, respectively.  Gross sales derived from foreign countries were approximately $2,107,000 and $2,759,000, representing 11% and 14% of gross sales for the nine months ended December 31, 2008 and 2007, respectively.  Gross sales are attributed to individual countries based on the customer’s shipping address.  The Company has no long-term assets located outside of the United States.

The following table sets forth the percentage of gross sales to each foreign country, which accounted for 10% or more of the Company’s foreign gross sales for the three and nine months ended December 31, 2008 and 2007:

Percentage of Gross Foreign Sales
	Three Months Ended December 31,						Nine Months Ended December 31,
Country	2008			2007			2008			2007
Canada		96	%		85	%		85	%		87	%
Other		5	%		15	%		15	%		13	%

(9)           Subsequent Event

On February 9, 2009, Andromeda Acquisition Corp. (“Andromeda”) announced that it plans to make a cash tender offer to purchase all outstanding shares of the Company for $0.36 per share.  Andromeda is a Delaware wholly-owned subsidiary of MW1 LLC (“MW1”) formed solely for the purpose of making the tender offer.  Currently, the sole member of MW1 is Mill Road Capital, L.P., a Delaware limited partnership formed by a core group of professionals to invest in small public companies.  Andromeda announced that it plans to commence the offer on or about February 13, 2009 and end the offer on or about March 16, 2009.  Additionally, it is expected that Galaxy Partners, the Company’s 51.1% majority shareholder, along with Mill Road Capital, L.P. will contribute their 14,370,728 combined shares of the Company’s common stock to MW1 prior to the expiration of the offer.

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GALAXY NUTRITIONAL FOODS, INC.

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

Information in this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to enhance a reader’s understanding of the financial condition, changes in financial condition and results of operations of our company.  This MD&A is a supplement to and should be read in conjunction with our financial statements and notes thereto appearing elsewhere in this report.  This Form 10-Q & MD&A contain forward-looking statements within the meaning of the federal securities laws that relate to future events or our future financial performance. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by our company.  Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “project,” “estimate,” “may,” “will,” “could,” “should,” “potential,” or “continue” or the negative or variations of these words or similar expressions are intended to identify forward-looking statements.   Additionally, these forward-looking statements include, but are not limited to statements regarding:

·   Paying or refinancing certain debt obligations;

·   Improving cash flows from operations;

·   Marketing our existing products and those under development;

·   Our estimates of future revenue and profitability;

·   Our expectations and forecasts regarding future expenses, including cost of goods sold (casein, in particular), delivery, selling, general and administrative, and research and development expenses;

·   Competition in our market; and

·   Our ability to operate as a going concern.

Although we believe that these forward-looking statements are reasonable at the time they are made, these statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual results may differ materially from our historical results and those expressed or forecasted in any forward-looking statements as a result of a variety of factors, including those set forth under “Risk Factors” and elsewhere in, or incorporated by reference into, this Form 10-Q and our Form 10-K for the fiscal year ended March 31, 2008.  We are not required and undertake no obligation to publicly update or revise any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

Terms such as “fiscal 2009”, “fiscal 2008”, or “fiscal 2007” refer to our fiscal years ending March 31, 2009, 2008, and 2007, respectively. Terms such as “first quarter,” “second quarter,” “third quarter,” or “fourth quarter” refer to the fiscal quarters ending June 30, September 30, December 31, or March 31, respectively.

This MD&A contains the following sections:

·   Business Environment

·   Critical Accounting Policies

·   Results of Operations

·   Liquidity and Capital Resources

·   Recent Accounting Pronouncements

Business Environment

General

Galaxy Nutritional Foods, Inc. (our “Company”) develops and internationally markets plant-based cheese alternatives, organic dairy and other organic and natural food products to grocery and natural foods retailers, mass merchandisers and food service accounts. Galaxy Nutritional Foods Veggie®, the leading brand in the grocery cheese alternative category and our Company’s top selling product group, is primarily merchandised in the produce section and provides calcium and protein without cholesterol, saturated fat or trans-fat. Other popular brands include: Galaxy Nutritional Foods Rice®, Veggy®, Vegan®, Rice Vegan®, and Wholesome Valley Organic®. Galaxy Nutritional Foods, Inc. is dedicated to developing nutritious and delicious food products made with high quality natural ingredients that exceed the expectations of today’s health conscious consumers. We are also committed to reducing our environmental impact as part of our Eat Green for Body & Earth™ program that offsets carbon emissions associated with product shipping and emphasizes the use of

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organic ingredients.  Our Company headquarters are located in Orlando, Florida, and our common stock is quoted on the OTC Bulletin Board under the symbol “GXYF.”

Cheese Alternative Category

We are the market leader within our cheese alternative category niche, but in being so, the category increases or decreases partly as a result of our marketing and pricing efforts.  We believe that the greatest source of future growth in the cheese alternative category will come through consumers shifting to cheese alternatives from natural cheese.  Our products typically sell at a premium over the price of natural cheese.  Our strategy is to broaden the consumer base to include younger, less price sensitive consumers seeking products with overall health and nutrition attributes. Historically, our products and marketing efforts appealed to older consumers purchasing cheese alternatives for specific dietary concerns.

Marketing

We use several internal and external reports to monitor sales and profitability by  brand, product, customer and channel of sale to determine the outside factors affecting the sales levels.  Marketing analyzes retail scan and internal sales data along with consumer insights for recommendations on pricing, product mix, new product and packaging opportunities and to assess market and competitive conditions.

Our fiscal 2009 marketing plan is focused on consumer-centric strategies and non-price based programs to increase brand awareness and purchase intent.  Consumer marketing programs include Veggie print advertising in Fitness and Parenting and Rice and Rice Vegan advertising in Vegetarian Times and VegNews.  Fiscal 2009 advertisements feature online coupon offers.  In addition to print advertising, we expanded consumer marketing efforts to include online advertising with various campaigns targeting our Veggie and Vegan brands.  Our public relations and media outreach continues to focus on consumer education and on our new environmental program.  As part of our public relations campaign, we partnered with Holistic Health Counselor and Gourmet Natural Foods Chef, Alex Jamieson. As a media spokesperson, Chef Jamieson assists in outreach to women’s food and health magazines.  Our Eat Green for Body & Earth™ campaign addresses the environmental impact of our business and communicates this message to our end consumers.  The initiative, in addition to carbon offsets, emphasizes the use of organic ingredients, which do not release synthetic fertilizers and pesticides into the environment.  Additionally, we have “greened” our offices by putting the environmentally conscious motto “reduce, reuse, recycle” into practice.  This program is being expanded in fiscal 2009 to include a notation of “Carbon Free Shipping” on our product labels.

As we grow our marketing initiatives, valuable insights on campaign efficacy are gained and used to fine-tune our efforts. Such information is then used to increase our return on marketing expenditures by focusing on those efforts that increase brand and product awareness, increase consumer education and ultimately broaden the consumer base within the cheese alternative category.

Conversion of Related Party Note Payable and Change in Control

Pursuant to a Note Purchase Agreement dated July 19, 2006 as modified on March 14, 2007, we issued an unsecured convertible note for $2,685,104 (the “Convertible Note”) to Mr. Frederick A. DeLuca, the Company’s largest stockholder.  The Convertible Note accrued interest at 12.5% per annum and matured on October 19, 2008.  No interest or principal payments were required under the Convertible Note until its maturity.  The Convertible Note together with any accrued and unpaid interest thereon, was convertible into shares of our common stock at a conversion price of $0.35 per share.

On November 18, 2008, our Company, Mr. DeLuca and Galaxy Partners, L.L.C., a Minnesota limited liability company (“Galaxy Partners”) entered into a Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to Galaxy Partners his 3,869,842 shares of our common stock and assigned to Galaxy Partners all of his right, title and interest in and to the Convertible Note. In connection with the Purchase Agreement and in accordance with the terms of the Convertible Note, Galaxy Partners converted all of the outstanding principal and accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278 shares of our common stock.  As a result of the Purchase Agreement and conversion of the Convertible Note into 9,941,278 shares, Galaxy Partners acquired an aggregate of 13,811,120 shares of our common stock and consequently became the majority stockholder in our Company, owning approximately 51.1% of the 27,051,294 issued and outstanding shares of our common stock.  Galaxy Partners is comprised of seven members.  In consideration of the conversion of the Convertible Note, we agreed to expand the size of our Board from 4 to 7 members and elected three of the seven members of Galaxy Partners to the Board - David B. Johnson, Timothy S. Krieger and Michael D. Slyce.  Mr. Krieger holds a 40% individual ownership in Galaxy Partners.   Mr. Johnson and Mr. Slyce each hold a 7.5% individual ownership in Galaxy Partners.  As the sole Governor/Director and CEO of Galaxy Partners, Mr. Krieger has the sole voting authority over all the 13,811,120 shares held by Galaxy Partners.

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In connection with the Purchase Agreement, Galaxy Partners obtained financing in the amount of $5,500,000 (the “Financing”) from Robert O. Schachter, who is one of the seven members of Galaxy Partners.  Pursuant to the terms of the Financing, the membership interests of Galaxy Partners owned by the majority of the remaining members of Galaxy Partners, including those owned by Messrs. Johnson, Krieger and Slyce, were pledged to Mr. Schachter.  In the event of default under the Financing, Mr. Schachter would be entitled to foreclose on the pledged interests, in which event Mr. Schachter would then indirectly own a majority of our common stock, which would constitute a further change in control of our Company.

As a result of the change in control, we are no longer subject to a termination fee from Schreiber in the event that we terminate the Supply Agreement prior to March 17, 2011.  However, the Purchase Agreement entered into on November 18, 2008 did not trigger a change in control or obligation as defined in the 2007 Stay Bonus, Severance Bonus and Sales Bonus Plan.

Measurements of Financial Performance

On a monthly basis, we compare the statements of income, balance sheets and statements of cash flows to budgeted expectations to identify variances and opportunities for cost savings.  In addition, we analyze sales and profitability relative to budgeted amounts for individual products, brand groups, channels of distribution and individual customers.  These reports are also tailored to provide us with information on promotional costs by product and customers.  Areas that are performing below expectations are reviewed to determine actions that we can take to improve performance.   Additionally, marketing uses this information to tailor our promotions to make them more effective and profitable.

We focus on several items in order to measure our performance.  We are working towards obtaining and maintaining positive trends in the following areas:

·   Operating cash flow

·   Gross margin in dollars and % of gross sales

·   Operating income excluding non-cash compensation related to stock-based transactions

·   EBITDA excluding non-cash compensation related to stock-based transactions

·   Volume and margin analysis by individual inventory items

·   Key financial ratios (such as accounts receivable aging and turnover ratios)

Critical Accounting Policies

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 disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of income and expense during the reporting periods presented.  Our significant estimates include the allowance for trade receivables which is made up of reserves for promotions, discounts and bad debts, inventory reserves, valuation of deferred taxes and valuation of compensation expense on stock-based awards.  Although we believe that these estimates are reasonable, actual results could differ from those estimates given a change in conditions or assumptions that have been consistently applied.

Management has discussed the selection of critical accounting policies and estimates with our Board of Directors, and the Board of Directors has reviewed our disclosure relating to critical accounting policies and estimates in this quarterly report on Form 10-Q. Our critical and significant accounting policies are described in Note 1 of our financial statements herein and in Note 1 of our Form 10-K for the fiscal year ended March 31, 2008.  The critical accounting policies used by management and the methodology for its estimates and assumptions are as follows:

Valuation of Accounts Receivable and Chargebacks

We record revenue upon shipment of products to our customers and upon reasonable assurance of collection on the sale.  We generally provide credit terms to customers based on net 30-day terms.  We perform ongoing credit evaluations of our accounts receivable balances.  Based on historical experience, we make reserves for anticipated future customer credits for rebates, sales promotions, coupons, spoils and other reasons that relate to current period sales.  In addition, we evaluate the accounts for potential uncollectible amounts based on a specific identification methodology and record a general reserve for all remaining balances.

Based on the age of the receivable, cash collection history and past dilution in the receivables, we make an estimate of our anticipated bad debt, anticipated future authorized deductions due to current period activity and anticipated collections on non-authorized amounts that customers have currently deducted on past invoices.  Based on this analysis, we reserved

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$274,000 and $862,000 for known and anticipated future credits and doubtful accounts at December 31, 2008 and 2007, respectively.  We believe that this estimate is reasonable, but there can be no assurance that our estimate will not change given a change in economic conditions or business conditions within the food industry, our individual customer base or our Company.  Actual bad debt expense averages less than 1% of gross sales.

Inventory

Inventories are valued at the lower of cost or market.  Cost is determined using a weighted average method which approximates the first-in, first out method.  We review our inventory valuation each month and write off or reserve for inventory based on known or anticipated obsolete, discontinued and damaged goods.  In addition, we reduce the value of any finished good item to market value when that value is believed to be less than the cost of the item. Based on this analysis, we reserved $7,000 and $5,615 for known and anticipated future reductions in inventory value at December 31, 2008 and 2007, respectively.  We believe that this estimate is reasonable, but there can be no assurance that our estimate will not change given a change in economic conditions or business conditions within the food industry or our Company.

Deferred Taxes

Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.  We have reserved our net deferred tax assets in full since we have not established a history of taxable income.

Valuation of Non-Cash Stock-Based Compensation

Statement of Financial Accounting Standard (“FAS”) No. 123 (revised 2004), “Share-Based Payment,” (“FAS No. 123R requires companies to measure the cost of employee services received in exchange for an award of equity instruments, including stock options, based on the grant-date fair value of the award and to recognize it as compensation expense over the period the employee is required to provide service in exchange for the award, usually the vesting period.

FAS No. 123R applies to new awards and to awards modified, repurchased, or cancelled after the effective date, as well as to the unvested portion of awards outstanding as of the effective date. We use the Black-Scholes option-pricing model to value our new stock option grants under FAS No. 123R. FAS No. 123R also requires us to estimate forfeitures in calculating the expense related to stock-based compensation. In addition, FAS No. 123R requires us to reflect cash flows resulting from excess tax benefits related to those options as a cash inflow from financing activities rather than as a reduction of taxes paid.

There were no issuances of stock awards or vesting of prior unvested stock awards during the three and nine months ended December 31, 2008 and 2007.  Therefore, there were no assumptions under the Black-Scholes option-pricing model and no stock-based compensation expense during the three and nine months ended December 31, 2008 and 2007.

Results of Operations

	3-Months Ended December 31,												9-Months Ended December 31,
	2008			2007			$ Change			% Change			2008			2007			$ Change			% Change
Net Sales	$	6,261,613		$	6,446,099		$	(184,486	)		-2.9	%	$	18,413,893		$	18,763,360		$	(349,467	)		-1.9	%
Cost of Goods Sold		4,310,492			4,145,200			165,292			4.0	%		12,514,672			11,346,406			1,168,266			10.3	%
Gross Margin	$	1,951,121		$	2,300,899		$	(349,778	)		-15.2	%	$	5,899,221		$	7,416,954		$	(1,517,733	)		-20.5	%
Gross Profit %		31.2	%		35.7	%								32.0	%		39.5	%

Sales

For the three months ended December 31, 2008 and 2007, our gross sales before discounts, returns and allowances were $6,551,093 and $6,888,900, respectively. For the nine months ended December 31, 2008 and 2007, our gross sales before discounts, returns and allowances were $19,109,219 and $20,317,013, respectively.  The following chart sets forth the percentage of gross sales derived from our product brands during the three and nine months ended December 31, 2008 and 2007:

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	Three Months Ended December 31,						Nine months Ended December 31,
Brand	2008			2007			2008			2007
Veggie		66.0	%		65.2	%		67.1	%		66.7	%
Rice		14.6	%		12.9	%		12.9	%		12.1	%
Private Label, Imitation and Other		8.1	%		10.3	%		9.2	%		10.4	%
Vegan		4.4	%		4.0	%		4.1	%		3.7	%
Veggy		3.5	%		4.2	%		3.4	%		4.3	%
Wholesome Valley Organic		3.4	%		3.4	%		3.3	%		2.8	%

Although gross sales decreased approximately 5% and 6% in the three and nine months ended December 31, 2008, respectively, compared to the same periods ended December 31, 2007, our net sales, after discounts, returns and allowances, decreased only 3% and 2% in the three and nine months ended December 31, 2008, respectively, compared to the same periods ended December 31, 2007.  The reason for the lower decrease in net sales is the strategic decision to reduce certain vendor promotions and discounts in order to help offset some of the increase in cost of goods sold as detailed below.  The sales mix in the three and nine months ended December 31, 2008 remained similar to that in the prior year periods.

We anticipate that our annual net sales in fiscal 2009 will be slightly lower than sales reported in fiscal 2008 reflecting the lower baseline sales projected after further elimination of lower margin imitation business.

Cost of Goods Sold

Cost of goods sold increased five percentage points to 69% of net sales in the three months ended December 31, 2008 compared to 64% of net sales in the three months ended December 31, 2007.  Cost of goods sold increased seven percentage points to 68% of net sales in the nine months ended December 31, 2008 compared to 61% of net sales in the nine months ended December 31, 2007.  This increase in cost of goods sold as a percentage of net sales is primarily due to increased prices in casein. Casein is a dried skim milk protein that is the principal raw ingredient used in most of our products.  The average price of casein increased 21% in the three months ended December 31, 2008 compared to the three months ended December 31, 2007 and increased 64% in the nine months ended December 31, 2008 compared to the nine months ended December 31, 2007 due to a worldwide shortage and a weaker US Dollar that began in the third quarter of fiscal 2008. In the first nine months of fiscal 2009, the average price of casein is approximately 41% higher than the annual fiscal 2008 average.  However, the second and third quarters of fiscal 2009 saw a 3% and 6% quarter to quarter decrease; thereby indicating a possible stabilization and reversal in the cost of casein.

Forecasts from our suppliers indicate that although these historically high casein prices are subsiding, our average fiscal 2009 prices will remain significantly higher than our average prices paid in fiscal 2008. This dramatic increase in supply costs has and will continue to substantially increase our cost of goods sold and correspondingly substantially reduce our gross margins in fiscal 2009.  However, based on additional discussions with casein suppliers, we do expect that casein prices in fiscal 2010 will significantly decline.  Management is in the process of evaluating the effects of reduced pricing for fiscal 2010.

During fiscal 2008 and the first half of fiscal 2009, we implemented several initiatives in an effort to at least partially minimize the negative effect of these casein price increases. These strategies included reducing promotional spending and consumer advertising and increasing customer pricing on certain affected product lines, as well as, proposing reformulations on existing products to reduce the amount of required casein and expanding and accelerating the roll-out of new products which do not require casein.

Gross Margin

Gross margin declined 15% and 21% in the three and nine months ended December 31, 2008 compared to the three and nine months ended December 31, 2007.  Additionally, gross profit declined approximately 5 percentage points from an average of 36% in the three months ended December 31, 2007 to 31% in the three months ended December 31, 2008, and approximately 8 percentage points from an average of 40% in the nine months ended December 31, 2007 to 32% in the nine months ended December 31, 2008.  This decrease in gross margin and profits is primarily due to the rapid increase in the cost of goods sold (primarily casein) as stated above.  We do not believe that we could have passed this entire cost increase on to our consumers through immediate price increases without causing substantial reductions in our sales volumes.

We anticipate that in fiscal 2009, gross margins on a majority of our products will be lower than those in fiscal 2008 since the cost increases primarily took place in the third and fourth quarter of fiscal 2008.  We further anticipate that gross

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margins as a percentage of net sales for fiscal 2009 will be approximately five to ten percentage points lower than our fiscal 2008 annual average.  Additionally, we anticipate that our income from operations will continue to be materially and adversely affected by the decline in gross margins in fiscal 2009.

EBITDA

We utilize certain GAAP measures such as Operating Income and Net Income and certain non-GAAP measures, in order to compute key financial measures that are reviewed by management, lenders and investors in order to effectively review our current on-going operations and analyze trends related to our financial condition and results of operations.  The non-GAAP measures are key factors upon which we prepare and review our budgets and forecasts. In our calculation of key financial non-GAAP measures for adjusted Operating Income, adjusted Net Income and adjusted EBITDA, we exclude items such as non-cash compensation related to stock-based transactions, certain employment contract expenses and disposal costs.  These adjusted measures are not in accordance with, or an alternative for, generally accepted accounting principles and may be different from non-GAAP measures reported by other companies.

EBITDA, (a non-GAAP measure):
	3-Months Ended December 31,												9-Months Ended December 31,
	2008			2007			$ Change			% Change			2008			2007			$ Change			% Change
Net Sales	$	6,261,613		$	6,446,099		$	(184,486	)		-2.9	%	$	18,413,893		$	18,763,360		$	(349,467	)		-1.9	%
Cost of Goods Sold		4,310,492			4,145,200			165,292			4.0	%		12,514,672			11,346,406			1,168,266			10.3	%
Gross Margin		1,951,121			2,300,899			(349,778	)		-15.2	%		5,899,221			7,416,954			(1,517,733	)		-20.5	%
Operating Expenses:
Selling		770,199			871,797			(101,598	)		-11.7	%		2,300,375			2,702,038			(401,663	)		-14.9	%
Delivery		265,134			263,923			1,211			0.5	%		758,191			772,786			(14,595	)		-1.9	%
General and administrative		550,944			672,530			(121,586	)		-18.1	%		1,800,850			1,883,647			(82,797	)		-4.4	%
Employment contract expense(1)		-			-			-			0.0	%		-			346,447			(346,447	)		-100.0	%
Research and development		75,409			86,511			(11,102	)		-12.8	%		218,685			249,506			(30,821	)		-12.4	%
Loss on disposal of assets		-			512			(512	)		-100.0	%		-			512			(512	)		-100.0	%
Total operating expenses		1,661,686			1,895,273			(233,587	)		-12.3	%		5,078,101			5,954,936			(876,835	)		-14.7	%
Income from Operations		289,435			405,626			(116,191	)		-28.6	%		821,120			1,462,018			(640,898	)		-43.8	%
Interest expense, net		(65,356	)		(110,261	)		44,905			-40.7	%		(281,212	)		(343,313	)		62,101			-18.1	%
Income before Taxes		224,079			295,365			(71,286	)		-24.1	%		539,908			1,118,705			(578,797	)		-51.7	%
Federal Income Tax Expense		-			-			-			0.0	%		-			(12,000	)		12,000			-100.0	%
NET INCOME		224,079			295,365			(71,286	)		-24.1	%		539,908			1,106,705			(566,797	)		-51.2	%
Interest expense, net		65,356			110,261			(44,905	)		-40.7	%		281,212			343,313			(62,101	)		-18.1	%
Taxes		-			-			-			0.0	%		-			12,000			(12,000	)		-100.0	%
Depreciation		10,967			11,246			(279	)		-2.5	%		33,950			33,308			642			1.9	%
EBITDA, (a non-GAAP measure)	$	300,402		$	416,872		$	(116,470	)		-27.9	%	$	855,070		$	1,495,326		$	(640,256	)		-42.8	%
EBITDA, as a % of Net Sales		4.8	%		6.5	%								4.6	%		8.0	%

(1)   In our calculation of key financial measures, we exclude the employment contract expenses related to Christopher Morini, because we believe that this item does not reflect expenses related to our current on-going operations.

Selling

Selling expense is partly a function of sales through variable costs such as brokerage commissions and promotional costs and partly fixed with certain fixed costs for marketing campaigns and employee salaries and benefits.  Selling expense as a percentage of net sales was approximately 12% and 14% in the three months ended December 31, 2008 and 2007, respectively.  Selling expense as a percentage of net sales was also approximately 13% and 14% in the nine months ended December 31, 2008 and 2007, respectively.  Historically, selling expenses averaged 14%-15% of net sales.  However,

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selling expenses as a percentage of net sales have decreased by two percentage points due to lower direct advertising costs and reduced travel expenses in the three and nine months ended December 31, 2008 compared to the three and nine months ended December 31, 2007.  Direct advertising costs primarily in print advertising were approximately $196,000 lower and travel and entertainment expenses were approximately $51,000 lower in the first nine months of fiscal 2009 due to a reduction in spending to help offset the higher cost of goods sold.

We expect that fixed selling expense amounts for advertising and market research in fiscal 2009 will be lower than fiscal 2008 due to the reasons disclosed above and selling expense as a percentage of net sales will average 13%-14%.

Delivery

Delivery expense is primarily a function of sales as our primary supplier drop-ships products to our customers and charges a fixed, per-pound contractual delivery fee that is subject to adjustment from time to time.  Delivery costs averaged 4% of net sales in the three and nine months ended December 31, 2008 and 2007 as anticipated.  We anticipate that delivery expense for fiscal 2009 will remain at approximately 4% of net sales.

General and Administrative

During the three and nine months ended December 31, 2008, general and administrative expenses decreased approximately $122,000 or 18% and $83,000 or 4%, respectively, compared to the three and nine months ended December 31, 2007.  Legal fees declined by approximately $127,000 as a result of a change in our primary general counsel and as a result of less time consuming legal transactions compared to the nine months ended December 31, 2007.  Additionally, director and officer (“D&O”) insurance costs decreased by approximately $37,000 due to lower policy limits.  However, this reduction in legal fees and D&O insurance was offset by a $72,000 increase in employee costs due to increases in existing employee payroll and benefits.

Excluding the effects of non-cash compensation related to stock-based transactions, which cannot be predicted, we anticipate that in fiscal 2009 general and administrative expenses will remain consistent with the total expense in fiscal 2008.

Employment Contract Expense

On June 1, 2007, Christopher Morini resigned from his position as Vice President of New Business Development.  In accordance with the Separation and General Release Agreement which became effective on June 9, 2007, between our Company and Mr. C. Morini, we accrued $346,447 for wages, health insurance benefits, and payroll taxes and expensed them under Employment Contract Expense-General and Administrative in the Statement of Operations in June 2007.  After an initial lump sum payment of approximately $100,087, the remaining obligation is being paid out in bi-weekly installments through February 2009.

Research and Development

Research and development expenses decreased by approximately $11,000 and $31,000 in the three and nine months ended December 31, 2008, respectively, compared to the three and nine months ended December 31, 2007.  During fiscal 2008, we incurred higher charges to reformulate our Rice Shred products and to develop a new product line for our Wholesome Valley Organic brand.  These charges were lower during fiscal 2009 due to less reformulations and product development in the first nine months of fiscal 2009..  However, we anticipate that research and development costs in fiscal 2009 will be comparable to the prior fiscal year as reformulation charges are expected to increase in the fourth quarter of fiscal 2009.

Interest Expense

Interest expense decreased by approximately $45,000 or 40% and $62,000 or 18% in the three and nine months ended December 31, 2008, respectively, compared to the three and nine months ended December 31, 2007. The decrease in interest expense is primarily the result of the conversion of the related party note payable in November 2008 (see discussion below under Financing Activities) and no debt discount amortization and less loan costs remaining to be amortized.

We anticipate that our interest expense will remain lower in fiscal 2009 due to lower debt balances and interest rates, as well as, the conversion of the related party note payable.  Our current loan facility with Commercial Finance Division accrues interest based on a variable prime plus rate.  Prime rate is currently at 3.25% and it is uncertain if this will change during fiscal 2009.  Any changes in the prime rate would affect our interest expense in fiscal 2009 based on the amount we have outstanding under our loan facility.

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Liquidity and Capital Resources

Future Capital Needs

As a result of the conversion of the Convertible Note (see discussion below under Financing Activities), the strength of our balance sheet greatly improved with no further debt obligations and our stockholders’ equity greater than $3 million. We also anticipate that stabilized gross margins will continue to provide positive operating cash flow in fiscal 2009.  With these improvements and over $3 million in cash currently available, we believe that we will have enough cash to meet our current liquidity needs in fiscal 2009 and fiscal 2010.

9-Months Ended December 31,	2008			2007			$ Change			% Change
Cash from (used in) operating activities	$	1,086,587		$	1,134,005		$	(47,418	)		-4.2	%
Cash from (used in) investing activities		(19,783	)		(14,345	)		(5,438	)		37.9	%
Cash from (used in) financing activities		(59,150	)		(556,886	)		497,736			-89.4	%
Net increase (decrease) in cash	$	1,007,654		$	562,774		$	444,880			79.1	%

Operating and Investing Activities

We are continuing to provide positive cash flow from operations due to timely collections on accounts receivable and maximization of our vendor terms. We continually review our accounts receivable collection, inventory levels and accounts payable practices in order to maximize cash flow from operations.

In the nine months ended December 31, 2008 and 2007, cash used in investing activities related to our purchase of additional office equipment.

Financing Activities

Debt Financing

On June 23, 2006, we entered into a Receivables Purchase Agreement with Commercial Finance Division, a subsidiary of Textron Financial Corporation (“Commercial Finance”), whereby Commercial Finance provides financing to our Company through advances against certain trade receivable invoices due to our Company (the “Commercial Finance Agreement”).  The Commercial Finance Agreement is secured by our accounts receivable and all other assets.  Generally, subject to a maximum principal amount of $3,500,000 which can be borrowed under the Commercial Finance Agreement, the amount available for borrowing is equal to 85% of our eligible accounts receivable invoices less a dilution reserve and any required fixed dollar reserves.  The dilution and fixed dollar reserves are currently set at 7% and $100,000, respectively.  Advances under the Commercial Finance Agreement bear interest at a variable rate equal to the prime rate plus 1.5% per annum (4.75% on December 31, 2008).  However, the Commercial Finance Agreement requires a $4,500 minimum monthly interest charge to be assessed.   We are also obligated to pay a $1,500 monthly service fee.

The initial term of the Commercial Finance Agreement ends on June 23, 2009 and may renew automatically for consecutive twelve-month terms unless terminated sooner.  The Commercial Finance Agreement may be accelerated in the event of certain defaults by our Company including among other things, a default in our payment and/or performance of any obligation to Commercial Finance or any other financial institution, creditor, or bank; and any change in the conditions, financial or otherwise, of our Company which reasonably causes Commercial Finance to deem itself insecure.  In such an event, interest on our borrowings would accrue at the greater of twelve percent per annum or the variable rate of prime plus 1.5% and we would be liable for an early termination premium of 1% on the maximum principal amount available under the Commercial Finance Agreement.  Although we had approximately $1.5 million available to draw pursuant to this Commercial Finance Agreement as of December 31, 2008, there were no amounts advanced, because we did not need additional cash on such date.  The net amount of cash used to pay down our obligation under our Commercial Finance Agreement during the nine months ended December 31, 2008 and 2007 was $0 and $556,886, respectively.

Equity Financing

On November 18, 2008, our Company, Frederick A. DeLuca and Galaxy Partners, L.L.C., a Minnesota limited liability company (“Galaxy Partners”) entered into a Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to Galaxy Partners his 3,869,842 shares of our common stock and assigned to Galaxy Partners all of his right, title and interest in and to an unsecured convertible note for $2,685,104 (the “Convertible Note”). In connection with the Purchase Agreement and in accordance with the terms of the Convertible Note, Galaxy Partners converted all of the outstanding principal and accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278 shares of our common stock.  We recorded $59,150 of stock issuance costs related to these transactions to additional paid in capital in the three months ended December 31, 2008.  As a result of the Purchase

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Agreement and conversion of the Convertible Note into 9,941,278 shares, Galaxy Partners acquired an aggregate of 13,811,120 shares of our common stock and consequently became the majority stockholder in our Company, owning approximately 51.1% of the 27,051,294 issued and outstanding shares of our common stock.

Recent Accounting Pronouncements

In February 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”) 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13,” (“FSP FAS 157-1”).  FSP FAS 157-1 amends FAS No. 157 to remove certain leasing transactions from its scope and is effective upon the initial adoption of FAS No. 157 which we adopted beginning April 1, 2008.  Additionally in February 2008, FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157,” which amends FAS No. 157 by delaying its effective date by one year for non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis.  Accordingly, we will begin applying fair value measurements for all non-financial assets and non-financial liabilities on April 1, 2009.

In May 2008, FASB issued FSP APB 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement),” (“FSP APB 14-1”). This FSP specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity's nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years, and is applied retrospectively to all periods presented. We are currently evaluating the impact of adopting FSP APB 14-1 on our results of operations and financial position.

In June 2008, FASB issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities.” The FSP concluded that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities under FASB No. 128, “Earnings per Share,” and should be included in the computation of earnings per share under the two-class method. The two-class method is an earnings allocation formula used to determine earnings per share for each class of common stock according to dividends declared and participation rights in undistributed earnings. FSP EITF 03-6-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, and is applied retrospectively to all periods presented.  We do not expect that the adoption of this FSP will have a material impact on our results of operations or financial position.

In June 2008, the FASB’s Emerging Issues Task Force reached a consensus regarding EITF Issue No. 07-5, “Determining Whether an Instrument (or Embedded Feature) Is Indexed to an Entity’s Own Stock” (EITF 07-5). EITF 07-5 outlines a two-step approach to evaluate the instrument’s contingent exercise provisions, if any, and to evaluate the instrument’s settlement provisions when determining whether an equity-linked financial instrument (or embedded feature) is indexed to an entity’s own stock. EITF 07-5 is effective for fiscal years beginning after December 15, 2008 and must be applied to outstanding instruments as of the beginning of the fiscal year of adoption as a cumulative-effect adjustment to the opening balance of retained earnings. Early adoption is not permitted. We are currently evaluating the impact of adopting EITF 07-5 on our results of operations and financial position.

The Recent Accounting Pronouncements should be read in conjunction with the pronouncements included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008.

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Item 4T. Controls and Procedures

Management is responsible for the preparation of our financial statements and related information. Management uses its best judgment to ensure that the financial statements present fairly, in all material respects, our financial position and results of operations in conformity with generally accepted accounting principles.

As of December 31, 2008, an evaluation was performed under the supervision and with the participation of our management, including the Chief Executive Officer ("CEO"), and the Chief Financial Officer ("CFO"), of the effectiveness of the design and operation of our disclosure controls and procedures to insure that we record, process, summarize and report in a timely and effective manner the information required to be disclosed in reports filed with or submitted to the Securities and Exchange Commission.  Based on that evaluation, our management, including the CEO and CFO, concluded that our disclosure controls and procedures were effective in timely bringing to their attention material information related to our Company required to be included in our periodic Securities and Exchange Commission filings. During the quarter ended December 31, 2008, there were no changes in our internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect those controls.

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PART II.  OTHER INFORMATION

Item 1A.                      Risk Factors

Statements other than historical information contained in this Form 10-Q are considered “forward-looking statements” as defined under the Private Securities Litigation Reform Act of 1995.  These statements relate to future events or our future financial performance. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by our Company.  Words such as “anticipate,” “expect,” “intend,” “plan,” “believe,” “seek,” “project,” “estimate,” “may,” “will,” “could,” “should,” “potential,” or “continue” or the negative or variations of these words or similar expressions are intended to identify forward-looking statements.  Although we believe that these forward-looking statements are reasonable at the time they are made, these statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual results may differ materially from our historical results and those expressed or forecasted in any forward-looking statement as a result of a variety of factors as set forth below.  We are not required and undertake no obligation to publicly update or revise any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.

In addition to the other information in this Form 10-Q and risk factors previously disclosed in our Annual Report on Form 10-K for the year ended March 31, 2008, the following are some of the factors as of February 10, 2009, that could cause our Company’s actual results to differ materially from the expected results described in or underlying our Company’s forward-looking statements.  These factors should be considered carefully while evaluating our business and prospects.   If any of the following risks actually occur, they could seriously harm our business, financial condition, results of operations or cash flows.

We may be required to repay our Convertible Note to Mr. DeLuca.

Pursuant to a Note Purchase Agreement dated July 19, 2006 as modified on March 14, 2007, we issued an unsecured convertible note for $2,685,104 (the “Convertible Note”) to Mr. Frederick A. DeLuca, the Company’s largest stockholder.  The Convertible Note accrued interest at 12.5% per annum and matured on October 19, 2008.  No interest or principal payments were required under the Convertible Note until its maturity.  The Convertible Note together with any accrued and unpaid interest thereon, was convertible into shares of our common stock at a conversion price of $0.35 per share.

On November 18, 2008, our Company, Mr. DeLuca and Galaxy Partners, L.L.C., a Minnesota limited liability company (“Galaxy Partners”) entered into a Stock Purchase Agreement (the “Purchase Agreement”).  Pursuant to the Purchase Agreement, in exchange for the sum of $5 million, Mr. DeLuca sold to Galaxy Partners his 3,869,842 shares of our common stock and assigned to Galaxy Partners all of his right, title and interest in and to the Convertible Note. In connection with the Purchase Agreement and in accordance with the terms of the Convertible Note, Galaxy Partners converted all of the outstanding principal and accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278 shares of our common stock.    Therefore, there is no further risk factor associated with repayment of the Convertible Note.

We may not be able to continue as a going concern on a long-term basis.

We received a report from our independent accountants relating to our audited financial statements as of March 31, 2008 containing a paragraph stating that because we may be required to pay the Convertible Note and accrued interest thereon in fiscal 2009 which may leave us with insufficient cash funds to continue operations, there is substantial doubt as to our ability to continue as a going concern.  Our ability to continue as a going concern depended upon the outcome of our discussions with Mr. DeLuca and others regarding options to refinance and/or convert all or a portion of the Convertible Note and accrued interest thereon into equity or successfully obtaining sufficient cash resources to pay this obligation.

In connection with the Purchase Agreement discussed above and in accordance with the terms of the Convertible Note, Galaxy Partners converted all of the outstanding principal and accrued interest under the Convertible Note totaling $3,479,447 into 9,941,278 shares of our common stock.    As a result of the conversion of the Convertible Note, the strength of our balance sheet greatly improved with no further debt obligations and our stockholders’ equity greater than $3 million.  Therefore, management does not believe there is any further risk associated with our ability to operate as a going concern in the near future.

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We may be required to pay substantial penalties under our Supply Agreement.

On March 17, 2008, we entered into a Second Amendment to our Supply Agreement dated June 30, 2005 with Schreiber Foods, Inc. (“Schreiber”).  The Second Amendment required us to pay a shortfall payment should we terminate the Supply Agreement prior to a stated date, other than as a result of a breach by Schreiber or change of control in our Company.  The shortfall payment starts at $5,100,000 as of March 17, 2008 and declines by $1,700,000 per contract year until March 17, 2011, at which time the shortfall payment is eliminated.  If there is a change of control in either our Company or Schreiber, then the shortfall payment obligation will terminate and be extinguished as of the date of such change of control. As a result of the change in control in November 2008, we are no longer subject to the termination fee described above and therefore, there is no longer a risk factor associated with the stated penalties under our Supply Agreement.

We may not be able come to a mutual agreement with our Chief Executive Officer and may need to seek a new Chief Executive Officer.

Effective with the signing of the Purchase Agreement on November 18, 2008, Michael E. Broll entered into an amendment to his employment agreement with our Company, whereby he would continue as our Chief Executive Officer and Board member through March 31, 2009.  Mr. Broll also serves as our President.  In the event the parties do not enter into a new employment arrangement, then upon receipt of Mr. Broll’s resignation as our Company’s Chief Executive Officer and from our Board of Directors on March 31, 2009, in consideration of his staying with our Company during the transition period subsequent to the change of control in our Company and in recognition of his waiver of his rights under our 2007 Stay, Severance and Sales Bonus Plan, we will pay Mr. Broll compensation of $20,000 per month for 25 consecutive months beginning on April 1, 2009 less any applicable federal and/or state taxes.

In the event that Mr. Broll resigns from our Company on March 31, 2009, we will need to seek someone to replace him as Chief Executive Officer. To date, the Board has not identified a candidate for the position of Chief Executive Officer.  In the event of Mr. Broll’s resignation, we may need to hire an executive recruitment firm to assist in finding a suitable candidate for such position and pay a substantial fee in connection with any such placement.  In addition, while we anticipate that certain members of our Board may take a greater role in the management and direction of our Company until a new Chief Executive Officer is hired, the Company may be adversely impacted if there is a significant period of time without the services and direction of a top executive officer.

The main ingredient in many of our products is subject to volatility and limited availability.  Price increases for this commodity adversely affect our business.

Our Supply Agreement with Schreiber is based on cost plus a processing fee.  Currently, the major cost ingredient in our products is casein, a dried skim milk protein that is purchased from foreign suppliers.  Because casein is purchased from foreign suppliers, its availability is subject to a variety of factors, including but not limited to, trade regulations, foreign supply and exchange rate fluctuations.  These factors could have an adverse effect on our business and our ability to compete with competitors that do not rely on foreign suppliers.  We cannot assure you that we could obtain casein from U.S. sources if the foreign supply of casein were reduced or terminated.  Even if we could obtain casein from U.S. sources, the prices for the casein would likely be significantly higher than we have paid historically.  Any of these events would negatively affect our business, results of operations and cash flows.

Additionally, due to a worldwide shortage and a weaker US Dollar that began in the third quarter of fiscal 2008, the average price of casein increased more than 21% and 64% in the three and nine months ended December 31, 2008, respectively, compared to the three and nine months ended December 31, 2007. In the first nine months of fiscal 2009, the average price of casein is approximately 41% higher than the annual fiscal 2008 average.  However, the second and third quarters of fiscal 2009 saw a 3% and 6% quarter to quarter decrease; thereby indicating a possible stabilization and reversal in the cost of casein.  Forecasts from our suppliers indicate that although these historically high casein prices are subsiding, our average fiscal 2009 prices will remain significantly higher than our average prices paid in fiscal 2008. This dramatic increase in supply costs has and will continue to substantially increase our cost of goods sold and correspondingly substantially reduce our gross margins in fiscal 2009.  However, based on additional discussions with casein suppliers, we do expect that casein prices in fiscal 2010 will significantly decline and that our gross margins will improve.  Management is in the process of evaluating the effects of reduced pricing for fiscal 2010.

We implemented several strategic plans of action in an effort to at least partially minimize the negative effect of these casein price increases. These strategies included reducing promotional spending and consumer advertising and increasing customer pricing on certain affected product lines, as well as, proposing reformulations on existing products to reduce the amount of required casein and expanding and accelerating the roll-out of new products which do not require casein.  Although we implemented these strategic plans of action, we anticipate that gross margins on a majority of our products and as a whole will remain lower in fiscal 2009 compared to fiscal 2008.  Additionally, we anticipate that our income from

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operations for fiscal 2009 will continue to be adversely affected by the lower gross margins when comparing to prior years unless the cost of casein declines.

One entity owns a majority of our outstanding shares, which could materially limit the ownership rights of investors.

As a result of the Purchase Agreement and conversion of the Convertible Note into 9,941,278 shares, Galaxy Partners acquired an aggregate of 13,811,120 shares of our common stock on November 18, 2008 and consequently became the majority stockholder in our Company, owning approximately 51.1% of the 27,051,294 issued and outstanding shares of our common stock.  At the present time, Galaxy Partners has three representatives out of a total of seven directors on our Board and exerts significant influence on the policies and direction of our Company.  As a result of its ownership of a majority of our outstanding common stock, at the next annual meeting of stockholders at which members of the Board are elected, Galaxy Partners could control the outcome of the vote on all persons who are submitted for election to the Board, and thereafter effectively control the policies and direction of our Company.  Galaxy Partners can similarly significantly affect, if not control, the outcome of any other matter submitted to a vote of the stockholders of our Company. Investors who purchase common stock in our Company will be unable to elect any specific members of the board of directors or exercise significant control over us or our business as a result of Galaxy Partners’ ownership of our common stock.

Stockholders may experience further dilution.

We have a total of 3,932,962 shares reserved for future issuance upon the exercise of options or warrants outstanding as of February 10, 2009.  None of these securities are “in the money,” as of such date.  “In the money” generally means that the current market price of the common stock is above the exercise price of the shares subject to the option, warrant or note conversion.  The issuance of common stock upon the exercise of these options and warrants could adversely affect the market price of the common stock or result in substantial dilution to our existing stockholders.  In addition, any future securities issuances by our Company could result in the issuance, or potential issuance, of a significant amount of equity securities that will cause substantial dilution to our stockholders, particularly given the current low trading price of our common stock.

Item 5.                Other Information

On February 9, 2009, Andromeda Acquisition Corp. (“Andromeda”) announced that it plans to make a cash tender offer to purchase all outstanding shares of our Company for $0.36 per share.  Andromeda is a Delaware wholly-owned subsidiary of MW1 LLC (“MW1”) formed solely for the purpose of making the tender offer.  Currently, the sole member of MW1 is Mill Road Capital, L.P., a Delaware limited partnership formed by a core group of professionals to invest in small public companies.  Andromeda announced that it plans to commence the offer on or about February 13, 2009 and end the offer on or about March 16, 2009.  Additionally, it is expected that Galaxy Partners L.L.C., the Company’s 51.1% majority shareholder, along with Mill Road Capital, L.P. will contribute their 14,370,728 combined shares of our Company’s common stock to MW1 prior to the expiration of the offer.  As a result of the tender offer, we will postpone our Annual Meeting of Stockholders (“Annual Meeting”) originally scheduled for Tuesday, February 10, 2009 until after the conclusion of the tender offer period.

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Item 6.                     Exhibits

The following exhibits are filed as part of this Form 10-Q:

Exhibit No                                           Exhibit Description

  *3.1 Restated Certificate of Incorporation of the Company as filed with the Secretary of State of the State of Delaware on December 23, 2002 (Filed as Exhibit 3.2 on Form 10-Q for the fiscal quarter ended December 31, 2002.)

  *3.2 Amended and Restated Bylaws of Galaxy Nutritional Foods, Inc. dated February 6, 2008 (Filed as Exhibit 3.2 on Form 10-Q for the fiscal quarter ended December 31, 2007.)

  *4.1 Asset Purchase Agreement dated June 30, 2005 between Galaxy Nutritional Foods, Inc. and Schreiber Foods, Inc. (Filed as Exhibit 4.25 on Form 8-K filed July 6, 2005.)

  *4.2 Warrant to Purchase Securities of Galaxy Nutritional Foods, Inc. dated July 19, 2006 in favor of Frederick A. DeLuca (Filed as Exhibit 4.27 on Form 8-K filed July 25, 2006.)

*10.1 Second Amended and Restated Employment Agreement dated as of October 13, 2003 between Galaxy Nutritional Foods, Inc. and Angelo S. Morini  (Filed as Exhibit 10.1 on Form 8-K filed October 20, 2003.)

*10.2 Employment Agreement dated July 8, 2004 between Galaxy Nutritional Foods, Inc. and Michael E. Broll (Filed as Exhibit 10.15 on Form 8-K filed July 13, 2004.)

*10.3 Second Amendment to the Employment Agreement dated May 3, 2007 between Galaxy Nutritional Foods, Inc. and Michael E. Broll. (Filed as Exhibit 10.41 on Form 8-K filed May 9, 2007.)

*10.4 Third Amendment to the Employment Agreement dated December 10, 2007 between Galaxy Nutritional Foods, Inc. and Michael E. Broll (Filed as Exhibit 10.44 on Form 10-Q for the fiscal quarter ended December 31, 2007.)

*10.5 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated August 7, 2006 in favor of Peter J. Jungsberger (Filed as Exhibit 10.33 on Form 10-Q for the fiscal quarter ended June 30, 2006.)

*10.6 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated August 7, 2006 in favor of Robert S. Mohel (Filed as Exhibit 10.34 on Form 10-Q for the fiscal quarter ended June 30, 2006.)

*10.7 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated August 17, 2006 in favor of David H. Lipka (Filed as Exhibit 10.35 on Form 8-K filed August 21, 2006.)

*10.8 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated August 17, 2006 in favor of Michael E. Broll (Filed as Exhibit 10.36 on Form 8-K filed August 21, 2006.)

*10.9 Non-plan Option to Purchase Securities of Galaxy Nutritional Foods, Inc. dated August 17, 2006 in favor of Angelo S. Morini (Filed as Exhibit 10.37 on Form 8-K filed August 21, 2006.)

*10.10 Separation and General Release Agreement dated June 1, 2007 between Galaxy Nutritional Foods, Inc. and Christopher Morini (Filed as Exhibit 10.43 on Form 10-K for the fiscal year ended March 31, 2007.)

*10.11 Stay, Severance and Sales Bonus Plan effective December 10, 2007 (Filed as Exhibit 10.45 on Form 10-Q for the fiscal quarter ended December 31, 2007.)

*10.12 Supply Agreement dated June 30, 2005 between Galaxy Nutritional Foods, Inc. and Schreiber Foods, Inc.  Portions of the Supply Agreement have been omitted as indicated by asterisks pursuant to a request for confidential treatment in accordance with Section 552(b)(4) of the Freedom of Information Act ("FOIA"), 5 U.S.C. 552(b)(4) (Filed as Exhibit 10.19 on Form 8-K filed July 6, 2005.)

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*10.13 Letter Agreement accepted November 9, 2006 between Galaxy Nutritional Foods, Inc. and Schreiber Foods, Inc. amending the Supply Agreement dated June 30, 2005 between the parties.  Portions of the Letter Agreement have been omitted as indicated by asterisks pursuant to a request for confidential treatment in accordance with Section 552(b)(4) of the Freedom of Information Act ("FOIA"), 5 U.S.C. 552(b)(4) (Filed as Exhibit 10.39 on Form 10-Q for the fiscal quarter ended September 30, 2006.)

*10.14 Second Amendment to Supply Agreement dated March 17, 2008 between Schreiber Foods, Inc. and Galaxy Nutritional Foods, Inc (Filed as Exhibit 10.46 on Form 8-K filed March 21, 2008)

*10.15 Note and Warrant Purchase Agreement dated September 12, 2005 between Galaxy Nutritional Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 10.22 on Form 8-K filed September 16, 2005.)

*10.16 First Amendment to Note and Warrant Purchase Agreement dated October 7, 2005 between Galaxy Nutritional Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 10.27 on Form 10-Q for the fiscal quarter ended September 30, 2005.)

*10.17 Convertible Note in the principal amount of $2,685,104.17 dated as of July 19, 2006 by Galaxy Nutritional Foods, Inc. in favor of Frederick A. DeLuca (Filed as Exhibit 4.26 on Form 8-K filed July 25, 2006.)

*10.18 Note Modification Agreement dated March 14, 2007 between Galaxy Nutritional Foods, Inc. and Frederick A. DeLuca  (Filed as Exhibit 10.40 on Form 8-K filed March 20, 2007.)

*10.19 Receivables Purchase Agreement, together with Addendum, dated June 23, 2006 between Galaxy Nutritional Foods, Inc. and Systran Financial Services Corporation, now Commercial Finance Division (Filed as Exhibit 10.30 on Form 8-K filed June 29, 2006.)

*10.20 First Amendment to Receivables Purchase Agreement dated March 28, 2007 between Galaxy Nutritional Foods, Inc. and Systran Financial Services Corporation, now Commercial Finance Division (Filed as Exhibit 10.42 on Form 10-K for the fiscal year ended March 31, 2007.)

*10.21 Sublease Agreement dated October 3, 2006 between Galaxy Nutritional Foods, Inc. and Oracle Corporation (Filed as Exhibit 10.38 on Form 8-K filed October 10, 2006.)

*10.22 Stock Purchase Agreement, dated November 18, 2008, by and among Galaxy Partners, L.L.C., Galaxy Nutritional Foods, Inc. and Frederick A. DeLuca (Filed as Exhibit 10.1 on Form 8-K filed November 21, 2008.)

*10.23 Amendment to Employment Agreement effective as of November 18, 2008 by and among Michael E. Broll and Galaxy Nutritional Foods, Inc. (Filed as Exhibit 10.2 on Form 8-K filed November 21, 2008.)

*10.24 David Lipka Waiver of Rights dated November 13, 2008 under the Company’s 2007 Stay Bonus, Severance Bonus and Sales Plan (Filed as Exhibit 10.3 on Form 8-K filed November 21, 2008.)

10.25 Lease Agreement dated January 14, 2009 between Galaxy Nutritional Foods, Inc. and Lake Point Business Park, LLC (Filed herewith.)

*14.1 Code of Ethics (Filed as Exhibit 14.1 on Form 10-K for the fiscal year ended March 31, 2007.)

*20.1 Audit Committee Charter (Filed as Exhibit 20.1 on Form 10-Q for the fiscal quarter ended September 30, 2003.)

*20.2 Compensation Committee Charter (Filed as Exhibit 20.2 on Form 10-Q for the fiscal quarter ended September 30, 2003.)

31.1 Section 302 Certification of our Chief Executive Officer (Filed herewith.)

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31.2 Section 302 Certification of our Chief Financial Officer (Filed herewith.)

32.1 Section 906 Certification of our Chief Executive Officer (Filed herewith.)

32.2 Section 906 Certification of our Chief Financial Officer (Filed herewith.)

* Previously filed and incorporated herein by reference.

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SIGNATURES

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

GALAXY NUTRITIONAL FOODS, INC.

Date: February 11, 2009                                                            /s/ Michael E. Broll                                                      

Michael E. Broll

Chief Executive Officer & Director

(Principal Executive Officer)

Date: February11, 2009                                                            /s/ Salvatore J. Furnari                                                      

Salvatore J. Furnari

Chief Financial Officer & Vice President of Finance

 (Principal Accounting and Financial Officer)

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