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

References in this Form 10-Q to the "Company," "MTS," "we," "our" or "us" means MTS Medication Technologies, Inc., together with its subsidiaries, except where the context otherwise indicates. This Form 10-Q contains forward-looking statements within the meaning of that term in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Additional written or oral forward-looking statements may be made by us from time to time, in filings with the SEC or otherwise. Statements contained herein that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions described above. Forward-looking statements may include, but are not limited to, projections of revenues, income or losses, capital expenditures, plans for future operations, the elimination of losses under certain programs, financing needs or plans, compliance with financial covenants in loan agreements, plans for sale of assets or businesses, plans relating to our products or services, assessments of materiality, predictions of future events and the effects of pending and possible litigation, as well as assumptions relating to the foregoing. In addition, when used in this discussion, the words "anticipates", "estimates", "expects", "intends", "believes", "plans" and variations thereof and similar expressions are intended to identify forward-looking statements.

Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified based on current expectations. Consequently, future events and actual results could differ materially from those set forth in, contemplated by, or underlying the forward-looking statements contained herein. Statements in Quarterly Reports, particularly in "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes to Condensed Consolidated Financial Statements, describe factors, among others, that could contribute to or cause such differences. Other factors that could contribute to or cause such differences include, but are not limited to, unanticipated increases in operating costs, labor disputes, capital requirements, increases in borrowing costs, product demand, pricing, market acceptance, intellectual property rights and litigation, risks in product and technology development and other risk factors detailed in our SEC.

Readers are cautioned not to place undue reliance on any forward-looking statements contained herein, which speak only as of the date hereof. We undertake no obligation to publicly release the result of any revisions of these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unexpected events.

Overview

The Company continues to experience growth for several reasons. First, the global aging population results in more medication being prescribed and increases the number of people that reside in skilled nursing and assisted living facilities. Our pharmacy customers deliver medication to those residents and we provide pharmacies with packaging supplies for medications as well as automation for fulfillment. As our customers grow we grow with them. Secondly, we have made strategic acquisitions in Europe which have added to the organic growth of our core products. We believe Europe represents a market that is very receptive to our packaging and automation systems and we expect the European market to continue to represent an expanding portion of our total consolidated revenue. Third, we have invested heavily in technology that has enhanced the automation we sell. As a result, we have experienced growth in sales of both prepackaging equipment, as well as our highly advanced robotic OnDemand systems.

Recently, our operating margins have been impacted by our expansion into new markets and introduction of new products. The principal reason for this is we have continued to invest in our infrastructure in terms of personnel and other resources. This investment has been necessary to help set the stage for future growth and take advantage of our opportunities. We believe these investments will enhance our chance of success in markets such as retail pharmacy, nutraceutical and our traditional long-term care market in the U.S. and Europe. We anticipate that ultimately our operating margins will benefit from the significant impact on our revenue that could result from the successful launch of our products into the retail pharmacy market, the introduction of our automation into the retail pharmacy medication delivery model and the continued acceptance of our OnDemand system automation by our long-term care market customers in the U.S. and Europe.

We believe that our base of business in the long-term care market provides us with a very reliable recurring stream of profitable revenue, and we remain committed to leverage that base to achieve our long-term objectives to grow the Company and create more value for our shareholders.

The following table sets forth, for the three-month periods indicated, certain key operating results and other financial information.

                                                                Three Months Ended June 30,
                                                             ---------------------------------
                                                                  2008                2007
                                                             --------------       ------------
                                                              (In Thousands; Except Per Share
                                                                         Amounts)

Net Sales                                                      $ 19,366             $ 14,820
Gross Profit Percentage                                            31.2 %               36.9 %
Operating Income Percentage                                         3.7 %                7.0 %
Net Income                                                     $    374             $    533
Net Income Per Common Share - Diluted                          $   0.06             $   0.08

RESULTS OF OPERATIONS

Three Months Ended June 30, 2008 and 2007

Net sales for the three months ended June 30, 2008 increased 30.7% to $19.4 million compared with $14.8 million during the same period of the prior fiscal year. Net sales increased for consumable punch cards and prepack machines primarily because of additional sales made to new and existing customers. In addition, revenue associated with the sale of OnDemand machines was $5.1 million during the three months ended June 30, 2008 compared with $2.0 million during the same period of the prior fiscal year. This increase relates primarily to the acceptance of seven OnDemand machines by our largest customer during the three months ended June 30, 2008. Also, our net sales in Europe increased 31% due to increased penetration of our products in that market.

Cost of sales for the three months ended June 30, 2008 was $13.3 million compared with $9.4 million during the same period of the prior fiscal year. Cost of sales as a percentage of sales increased to 68.8% from 63.1% during the same period of the prior fiscal year. Cost of sales as a percentage of sales increased primarily because the proportion of revenue associated with OnDemand machines, which have a higher cost of sales percentage than consumables.

Selling, general and administration expenses for the three months ended June 30, 2008 increased 18.4% to $4.5 million from $3.8 million of the prior fiscal year primarily due to travel and personnel costs associated with support of our OnDemand machine installations, general administrative costs in the U.S. and Europe, increased research and development expenses and higher legal, auditing and consulting expenses.

Depreciation and amortization expense for the three months ended June 30, 2008 increased 33.4% to $795,000 from $596,000 during the same period of the prior fiscal year. The increase resulted primarily from increased depreciation and amortization associated with capital expenditures and acquired intangible assets.

Interest expense for the three months ended June 30, 2008 decreased 16.6% to $126,000 from $151,000 during the same period of the prior fiscal year. The decrease results from a decrease in interest rates.

Income tax expense decreased 40.8% to $213,000 during the three months ended June 30, 2008 compared with $360,000 during the same period of the prior fiscal year. The decrease results from the fact that our net income before tax decreased and our effective tax rate decreased to 36.3% from 40.3%. Our effective tax rate decreased as a result in higher net income from our European operations, which are taxed at lower rates.

Segments

During the first quarter of fiscal year 2009, we began to evaluate our business under three segments: (a) consumables; (b) packaging automation; and
(c) medication administration systems. The consumable segment primarily consists of the manufacturing of punch cards and blisters and other consumable medication packaging. The packaging automation segment consists of products that provide our customers with the ability to package medication into our consumable products in an efficient manner. This type of automation allows the packaging of medication in either a pre-pack or an on-demand manner, which means that our pharmacy customers can elect to package medications for inventory awaiting an order from their long-term care customers or wait until the long-term care customers require the medication and package it at that time. The medication administration systems segment consists of automation products designed to provide our customers with a system to administer medication to residents at long-term care facilities. We currently sell one product, MedLocker, and have developed another product, MedTimes, which is now in beta stage. These segments represent the manner in which we now manage our operations. Prior to this change, we managed our business as one segment.

Segment Results of Operations

    Operating income (loss), as presented below is net sales less cost of sales
and other operating expenses that are directly identifiable to the respective
segment or allocated on the basis of sales or manpower. Operating income is
reconciled to earnings before income taxes in Note 10 to the Consolidated
Financial Statements included in the report.

Consumables
                         Three Months Ended June 30,
                     -----------------------------------
                           2008               2007
                     ----------------    ---------------
                               (In Thousands)

Net Sales             $     13,092        $     11,789
Operating Income      $      1,615        $      2,112
Operating Margin              12.3 %              17.9 %

Net sales in the first quarter increased approximately $1.3 million, or 11%, primarily due to growth in sales to the U.S. long-term care market of approximately 8% and growth in the European domiciliary and retail markets of approximately 31%. The growth in the U.S. is primarily attributable to the increase in medications dispensed in long-term care facilities. The European growth is primarily the result of increased penetration of our products into that market.

Operating margins declined in the first quarter primarily due to (a) higher freight costs that resulted from increased fuel surcharges and a higher percentage of products sold indirectly to our end customers through wholesalers, which are shipped at our expense; (b) increases in raw material costs primarily related to materials that have a high petroleum-based content; (c) increased scrap rates and labor costs; (d) additional personnel added to the entire Company and allocated to this segment based on revenue; (e) higher audit, tax, consulting and legal costs; (f) increased research and development expenses; and
(g) higher depreciation expense associated with assets related to this segment.

Packaging Automation
                        Three Months Ended June 30,
                     ----------------------------------
                           2008               2007
                     ----------------    --------------
                               (In Thousands)

Net Sales             $    6,191          $    2,975
Operating Loss        $     (246 )        $     (703 )
Operating Margin            (4.0 %)            (23.6 %)

Net sales in the first quarter increased $3.2 million, or 108%, because we have entered into an agreement with our largest customer for the sale of twenty-four OnDemand machines. During the first quarter, we recorded $4.1 million in revenue associated with seven machines that were installed and accepted by the customer. In addition, we sold two AccuFlex machines to other independent pharmacies, which resulted in approximately $653,000 in revenue.

Our operating margin during the first quarter improved over the prior fiscal year because we realized additional gross profit on the increased net sales, which offset a portion of the indirect costs associated with this segment.

Medication Administration Systems

                         Three Months Ended June 30,
                     -----------------------------------
                           2008               2007
                     ----------------    ---------------
                               (In Thousands)

Net Sales             $        83         $        56
Operating Loss        $      (480 )       $      (245 )
Operating Margin           (578.3 %)           (437.5 %)

Net sales in the first quarter increased due to increased sales of our MedLocker systems. There was no revenue recorded for MedTimes in the first quarter of this year or last year.

The operating loss this quarter increased over the prior fiscal year because we have added personnel to develop the MedTimes product and work with our beta site customer to evaluate the product and increased research and development expenditures.

LIQUIDITY AND CAPITAL RESOURCES

During the three months ended June 30, 2008, we had net income of $374,000 compared with $533,000 during the same period of the prior fiscal year. Cash provided by operations decreased to $1.08 million from $1.14 million during the three months ended June 30, 2008 and 2007, respectively, primarily due to lower net income in the first quarter of this fiscal year compared to the first quarter of the prior fiscal year. We had working capital of $13.8 million at June 30, 2008 compared to $13.6 million at March 31, 2008 and $7.2 million at June 30, 2007.

Investing activities used $1.2 million during the three months ended June 30, 2008 compared with $590,000 during the same period of the prior fiscal year. The increase results primarily from an increase in expenditures for manufacturing equipment used primarily in our consumables segment, as well as additional information technology equipment used throughout the Company.

Financing activities provided $0 during the three months ended June 30, 2008 compared with $198,000 used in the same period of the prior fiscal year. The change results primarily from lower net advances under the Credit Facility.

Our short-term and long-term liquidity is primarily dependent on our ability to generate cash flow from operations. Inventory levels may change significantly as we complete the manufacturing and installation of our OnDemand machines pursuant to the contract with our largest customer. Increases in net sales may result in corresponding increases in accounts receivable. Cash flow from operations and borrowing availability under the Credit Facility is anticipated to support an increase in accounts receivable and inventory.

We have new product development projects underway, principally related to our MedTimes system, which are expected to be funded by cash flow from operations. These projects are monitored on a regular basis to attempt to ensure that the anticipated costs associated with them do not exceed our ability to fund them from cash flow from operations and other sources of capital.

There was $11.7 million borrowed and an additional $1.6 million available under our Credit Facility at June 30, 2008.

The Credit Facility contains financial covenants that, among other things, require us to maintain certain financial ratios. We were in compliance with all provisions of the loan agreements at June 30, 2008.

We believe that the cash generated from operations during this fiscal year, and amounts available under the Credit Facility will be sufficient to meet our capital expenditures, product development, working capital needs and the principal payments required by our term loan agreements.

ESTIMATES AND CRITICAL ACCOUNTING POLICIES

The preparation of our consolidated financial statements in conformity with generally accepted accounting principles in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and revenue and expenses for the respective period-ended for such statements. The determination of estimates requires the use of judgment since future events and their affect on our operations cannot be determined with absolute certainty. Actual results typically differ from these estimates in some fashion, and at times, these variances may be material to our financial statements. Our management continually evaluates its estimates and assumptions, which are based on historical experience and other factors that are believed to be reasonable under these circumstances. These estimates and our actual results are subject to the risk factors listed under "Item 1. Business" in our Form 10-K for the fiscal year ended March 31, 2008. Nevertheless, our management believes the following items involve a higher degree of complexity and, judgment and therefore, has commented on these items below.

Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiaries, MTSP, MTS Limited and MTS GmbH. All significant inter-company accounts and transactions have been eliminated in consolidation.

Revenue Recognition

We recognize revenue on the sale of machines, other than OnDemand machines, and all consumables when title and risk of loss to the products shipped has transferred to the customer. We recognize revenue related to the sale of our OnDemand machines as prescribed in SOP 97-2, Software Revenue Recognition, because the software component of the OnDemand machine is significant and not incidental to the value and functionality of the machine. In addition, the sale of an OnDemand machine represents an arrangement that encompasses multiple deliverables and therefore each deliverable represents a separate unit of accounting. The separate deliverables are comprised of (a) the OnDemand machine installed at the customers locations; (b) the user training; (c) certain component parts that are sold separately, principally cassettes that hold medications; and (d) maintenance. These separate deliverables are incidental to the functionality of the machine. The vendor specific objective evidence of fair value of the deliverables outlined in (b-d) has been determined based upon the value of these deliverables if they were sold separately. The fair value of the deliverable outlined in (a) has been determined using the residual method which equals the total selling price of the OnDemand machine, including installation, training and cassettes, less the aggregate fair value of (b-d). The terms of the sale arrangement for an OnDemand machine is typically FOB shipping point, at which time title and risk of loss transfers to the customer, however, because the installation of the machine is essential to the functionality of the machine the recognition of any of the revenue associated with the machine is deferred until the machine is installed. For those cassettes that are provided to the customer after the OnDemand machine is installed, the revenue associated with those cassettes is recognized upon their delivery. When the training is performed, we recognize the revenue associated with the training. Revenue associated with annual maintenance contracts is recognized in equal amounts over a twelve-month period.

Revenue includes certain amounts invoiced to customers for freight and handling charges. We include the actual cost of freight and handling incurred in the cost of sales.

Revenue is reported net of rebates and discounts provided to customers and sales taxes. Rebates are generally determined based upon pricing agreements that offer certain customers incentives to purchase products from us. Discounts are provided from time to time primarily to compensate customers for inconveniences caused by late shipments, defective product or pricing errors.

Accounts Receivable

Trade accounts receivable are recorded based upon the invoiced amount, are generally not interest bearing and are considered past due when full payment is not received by the specified credit terms. We do not typically require collateral when granting credit; however, customer credit worthiness is reviewed prior to granting credit. We normally estimate the uncollectibility of our accounts receivable. We consider many factors when making our estimates, including analyzing accounts receivable and historical bad debts, customer concentrations, customer credit worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the reserve for uncollectible accounts. We review the status of our accounts monthly, assessing the customer's ability to pay. When a specific account is deemed uncollectible, the account is written off against the reserve for uncollectible accounts.

Inventories

Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out ("FIFO") method. The elements of costs included in the valuation of inventory are the direct costs associated with materials purchased, direct labor expended to manufacture the inventory and an allocation of general overhead expenses incurred to operate the manufacturing facilities. The allowance for inventory obsolescence and slow moving inventory is reviewed on a regular basis. We review various information related to the age and turnover of specific inventory items to assist with this assessment.

Self-Insurance Plan Reserve

We have a medical health benefit self-insurance plan, which covers substantially all of our employees. During the three months ended June 30, 2008, we were reinsured for claims that exceed $100,000 per participant and an annual maximum aggregate limit of approximately $1.3 million. Future claims may affect the reinsurance limits that may be available to us.

Income Taxes

Income taxes are provided for under the liability method in accordance with SFAS No. 109, Accounting for Income Taxes, whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management considers anticipated future taxable income, the reversal of taxable temporary differences, and tax planning strategies in making the determination. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Product Development

All costs incurred subsequent to the completion of research and development activities associated with software components' achievement of technological feasibility are capitalized until the product is available for general release to customers. Product development costs are generally amortized over a three- to five-year period beginning on the date the product is released for sale to customers. We review the viability and recoverability of these costs on a regular basis.

Warranty

We establish a reserve for warranty costs we may incur during the warranty period that is provided for in the machine sales agreements with our customers. These estimates are established using historical information on the nature, frequency and average cost of claims. Actual experience could differ from the amounts estimated.

Off-Balance Sheet Arrangements

We currently do not have any off-balance sheet arrangements.

Contractual Obligations

Not Applicable.