10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007

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 1-15445

FAMILYMEDS GROUP, INC.

(Exact name of registrant as specified in its charter)

NEVADA	34-1755390
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

312 Farmington Avenue, Farmington, CT 06032

(Address of principal executive offices)

(860) 676-1222

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes   o     No   x

As of May 15, 2007 there were 6,959,017 shares of common stock, par value $0.001 per share, outstanding.

FAMILYMEDS GROUP, INC. AND SUBSIDIARIES

FORM 10-Q

FOR THE THREE MONTHS ENDED MARCH 31, 2007

TABLE OF CONTENTS

	Page No.
PART I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements of Familymeds Group, Inc. and Subsidiaries	1
Condensed Consolidated Balance Sheets as of March 31, 2007 and December 30, 2006 (unaudited)	1
Condensed Consolidated Statements of Operations for three months ended March 31, 2007 and April 1, 2006 (unaudited)	2
Condensed Consolidated Statements of Cash Flows three months ended March 31, 2007 and April 1, 2006 (unaudited)	3
Notes to Condensed Consolidated Financial Statements (unaudited)	4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3. Quantitative and Qualitative Disclosures About Market Risk	30
Item 4. Controls and Procedures	30
PART II - OTHER INFORMATION
Item 1. Legal Proceedings	31
Item 1A. Risk Factors	31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	31
Item 3. Default upon Senior Securities	31
Item 4. Submission of Matters to a Vote of Security Holders	31
Item 5. Other Information	32
Item 6. Exhibits	32
SIGNATURES	33

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PART I - FINANCIAL INFORMATION

Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FAMILYMEDS GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 2007 AND DECEMBER 30, 2006
(in thousands, except share data)
(unaudited)
	March 31, 2007			December 30, 2006
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	854		$	845
Trade receivables, net of allowance for doubtful accounts of approximately
$4,006 and $3,720 in 2007 and 2006, respectively		13,504			16,038
Inventories		18,419			22,417
Prepaid expenses and other current assets		1,499			1,553
Total current assets		34,276			40,853
PROPERTY AND EQUIPMENT—Net of accumulated depreciation and amortization
of approximately $14,328 and $14,502 in 2007 and 2006, respectively		5,732			6,269
INTANGIBLE ASSETS—Net of accumulated amortization of
approximately $18,910 and $20,657 in 2007 and 2006, respectively		1,118			1,289
OTHER NONCURRENT ASSETS		750			750
TOTAL ASSETS	$	41,876		$	49,161
LIABILITIES AND STOCKHOLDERS’ DEFICIT
CURRENT LIABILITIES:
Notes payable, net of discount of $2,122 and $2,247 in 2007 and 2006	$	6,879		$	6,753
Promissory notes payable		76			76
Revolving credit facility		33,360			37,467
Accounts payable		12,911			14,843
Accrued expenses		3,502			4,269
Other current liabilities		55			59
Total current liabilities		56,783			63,467
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ DEFICIT:
Series A convertible preferred stock, $1,000 par value, 500,000 authorized and none outstanding		-			-
Common stock, $.001 par value, 200,000,000 shares authorized; 6,962,821 shares issued and outstanding for 2007 and 2006, respectively.		67			67
Additional paid in capital		230,996			230,949
Accumulated deficit		(245,970	)		(245,322	)
Total stockholders’ deficit		(14,907	)		(14,306	)
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT	$	41,876		$	49,161

See notes to condensed consolidated financial statements.

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FAMILYMEDS GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2007 AND APRIL 1, 2006 (Going Concern Basis)
(in thousands, except per share data)
(Unaudited)
	Three Months Ended
	March 31, 2007			April 1, 2006
NET REVENUES	$	52,396		$	56,040
COST OF SALES		42,626			45,125
Gross margin		9,770			10,915
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES		11,963			12,987
GAIN ON SALE OF PHARMACY ASSETS		(3,100	)		-
DEPRECIATION AND AMORTIZATION EXPENSE		524			838
OPERATING INCOME (LOSS)		383			(2,910	)
OTHER INCOME (EXPENSE):
Interest expense		(1,031	)		(1,396	)
Interest income		-			10
Other income		-			59
Total other expense, net		(1,031	)		(1,327	)
Loss from continuing operations		(648	)		(4,237	)
Income from discontinued operations		-			181
NET LOSS	$	(648	)	$	(4,056	)
BASIC AND DILUTED INCOME (LOSS) PER COMMON SHARE:
Loss from continuing operations		(0.09	)		(0.64	)
Income from discontinued operations		-			0.03
Net loss	$	(0.09	)	$	(0.61	)
WEIGHTED AVERAGE SHARES OUTSTANDING:
Basic and Diluted Shares		6,963			6,587

See notes to condensed consolidated financial statements.

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FAMILYMEDS GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED MARCH 31, 2007 AND APRIL 1, 2006 (Going Concern Basis)
(in thousands)
(Unaudited)
	Three Months Ended
	March 31, 2007			April 1, 2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(648	)	$	(4,056	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		524			838
Stock compensation expense		47			125
Noncash interest expense		126			314
Amortization of deferred financing fees		76			75
Provision for doubtful accounts		286			27
Gain on sale of pharmacy assets		(3,100	)		-
Effect of changes in operating assets and liabilities:
Trade receivables		2,248			1,541
Inventories		2,223			1,069
Prepaid expenses and other current assets		54			306
Accounts payable		(1,932	)		716
Accrued expenses		(767	)		229
Other		(4	)		(156	)
Net cash provided by (used in) operating activities		(867	)		1,028
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(147	)		(845	)
Purchases of pharmacy assets		-			(244	)
Proceeds from sale of pharmacy assets		5,130			-
Net cash provided by (used in) investing activities		4,983			(1,089	)
CASH FLOWS FROM FINANCING ACTIVITIES:
(Repayment of) proceeds from revolving credit facility, net		(4,107	)		192
Repayment of promissory notes payable		-			(358	)
Proceeds from exercise of stock options		-			3
Net cash used in financing activities		(4,107	)		(163	)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		9			(224	)
CASH AND CASH EQUIVALENTS—Beginning of period		845			6,681
CASH AND CASH EQUIVALENTS—End of period	$	854		$	6,457
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest	$	797		$	1,008
Noncash transactions—
Subordinated Convertible Debenture interest payments made in common stock	$	-		$	900

See notes to condensed consolidated financial statements.

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FAMILYMEDS GROUP, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements

(Unaudited)

NOTE 1 - BUSINESS

Asset Sale, Plan Of Complete Liquidation And Dissolution, Business, Discontinued Operations And Going Concern

Familymeds Group, Inc. (“Familymeds,” the “Company,” or “we” and other similar pronouns) is a pharmacy and drug distribution provider formed by the merger on November 12, 2004 of DrugMax, Inc. and Familymeds Group, Inc.  Familymeds Group, Inc. was formerly known as DrugMax, Inc. and on July 10, 2006, the Company amended its Articles of Incorporation to change its name from DrugMax, Inc. to Familymeds Group, Inc. As of March 31, 2007, we operated 67 Company-owned locations including 64 pharmacies, one health and beauty location, one non-pharmacy mail order center, and a drug distribution business primarily focused on the direct distribution of specialty pharmaceuticals to physicians, medical clinics and other health care providers known as Familymeds Medical Supply.  The Company also franchises 7 pharmacies.   The Company’s pharmacies are located in 12 states and operate under the Familymeds Pharmacy, Arrow Pharmacy & Nutrition Center, and Worksite Pharmacy ^SM brand names. The Company reports on a 52-53 week fiscal year.

As of March 31, 2007 and December 30, 2006, the Company had a net shareholders’ deficit of $14.9 million and $14.3 million and had incurred net losses of $0.6 million, $7.2 million, $54.9 million and $39.8 million for the three months ended March 31, 2007 and for the years ended December 30, 2006, December 31, 2005, and January 1, 2005, respectively. 

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

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

Also during the third and fourth quarters of 2006, the Company closed or sold underperforming stores and continued to evaluate its ongoing operations to improve results.  During the 2nd half of 2006, the Company implemented selling and general administrative expense reduction measures, including a workforce reduction of 33 employees at the Company headquarters in Farmington, Connecticut in July 2006, directed at reducing costs and improving overall liquidity.Despite these efforts, the Company continued to experience a reduction in gross margins due to the increased number of participants enrolled in Medicare Part D plans and the increased pressure by other third parties to reduce prescription reimbursement rates.  

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

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

As a result, and, in light of the factors noted above, the current competitive environment and the Company’s highly leveraged capital structure, the Board of Directors concluded that the Company lacked the capital resources necessary in the long-term to compete effectively in its industry and in an effort to maximize the value of the shareholders’ investment in the Company, the Board of Directors decided to examine certain financial and strategic alternatives to the Company remaining independent.

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

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

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

Asset Sale

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

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

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

5

Plan of Complete Liquidation and Dissolution

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

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

· dissolve Familymeds;

· liquidate the Company’s assets;

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

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

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

The results of operations acquired in the merger have been included in the Company’s consolidated statements of operations (primarily in discontinued operations as described below).

During fiscal year ended December 31, 2005, the Company operated two drug distribution facilities: Valley Drug Company and Valley Drug Company South. During the third quarter of 2005, the Company determined that it would sell certain assets of the drug distribution business and eliminate operations conducted out of the New Castle, Pennsylvania facility and the St. Rose, Louisiana facility related to the distribution to independent pharmacies. Accordingly, since October 1, 2005, the Company considered substantially all of the wholesale distribution business as discontinued operations for financial statement presentation purposes.

There were no net revenues related to the discontinued operations for the three months ended March 31, 2007 and April 1, 2006, respectively.  The income from discontinued operations was $0.0 million and $0.2 million for the three months ended March 31, 2007 and April 1, 2006, respectively.

NOTE 2 - BASIS OF PRESENTATION

Basis of Presentation (Liquidation and Going Concern Basis of Accounting)

The Company’s shareholders approved the Plan of Complete Liquidation and Dissolution on March 30, 2007, the last business day of the fiscal quarter ended March 31, 2007. Accordingly, effective April 1, 2007, the Company adopted the liquidation basis of accounting. The accompanying condensed consolidated financial statements have been prepared on the going concern basis of accounting.

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As of March 31, 2007 and December 30, 2006, the Company had a net shareholders’ deficit of $14.9 million and $14.3 million and had incurred net losses of $0.6 million, $7.2 million, $54.9 million and $39.8 million for the three months ended March 31, 2007 and for the years ended December 30, 2006, December 31, 2005, and January 1, 2005, respectively.  In addition to the Plan of Complete Liquidation and Dissolution, these matters raise substantial doubt about the Company's ability to continue as a going concern.

NOTE 3 - PER SHARE INFORMATION

The computations of basic and diluted net loss per common share are based upon the weighted average number of common shares outstanding and potentially dilutive securities. Potentially dilutive securities would include all-in-the money stock options and warrants.  All outstanding options and warrants to purchase shares of common stock were excluded from the March 31, 2007 and April 1, 2006 computations of diluted net loss per common share because inclusion of such shares would have been anti-dilutive.

NOTE 4 - STOCK BASED COMPENSATION

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), “Share-Based Payment (as amended).” SFAS No. 123(R) eliminates the alternative to use the intrinsic value method of accounting that was provided in SFAS No. 123, which generally resulted in no compensation expense recorded in the financial statements related to the issuance of equity awards to employees. SFAS No. 123(R) requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS No. 123(R) establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all companies to apply a fair-value-based measurement method in accounting generally for all share-based payment transactions with employees and was adopted by the Company on January 1, 2006.

Share Based Compensation Plans

As of March 31, 2007, we have two share-based compensation plans, which are described below.

The DrugMax, Inc. 1999 Incentive and Non-Statutory Stock Option Plan permits the granting of stock options to purchase shares of common stock up to a total of 600,000 shares. The exercise price per share of common stock covered by an option may not be less than the par value per share on the date of grant, and in the case of an incentive stock option, the exercise price may not be less than the market value per share on the date of grant. The terms of any option grants are established by the Board of Directors and / or compensation committee, subject to the requirements of the plan, but, generally, these options vest over a three year period at a rate of 33% each year. The Plan will expire on August 13, 2009. Options are issued to non-employee directors under this plan.

Each outside Director is issued an option to purchase 1,000 shares of common stock annually each year following his or her election to the Board of Directors. Each outside Director who serves as a member of a committee is issued an option to purchase 500 shares of the Company’s common stock annually. The chairperson of each committee, other than the Audit Committee, is issued an option to purchase an additional 500 shares of common stock annually. The chairperson of the Audit Committee and the Chairman of the Board shall receive an option to purchase 1,000 shares of the Company’s common stock annually. The foregoing options are granted under the Company’s 1999 Incentive and Non-Statutory Stock Option Plan. The exercise price for the options is determined as of the annual shareholders meeting of each year.

7

The DrugMax, Inc. 2003 Restricted Stock Plan permits the granting of shares of restricted common stock up to a total of 350,000 shares. The Board of Directors determines the price, if any, on the date of grant. The Plan will expire on August 27, 2013. Restricted shares are issued to non-employee directors under this plan.

Upon election to the Board of Directors, each outside Director, receives an award of restricted stock in the amount of $50,000. Such shares vest 1/3 upon the date of grant and 1/3 on the first and second anniversary thereafter. Further, on each year following his or her election to the Board, each outside Director receives an award of restricted stock in the amount of $25,000. The foregoing shares are granted under the Company’s 2003 Restricted Stock Plan.

There were no option grants during the three months ended March 31, 2007. The Company uses the Black-Scholes option-pricing model to calculate the fair value of options. The key assumptions for this valuation method include the expected term of the option, stock price, volatility, risk-free interest rate, dividend yield and exercise price. Many of these assumptions are judgmental and highly sensitive in the determination of compensation expense. Under the assumptions indicated below, the weighted-average fair value for each option granted during the three months ended April 1, 2006 was $8.38. The table below indicates the key assumptions used in the option valuation calculations for options granted in the three months ended March 31, 2007 and April 1, 2006 and a discussion of our methodology for developing each of the assumptions used in the valuation model:

	Three Months Ended April 1, 2006
Risk-free interest rate		4.62	%
Expected life		3 years
Volatility		77	%
Dividend yield		-	%

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

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

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

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

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The following table summarizes information about our stock option plan for the three months ended March 31, 2007.

	Number of Options		Weighted Average Exercise Price		Weighted Average Remaining Contractual life		Weighted Average Fair Value
Balance, December 30, 2006		390,907	$	11.61		8.1 years	$	18.24
Granted		-		-		-		-
Exercised		-		-		-		-
Forfeited		425		14.82				6.72
Options outstanding, March 31, 2007		390,482	$	11.61		7.8 years	$	18.26
Options exercisable, March 31, 2007		287,463	$	12.14		7.6 years	$	23.07

As of March 31, 2007, there was $0.2 million of total unrecognized compensation cost related to stock options. These costs are expected to be recognized over a weighted average period of 1.0 year. There was no cash received from stock option exercises for the three months ended March 31, 2007. There were no income tax benefits from share based arrangements.

Share based compensation expense was $0.05 million and $0.1 million for the three months ended March 31, 2007 and April 1, 2006, respectively.

The following table summarizes information about restricted stock awards issued under the 2003 Restricted Stock Plan for the three months ended March 31, 2007:

	Shares		Weighted Average Grant-Date Fair Value
Non Vested Balance at December 30, 2006		42,825	$	10.46
Granted		-		-
Vested		-		-
Non Vested Balance at March 31, 2007		42,825	$	10.46

As of March 31, 2007, there was $0.4 million of total unrecognized compensation costs related to restricted stock awards. These costs are expected to be recognized over a weighted average period of 1.0 year. At March 31, 2007, an aggregate of 375,437 shares of common stock remained available for future grants under our stock plans, which cover restricted stock awards and stock options. We issue shares to satisfy stock option exercises and restricted stock awards.

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NOTE 5 - INTANGIBLE ASSETS

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

	March 31, 2007					December 30, 2006
	Gross Carrying Amount		Accumulated Amortization			Gross Carrying Amount		Accumulated Amortization
Intangible assets	$	20,028	$	(18,910	)	$	21,946	$	(20,657	)

The remaining weighted average amortization period for intangible assets is approximately 1 year assuming the Company completes its Plan of Liquidation and Dissolution. Amortization expense related to intangible assets was approximately $0.2 million and $0.5 million for the three months ended March 31, 2007 and April 1, 2006, respectively. These intangible assets are expected to be fully amortized during fiscal 2007.

NOTE 6 —DEBT

Debt consists of the following (amounts in thousands):

	March 31, 2007		December 30, 2006
Revolving credit facility (1)	$	33,360	$	37,467
Promissory notes payable		76		76
Subordinated notes payable, net of discount of $2,122 and $2,247, respectively		6,879		6,753
Total	$	40,315	$	44,296

(1) On May 11, 2007, the Company terminated its $65 million revolving credit facility and in connection therewith repaid all outstanding amounts under the revolving credit facility along with a termination fee of $0.7 million.

Credit Facility

On October 12, 2005, the Company entered into a Loan and Security Agreement with Wells Fargo Retail Finance, LLC (“WFRF”), pursuant to which WFRF provided the Company with a senior secured revolving credit facility up to $65.0 million (the “New Credit Facility”). On that same date the Company terminated its $65.0 million Amended and Restated Credit Agreement with General Electric Capital Corporation (“GECC”) and in connection therewith repaid all outstanding amounts due under the credit facility to GECC along with a $0.5 million termination fee. The $65.0 million of maximum availability under the New Credit Facility is reduced by a $7.0 million reserve. Available credit is based on eligible receivables, inventory and prescription files, as defined in and determined pursuant to the agreement, and may be subject to reserves as determined by the lender from time to time. Interest on the revolving line of credit is calculated at the prime index rate plus an applicable prime margin (as defined in the agreement), unless the Company or the lender chooses to convert the loan to a LIBOR-based loan. In each case, interest is adjusted quarterly. The applicable prime index margin as of March 31, 2007 and December 30, 2006 was 8.25% and 8.25%, respectively. As of March 31, 2007 and December 30, 2006, the interest rate, including applicable margin, used to calculate accrued interest was 8.5% and 8.5%, respectively. Interest is payable monthly.

The New Credit Facility included an early termination fee of $0.7 million if paid in full before October 12, 2008. The New Credit Facility was secured by substantially all assets of the Company. As of March 31, 2007, $33.4 million was outstanding on the revolving line of credit and $1.8 million was estimated as available for additional borrowings, based on eligible receivables, inventory and prescription files.

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In connection with the Walgreens’ Asset Sale, Wells Fargo Retail Finance, LLC, as agent for the revolving credit lenders consented to the Asset Sale and the consummation of the sale, subject to various terms and conditions. Among those conditions, we agreed that all proceeds received by us from the sale shall be paid to Wells Fargo for application to the credit facility until all amounts due under the facility are paid in full and the Loan Agreement is terminated. Accordingly, on May 11, 2007, the Company terminated its $65 million Loan Agreement and in connection therewith repaid all outstanding amounts under the Loan Agreement along with a termination fee of $0.7 million.

Note and Warrant Purchase Agreement

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

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

Principal on each of the Notes is due and payable in successive quarterly installments each in the amount of $0.17 million and $0.33 million, respectively, beginning on September 1, 2006 and on each December 1, March 1, June 1 and September 1 thereafter and continuing until June 23, 2011, on which date all outstanding principal and accrued and unpaid interest is due. The Company intends to payoff these notes prior to the end of the second quarter of 2007 and therefore did not make the March 1, 2007 and does not intend to make the June 1, 2007 principal payments. Deerfield has accepted this arrangement. The Notes bear interest at a rate equal to 2.5% for the first year, 5.0% for the second year, 10.0% for the third year, 15.0% for the fourth year and 17.5% for the fifth year. The Notes may be prepaid by the Company at anytime without penalty. Interest expense has been estimated over the five year period to be approximately $1.8 million (excludes the effect of amortization of the debt discount of $2.5 million discussed below) and due to the increasing interest rate on this debt, the Company records the average quarterly interest expense and record a corresponding asset or liability for the difference not currently payable each quarter. As of March 31, 2007, the Company has classified this liability as current as it expects to retire this obligation within 12 months of the balance sheet date.

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

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

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

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

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

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

NOTE 7 - INCOME TAXES

The Company incurred a net loss for the three months ended March 31, 2007 and April 1, 2006. No income tax expense had been recorded during these periods due to the significant net operating losses available to the Company to offset such net income. The Company has established a valuation allowance on all of its deferred tax assets due to the uncertainty of their realization.

On December 31, 2006, the Company adopted the Financial Accounting Standards Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) an interpretation of Financial Accounting Standards Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation requires that the Company recognize in the financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. FIN 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods and disclosure. The adoption of FIN 48 had no material impact on its financial position or results of operations as a full valuation allowance has been established.

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NOTE 8- CONTINGENCIES

Prior to fiscal 2006, the Company’s drug distribution operations operated out of two locations, one in New Castle, Pennsylvania and one in St. Rose, Louisiana.  The Pennsylvania operations were located at 209 Green Ridge Road, New Castle, Pennsylvania 16105, a facility consisting of approximately 45,000 square feet of office, warehouse, shipping and distribution space. Valley Drug Company (“Valley North”) leased this premises from Becan Development LLC (“Becan”), a company owned by a current director of the Company (Jugal Taneja) and certain former directors, officers and employees of the Company. The original lease (dated December 30, 2003) (the “Original Lease”) provided for a term of 15 years, expiring December 30, 2018, and monthly lease payments of $17,000.  When the Original Lease was executed, Becan and Valley North entered into a Consent, Subordination and Assumption Agreement (the “Guarantee”) with the Pennsylvania Industrial Development Authority (“PIDA”) and Regional Industrial Development Corporation of Southwest Pennsylvania (“RIDC”) dated December 30, 2003, pursuant to which, among other things, Becan and Valley North, jointly and severally, assumed all obligations of RIDC to make payments and discharge all obligations expenses, costs and liabilities of RIDC in connection with the PIDA note (the “PIDA Note”). The PIDA Note is also secured by the Original Lease and the property.

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

As of March 31, 2007 and December 30, 2006, the Company has not recorded any liabilities related to the Guarantee. However, should the Company be required to perform under the terms of the Guarantee, the Company would be required to pay all amounts owed under the PIDA Note, which as of March 31, 2007 was approximately $0.8 million. The Company believes it will not be required to perform under the terms of the Guarantee. Further any requirement to perform under the Guarantee would be mitigated by the indemnification by Becan and its principals. Additionally, management believes, the fair value of the Pennsylvania facility that could be realized upon the sale of the facility exceeds the amounts outstanding on the PIDA Note and the other loans related to the premises.

NOTE 9- SUBSEQUENT EVENTS

On May 11, 2007, the Company terminated its $65 million New Credit Facility and in connection therewith repaid all outstanding amounts under the credit facility along with a termination fee of $0.7 million.

On April 4, 2007, the Company received a portion of the purchase price and began the process of selling its pharmacy assets to Walgreens. The closing of the sale of all of the assets to Walgreens is expected to be completed by the end the second quarter of 2007. Through May 11, 2007, Walgreens has paid approximately $43.4 million in cash proceeds of which $3.0 million will be kept in escrow to satisfy our post-closing indemnification obligations, if any.

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On April 2, 2007, Rakesh K. Sharma resigned as a director to the Company.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes found elsewhere in this Form 10-Q. This discussion, as well as the notes to our unaudited condensed consolidated financial statements, contain forward-looking statements based upon our current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions, as set forth under “Cautionary Statement Regarding Forward-Looking Statements.” Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of many factors.

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

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

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

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Cautionary Statement Concerning Forward-Looking Statements

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

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

· expected cash to be received from the asset sales, including but not limited to, inventories, accounts receivable, fixed assets, prescription files and other assets, and cash to be disbursed to settle our obligations and liabilities, both known and unknown;

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

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

· possible or assumed future results of operations; and

· future revenue and earnings.

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

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

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

· the uncertainty of general business and economic conditions;

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

· the loss of key personnel including pharmacists;

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· the impact of competition, both expected and unexpected;

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

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

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

Recent Developments - Plan of Liquidation

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

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

· dissolve the Company;

· liquidate our assets;

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

· distribute any remaining assets to our shareholders.

Since the approval of the Plan of Complete Liquidation and Dissolution by our shareholders on March 30, 2007, we have begun implementing the plan by attempting to sell our assets and satisfy our obligations. Among other things, on April 4, 2007, we began to the process of closing the Asset Sale to Walgreens. The Asset Sale to Walgreens will be completed on a staggered basis. The closing of the sale of all of the assets to Walgreens is expected to be completed by the end the second quarter of 2007. Through May 11, 2007, Walgreens has paid approximately $43.4 million in cash proceeds of which $3.0 million will be kept in escrow to satisfy our post-closing indemnification obligations, if any.

Pursuant to our Asset Purchase Agreement with Walgreens, dated February 14, 2007, we will, subject to certain terms and conditions, sell up to 53 of our locations and related assets to Walgreens. Of the 53 locations, 33 of the clinic and Worksite locations will remain open and continue to operate in place. As consideration for this sale, Walgreens will assume only certain of our liabilities, including certain automobile and real estate leases, and will pay us approximately $43.0 million for pharmacy assets, in addition to amounts for customer accounts receivable and inventories related to those locations, subject to certain adjustments.

In connection with the Asset Sale, Wells Fargo Retail Finance, LLC, as agent for the revolving credit lenders pursuant to the Loan and Security Agreement dated as of October 12, 2005 (as amended, modified, supplemented or restated and in effect from time to time, the “Loan Agreement”) among (i) Familymeds Group, Inc. (f/k/a Drugmax, Inc.), as Lead Borrower, (ii) the other Borrowers party thereto from time to time, (iii) the Revolving Credit Lenders party thereto from time to time, (iv) and Wells Fargo, has consented to the Asset Sale and the consummation of the sale, subject to various terms and conditions. Among those conditions, we agreed that all proceeds received by us from the sale shall be paid to Wells Fargo for application to the credit facility until all amounts due under the facility are paid in full and the Loan Agreement is terminated. Accordingly, on May 11, 2007, the Company terminated its $65 million Loan Agreement and in connection therewith repaid all outstanding amounts under the Loan Agreement along with a termination fee of $0.7 million.

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We intend to sell our remaining assets to several other national and regional pharmacy operators. We also have begun this process. During the first quarter of 2007, we sold 10 pharmacy locations and we expect to sell 60 additional locations to Walgreens and others by the end of the second quarter of 2007. 

The Company previously reported it had executed asset purchase agreements and letters of intent for the sale of the majority of its assets. To date, the Company has sold and closed pharmacies together with related pharmacy assets to multiple buyers, including Walgreens. One non-Walgreens original potential purchaser of pharmacy assets who had previously executed a letter of intent has decided not to pursue the transaction. As a result, the Company has continued to market those assets to other potential buyers and has subsequently signed a new letter of intent for a portion of those assets. However, the new potential purchaser has proposed a transaction which would exclude certain assets and changes the valuation on the assets included.

The Company will continue to market all remaining assets and continue to seek better valuations, however potential valuation differences may result in a reduced overall recovery estimated to be $2.0-$5.0 million less than originally estimated.

Additionally, as a result of its announcement to sell the majority of its assets and to execute its Plan of Complete Liquidation and Dissolution, the Company has started to lose key employees and certain account receivable have delayed payments to the Company. Further, while the Company continues to expect the final Walgreens transaction to close by the end of the second quarter of 2007 as previously disclosed, the Company has incurred delays in the staggered Walgreens closings.

These factors, coupled with delays in the sales of the Company’s remaining assets, currently are expected to result in (a) delays in implementing the Plan of Complete Liquidation and Dissolution, including delays in the initial distributions to shareholders, which initial distributions management previously estimated would take place by the end of the second quarter of 2007 and which management now believes will take place during the third quarter of 2007 (b) lower than previously-estimated amounts being distributed to shareholders in connection with the Plan of Complete Liquidation and Dissolution, unless the Company is successful in selling its remaining assets at a greater value or recovering greater value through the reduction of its estimated liabilities, of which there can be no assurances.

Management currently does not believe it can quantify the aggregate impact of these factors on the amount of the distribution to shareholders.

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

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

General Description of the Business

Familymeds Group, Inc. (“Familymeds,” the “Company,” or “we” and other similar pronouns) is a pharmacy and drug distribution provider formed by the merger on November 12, 2004 of DrugMax, Inc. and Familymeds Group, Inc.  Familymeds Group, Inc. was formerly known as DrugMax, Inc. and on July 10, 2006, the Company amended its Articles of Incorporation to change its name from DrugMax, Inc. to Familymeds Group, Inc. We are incorporated in the state of Nevada and our corporate offices are located at 312 Farmington Avenue, Farmington, CT 06032, telephone (860) 676-1222. As of March 31, 2007, we operated 67 Company-owned locations including 64 pharmacies, one health and beauty location, one non-pharmacy mail order center, and a drug distribution business primarily focused on the direct distribution of specialty pharmaceuticals to physicians, medical clinics and other health care providers known as Familymeds Medical Supply.  The Company also franchises 7 pharmacies.  During the first quarter of 2007, we have sold 10 pharmacy locations and we expect to sell 60 additional locations by the end of the second quarter of 2007 pursuant to signed asset purchase agreements  Our pharmacies are located in 12 states and operate under the Familymeds Pharmacy, Arrow Pharmacy & Nutrition Center, and Worksite Pharmacy ^SM brand names.

As of March 31, 2007 and December 30, 2006, the Company had a net shareholders’ deficit of $14.9 million and $14.3 million and had incurred net losses of $0.6 million, $7.2 million, $54.9 million and $39.8 million for the three months ended March 31, 2007 and for the years ended December 30, 2006, December 31, 2005, and January 1, 2005, respectively. 

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

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

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

Pharmacy Operations

As of March 31, 2007, we operated 67 Company owned locations including 64 pharmacies, one home health center, one health and beauty location and one non-pharmacy mail order center, in 12 states under the Familymeds Pharmacy, Arrow Pharmacy & Nutrition Center, and Worksite Pharmacy^SM brand names. We have pharmacies which are located at the point of care between physicians and patients, oftentimes inside medical office buildings or on a medical campus. The balance of our locations are usually nearby medical facilities though more retail accessible.

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

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

Worksite Pharmacy^SM

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

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

Medical Supply

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

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Revenues from this operation for the three months ended March 31, 2007 and April 1, 2006 were $1.0 million and $0.9 million, respectively. The Company expects revenues from this operation to decline as we have announced our Plan of Complete Liquidation and Dissolution.

Patient Compliance

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

Medicare Part D

As of January 1, 2006, Medicare beneficiaries had the opportunity to receive subsidized prescription drug coverage through the Medicare Part D program. The new drug benefit is delivered by competing plans, and our pharmacies have contracted with each of the major providers to ensure our customers can continue purchasing their prescriptions from our pharmacies. While the new Medicare drug benefit is entirely voluntary, we believe a significant portion of the Medicare population will enjoy this new benefit. During the three months ended March 31, 2007 and April 1, 2006, net revenues from Medicare Part D prescriptions represented 20.8% and 14.0% of total prescription sales, respectively. The gross margin from this business is less than what the traditional prescription drug plans provide and the accounts receivable days outstanding is more than what the traditional prescription drug plans.

Supply Chain Management

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

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

Discontinued Operations

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

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

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

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

During the three months ended March 31, 2007, there were no activities relating to our discontinued operations. This compares with no net revenues related to the discontinued operations and income from discontinued operations of $0.2 million for the three months ended April 1, 2006.

Comparison of Operating Results for the three months ended March 31, 2007 and April 1, 2006.

The Company’s shareholders approved the Plan of Complete Liquidation and Dissolution on March 30, 2007, the last business day of the fiscal quarter ended March 31, 2007. Accordingly, effective April 1, 2007, the Company adopted the liquidation basis of accounting. The condensed consolidated balance sheets as of March 31, 2007 and December 30, 2006 and the condensed consolidated statements of operations and cash flows for the three months ended March 31, 2007 and April 1, 2006  have been prepared on the going concern basis of accounting.

We refer to prescription products as Rx products and to the remaining products, such as over-the-counter medications, home medical equipment and home health appliances, as non-Rx products. While non-Rx reflects a smaller percentage of our overall revenues, the gross margin for non-Rx products is higher. The Rx portion of the pharmacy business is dependent upon a number of third party payors that pay a portion or all of the Rx cost on behalf of the customers, “Third Party Customers.” Prescriptions generated by Third Party Customers represented approximately 96% and 93%, respectively of Rx revenues for the three months ended March 31, 2007 and April 1, 2006, respectively.

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For financial statement presentation purposes, the Company has reported substantially all of the full-line wholesale drug distribution as discontinued operations.

Net Revenues

Net revenue performance is detailed below:

	Three months Ended March 31, 2007			Three months Ended April 1, 2006
Net Rx and non-Rx revenues (in millions) (1)	$	51.4		$	55.1
Familymeds Medical Supply		1.0			0.9
Total net revenues (in millions)	$	52.4		$	56.0
Rx % of location net revenues		93.3	%		94.4	%
Third party % of Rx net revenues		96.4	%		93.0	%
Number of Company locations		64			78
Average location net revenue per location (in millions)	$	0.8		$	0.7

(1)  Net revenues are net of contractual allowances.

	Three Months Ended March 31, 2007 versus April 1, 2006
Net revenues increases (decreases) are as follows (in millions):
Net effect of location openings/closings (1)	$	(4.6	)
Rx revenues (2)		0.7
Non-Rx revenues		0.2
Familymeds Medical Supply (3)		0.1
Net decrease	$	(3.6	)

(1) The net effect of location openings/closing represents the revenues of locations that were not open during the full periods compared.

(2) Represents the net impact of price increases for brand name prescription products offset by an increase in the number of prescriptions filled for lower priced generic prescription products.

(3) Represents Familymeds Medical Supply revenues related to direct distribution to physicians, medical clinics and other health care providers. In October 2006, this operation was moved to Farmington, Connecticut and is now doing business as Familymeds Medical Supply.

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Gross Margin

Gross margin was $9.8 million or 18.6% for the three months ended March 31, 2007 in gross margin percentage. This compares to $10.9 million or 19.5% for the three months ended April 1, 2006. The decrease in gross margin percentage reflects the adverse effect of the efforts of managed care organizations, pharmacy benefit managers and other third party payors to reduce their prescription costs, as well as the impact of Medicare Part D. In recent years, our industry has undergone significant changes driven by various efforts to reduce costs. As employers and managed care organizations continue to focus on the costs of branded and specialty pharmaceuticals, we expect there will continue to be negative pressure on gross margins. The Company, like several others in the pharmacy industry, continues to experience a significant negative impact on gross margins due to the increasing number of prescriptions filled under Medicare Part D.

Information that helps explain our gross margin trend is detailed below:

	Three months Ended March 31, 2007 Versus April 1, 2006
Gross margin increases (decreases) are as follows (in millions):
Net effect of location openings/closings	$	(0.9	)
Rx gross margin		(1.2	)
Non-Rx gross margin		0.5
Familymeds Medical Supply		0.5
Net decrease	$	(1.1	)

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Operating Expenses and Income

Operating expenses include selling, general and administrative (“SG&A”) expenses, depreciation and amortization expense and gains on the sales of pharmacy assets. Net operating expenses were $9.4 million or 17.9% of net revenues for the three months ended March 31, 2007. This compared to $13.8 million or 24.7% of net revenues for the three months ended April 1, 2006.

Information that helps explain our operating expense trend is detailed below: 

	Three months  Ended March 31, 2007 versus April 1, 2006
Changes in net operating expenses are as follows (in millions):
Selling, general and administrative expenses (1)	$	(1.0	)
Gain on sale of pharmacy assets (2)		(3.1	)
Depreciation and amortization (3)		(0.3	)
Net decrease	$	(4.4	)

(1) The decrease in selling, general and administrative expenses is mainly due to decreases in payroll and benefits of $0.3 million, recruiting $0.2 million, stock option expense of $0.1 million, professional services of $0.1 million, delivery in the drug distribution business of $0.2 million.

(2) The gain on sale of pharmacy assets relates to the completion of sales of certain stores related to our Plan of Complete Liquidation and Dissolution of the Company and represents the excess of the proceeds of the sale of 10 pharmacy locations over the net book value of the assets sold.

(3) Depreciation and amortization expense was approximately $0.5 million and $0.8 million for the three months ended March 31, 2007 and April 1, 2006, respectively.

Interest Expense

Interest expense was $1.0 million for the three months ended March 31, 2007 versus $1.4 million for the three months ended April 1, 2006. The decrease was due to a lower outstanding debt balances.

Income Taxes

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

Net Loss

Net loss for the three months ended March 31, 2007 was $0.6 million versus a net loss of $4.1 million for the three months ended April 1, 2006.  Factors impacting these results are discussed above.

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Inflation and Seasonality

Management believes that inflation had no material effect on the operations or our financial condition for the three months ended March 31, 2007 and April 1, 2006. Historically, our third quarter business has been affected by seasonality and has been lower than our other three fiscal quarters’ business due to the effect of reduced patient visits and doctor referrals during typical summer vacation months.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations and have met our capital requirements primarily through private issuances of equity securities, convertible notes, bank borrowings, trade creditors and cash generated from operations.  Our principal sources of liquidity as of March 31, 2007, consisted of cash and cash equivalents of approximately $0.8 million along with approximately $1.8 million in estimated availability under our $65.0 million revolving credit facility.

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

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

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

Credit Facility

On October 12, 2005, the Company entered into a Loan and Security Agreement with Wells Fargo Retail Finance, LLC (“WFRF”), pursuant to which WFRF will provide the Company with a senior secured revolving credit facility up to $65.0 million (the “New Credit Facility”). On that same date the Company terminated its $65.0 million Amended and Restated Credit Agreement with General Electric Capital Corporation (“GECC”) and in connection therewith repaid all outstanding amounts due under the credit facility to GECC along with a $0.5 million termination fee. The $65.0 million of maximum availability under the New Credit Facility is reduced by a $7.0 million reserve. Available credit is based on eligible receivables, inventory and prescription files, as defined in and determined pursuant to the agreement, and may be subject to reserves as determined by the lender from time to time. Interest on the revolving line of credit is calculated at the prime index rate plus an applicable prime margin (as defined in the agreement), unless the Company or the lender chooses to convert the loan to a LIBOR-based loan. In each case, interest is adjusted quarterly. The applicable prime index margin as of March 31, 2007 and December 30, 2006 was 8.25% and 8.25%, respectively. As of March 31, 2007 and December 30, 2006, the interest rate, including applicable margin, used to calculate accrued interest was 8.5% and 8.5%, respectively. Interest is payable monthly.

The New Credit Facility included an early termination fee of $0.7 million if paid in full before October 12, 2008. The New Credit Facility is secured by substantially all assets of the Company. As of March 31, 2007, $33.4 million was outstanding on the revolving line of credit and $1.8 million was estimated to be available for additional borrowings, based on eligible receivables, inventory and prescription files.

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In connection with the Asset Sale, Wells Fargo Retail Finance, LLC, as agent for the revolving credit lenders consented to the Asset Sale and the consummation of the sale, subject to various terms and conditions. Among those conditions, we agreed that all proceeds received by us from the sale shall be paid to Wells Fargo for application to the credit facility until all amounts due under the facility are paid in full and the New Credit Facility is terminated. Accordingly, on May 11, 2007, the Company terminated its $65 million credit facility and in connection therewith repaid all outstanding amounts under the New Credit Facility along with a termination fee of $0.7 million.

Note and Warrant Purchase Agreement

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

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

Principal on each of the Notes is due and payable in successive quarterly installments each in the amount of $0.2 million and $0.3 million, respectively, beginning on September 1, 2006 and on each December 1, March 1, June 1 and September 1 thereafter and continuing until June 23, 2011, on which date all outstanding principal and accrued and unpaid interest is due. The Company intends to payoff these notes prior to the end of the second quarter of 2007 and therefore did not make the March 1, 2007 and does not intend to make the June 1, 2007 principal payments.  Deerfield has accepted this arrangement. The Notes bear interest at a rate equal to 2.5% for the first year, 5.0% for the second year, 10.0% for the third year, 15.0% for the fourth year and 17.5% for the fifth year. The Notes may be prepaid by the Company at anytime without penalty. Interest expense has been estimated over the five year period to be approximately $1.8 million (excludes the effect of amortization of the debt discount of $2.5 million discussed below) and due to the increasing interest rate on this debt, the Company records the average quarterly interest expense and records a corresponding asset or liability for the difference not currently payable each quarter. As of March 31, 2007, the Company has classified this liability as current as it expects to retire this obligation within 12 months of the balance sheet date.

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

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

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

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

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

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

Operating, Investing and Financing Activities 

Cash Inflows and Outflows

During the three months ended March 31, 2007, the net increase in cash and cash equivalents remained unchanged for December 30, 2006 compared to a net decrease of $0.2 million during the three months ended April 1, 2006. As reported on our condensed consolidated statements of cash flows, our change in cash and cash equivalents during the three months ended March 31, 2007 and April 1, 2006 is summarized as follows:

	Three months ended
Dollars in thousands	March 31, 2007			April 1, 2006
Net cash (used in) provided by operating activities	$	(867	)	$	1,028
Net cash provided by (used in) investing activities		4,983			(1,089	)
Net cash used in financing activities		(4,107	)		(163	)
Change in cash and cash equivalents	$	9		$	(224	)

Details of our cash inflows and outflows are as follows during the three months ended March 31, 2007:

Operating Activities: During the three months ended March 31, 2007, we used $0.9 million in cash and cash equivalents in operating activities as compared with $1.0 million provided by during the same prior year period. For the three months ended March 31, 2007, this was comprised primarily of net loss of $0.6 million and a decrease in working capital of $1.8 million and is partially offset by non-cash charges totaling $2.1 million. For the three months ended April 1, 2006, the use of cash consisted primarily of a net loss of $4.1 million offset by a decrease in working capital of $3.7 million and is offset by non-cash items of $1.4 million. Components of our significant non-cash adjustments for the three months ended March 31, 2007 and April 1, 2006 are as follows:

Non-cash Adjustments	Three months ended March 31, 2007 (amounts in  thousands)			Three months ended April 1, 2006 (amounts in thousands)		Explanation of Non-cash Activity
Depreciation and amortization	$	524		$	838		Consists of depreciation of property and equipment as well as amortization of intangibles.
Non cash interest expense		126			314		Interest expense related to the Deerfield notes paid in common stock and ABDC principal payment shortfalls paid in common stock.
Gain on sale of pharmacy assets		(3,100	)		-		Gain on the sale of pharmacy assets.
Other non-cash items, net		409			227		Other non-cash items include amortization of deferred financing fees, adjustments to our allowance for doubtful accounts and non-cash stock-based compensation.
Total non-cash adjustments to net income	$	(2,041	)	$	1,379

Investing Activities: Cash provided by investing activities was $3.2 million for the three months ended March 31, 2007, as compared with $1.1 million used in investing activities in the three months ended April 1, 2006. Specific investing activity during the three months ended March 31, 2007 and April 1, 2006 was as follows:

· During the three months ended March 31, 2007, we invested approximately $0.1 million in fixed assets.

· During the first three months of 2007, we received cash of approximately $5.1 million from the sale of our pharmacy locations.

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Financing Activities: Net cash used in financing activities was $4.1 million during the three months ended March 31, 2007, as compared with $0.2 million used in the three months ended April 1, 2006. Specific financing activity during the three months ended March 31, 2007 and April 1, 2006 was as follows:

·  During the three months ended March 31, 2007, we repaid $4.1 million of our revolving credit facility. This compares to $0.2 million in net proceeds in the same period of 2006.

·  During the three months ended March 31, 2007, we did not make any scheduled debt repayments under our outstanding subordinated notes. This compares to $0.4 million for scheduled debt repayments in the same period of 2006.

·  During the first three months of 2007, we also did not receive any proceeds from the issuance of common stock under our employee stock plans. This compares to $0.003 million for proceeds related to employee stock option exercises in the same period of 2006.

Off-Balance Sheet Arrangements

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

Critical Accounting Policies and Estimates

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

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Goodwill and Identifiable Intangible Assets

Useful lives for identifiable intangibles are determined based on the expected future period of benefit of the asset, the assessment of which considers various characteristics of the asset, including historical cash flows. After goodwill is initially recorded, annual impairment tests are required, or more frequently if impairment indicators are present. The amount of goodwill cannot exceed the excess of the fair value of the related reportable unit (which is based, in part, on the Company’s stock price) over the fair value of reporting unit’s identifiable assets and liabilities. Continued downward movement in the Company’s common stock price could have a material effect on the fair value of goodwill in future measurement periods. As of December 30, 2006, all remaining goodwill was impaired and written off.

Impairment of Other Long-lived Assets

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

Our impairment loss calculations contain uncertainty since we must use judgment to estimate future revenues, profitability and cash flows. When preparing these estimates, we consider historical results and current operating trends and our consolidated revenues, profitability and cash flow results and forecasts. These estimates can be affected by a number of factors including, but not limited to, general economic conditions, the cost of real estate, the continued efforts of third party customers to reduce their prescription drug costs, regulatory changes the continued efforts of competitors to gain market share and consumer spending patterns. If these projections change in the future, we may be required to write-down our long-lived assets. Long-lived assets evaluated for impairment include property and equipment as well as intangible assets, which as of March 31, 2007 were approximately $5.7 million and $1.1 million, respectively and at December 30, 2006 were approximately $6.3 million and $1.3 million, respectively.

Trade Receivables

At March 31, 2007 and December 30, 2006, trade receivables reflected approximately $17.5 million and $19.7 million, respectively, of amounts due from various insurance companies, governmental agencies and individual customers. Of these amounts, there was approximately $4.0 million and $3.7 million reserved as of March 31, 2007 and December 30, 2006, respectively, for a balance of net trade receivables of $13.5 million and $16.0 million, respectively. We use historical experience, market trends and other analytical data to estimate our allowance for doubtful accounts. Based upon these factors, the reserve at March 31, 2007 is considered adequate. Although we believe that the reserve estimate is reasonable, actual results could differ from our estimate, and such differences could be material. If the estimate is too low, we may incur higher bad debt expenses in the future resulting in lower net income or higher net losses. If the estimate is too high, we may experience lower bad debt expense in the future resulting in higher net income or lower net losses.

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Inventories

Inventories consist of pharmaceuticals and other retail merchandise owned by us. Inventories are stated at the lower of cost (first-in, first-out method for pharmaceutical inventory and retail method for retail merchandise inventory) or market. Physical inventory counts are taken on a regular basis in each location to ensure that the amounts reflected in the unaudited condensed consolidated financial statements are properly stated. We use historical data to estimate our inventory loss reserves and we have not made any material changes in the accounting methodology used to establish our inventory loss reserves during the past three years. If the estimate of inventory losses is too low we may incur higher cost of sales in the future resulting in lower net income or higher net losses. If the estimate of inventory losses incurred is too high, we may experience lower cost of sales in the future resulting in higher net income or lower net losses. Inventories as of March 31, 2007 and December 30, 2006 were approximately $22.2 million and $25.0 million, respectively, net of approximately $3.8 million and $2.6 million of inventory loss reserves, respectively.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

As of March 31, 2007, $33.4 million and $9.0 million were outstanding on our revolving credit facility and Deerfield Notes, respectively. These borrowings are at a variable rate of interest. Assuming total debt of $42.4 million was outstanding for a full year, a 1% change in interest rates would change our interest expense by $0.4 million annually.

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

Item 4. CONTROLS AND PROCEDURES.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

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

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Changes in Internal Control Over Financial Reporting. There has been no change in our internal control over financial reporting during the first quarter of 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS.

There has been no significant change in the status of the legal matters described in the Company’s fiscal 2006 Form 10-K, as amended.

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

Item 1A. RISK FACTORS.

There have been no material changes to the Risk Factors described in the Company’s fiscal 2006 Form 10-K, as amended.

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

 None.

Item 3. DEFAULT UPON SENIOR SECURITIES.

 None.

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

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

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

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

There were no broker non-votes for this item.

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

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

31

There were no broker non-votes for this item.

Item 5. OTHER INFORMATION.

None.

Item 6. EXHIBITS

31.1	Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *
32.1	Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *
32.2	Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *

* Filed herewith.

32

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Familymeds Group, Inc.
Date: May 21, 2007	By:	/s/ Edgardo A. Mercadante
		Edgardo A. Mercadante  President, Chief Executive Officer and Chairman of the Board  (Principal Executive Officer)

 

Date: May 21, 2007	By:	/s/ James A. Bologa
		James A. Bologa  Senior Vice President, Chief Financial Officer and Treasurer  (Principal Financial and Accounting Officer)

33

EX-31.1

Exhibit 31.1

CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER

PURSUANT TO SECTION 302 OF THE

SARBANES-OXLEY ACT OF 2002 AS AMENDED

I, Edgardo A. Mercadante, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Familymeds Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; and

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report.

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant, and we have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period for which this report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially effect, the registrants internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated: May 21, 2007	By:	/s/ Edgardo A. Mercadante
		Edgardo A. Mercadante  President, Chief Executive Officer, Chairman of the Board

EX-31.2

EXHIBIT 31.2

CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER

PURSUANT TO SECTION 302 OF THE

SARBANES-OXLEY ACT OF 2002, AS AMENDED

I, James A. Bologa, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Familymeds Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; and

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report.

4. The registrant’s other certifying officer and I am responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant, and we have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period for which this report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially effect, the registrants internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated: May 21, 2007	By:	/s/ James A. Bologa
		James A. Bologa  Senior Vice President, Chief Financial Officer and  Treasurer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Familymeds Group, Inc. (the “Company”) on Form 10-Q for the quarter ended March 31, 2007, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Edgardo A. Mercadante, President, Chief Executive Officer, Chairman of the Board and Principal Executive Officer of the Company, certify pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:

(1) The Report fully complies with requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Edgardo A. Mercadante

Edgardo A. Mercadante

President, Chief Executive Officer,

Chairman of the Board and

Principal Executive Officer

May 21, 2007

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report of Familymeds Group, Inc. (the “Company”) on Form 10-Q for the quarter ended March 31, 2007, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, James A. Bologa, Senior Vice President, Chief Financial Officer and Principal Financial and Accounting Officer of the Company, certify pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge:

(1) The Report fully complies with requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ James A. Bologa

James A. Bologa

Senior Vice President, Chief Financial Officer,

Principal Financial and Accounting Officer

May 21, 2007