General

The following discussion should be read in conjunction with the financial statements and related notes and other information included in this report. The financial results reported herein do not indicate the financial results that may be achieved by the Company in any future period.

Other than the historical facts contained herein, this Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, particularly statements relating to our expectations relating to, among other things, the Company's results of operations, future plans and growth strategies. The Company's actual results regarding such matters may vary materially as a result of certain risks and uncertainties. For a discussion of such risks and uncertainties, please see the Company's Annual Report on Form 10-K for the year ended December 31, 2007 and Item 1A of part II of this Quarterly Report. In addition to the risks and uncertainties discussed in the Annual Report, the risks set forth herein, including the risks associated with any reduction of sales to two major customers currently comprising a majority of total revenues and the importation of frozen pasta dough by major Italian producers, the Company's ability to expand distribution of food products to new and existing customers, to attract and retain qualified management, to integrate newly acquired businesses and to compete in the competitive food products industry, should be considered.

Background

Monterey Gourmet Foods was incorporated in June 1989 as a producer and wholesaler of refrigerated gourmet pasta and sauces to restaurants and grocery stores in the Monterey, California area. The Company has since expanded its operations to provide a variety of gourmet refrigerated food products to grocery and club stores throughout the United States, selected regions in Canada, the Caribbean, Latin America and Asia Pacific. The Company's overall strategic plan is to enhance the value of the Monterey Gourmet Foods brands by distributing its gourmet products through multiple channels of distribution.

The Company's product distribution to grocery and club stores increased from approximately 25 stores as of December 1989, to over 11,000 stores by September 30, 2008. During recent years the Company added retail and club distribution through internal growth and through Isabella's Kitchen, Emerald Valley Kitchen, CIBO Naturals, Sonoma Cheese, and Casual Gourmet acquisitions. In 2004, the Company's shareholders approved the change of the name of the Company to Monterey Gourmet Foods, Inc. The name change was made to more accurately define the Company's strategic direction. The name change also announces to the investor community, our customers and consumers, our strategic direction to become a complete supplier of gourmet refrigerated foods.

Since 2004, the Company has launched many new product lines outside its core pasta/sauce business, including gourmet refrigerated entrees, fresh tamales, dips, spreads, and frozen One-Step meal entrees. The Company has also been able to increase distribution by introducing whole wheat, organic, and made with organic pastas which are higher in dietary fiber, have a favorable glycemic index, and are made with whole grains and organic items.

In January 2004, the Company acquired CIBO Naturals, a maker of sauces, dips and spreads. In January 2005 the Company acquired Casual Gourmet Foods, Inc. a marketer of flavorful low fat, low-calorie chicken sausages, chicken burgers and soups. Sonoma Foods, Inc., acquired in April 2005 markets a line of refrigerated specialty cheese products that features its flagship line of traditional and flavored Sonoma Jack cheeses which have earned numerous awards over the years. Monterey Gourmet Foods believes that the convenient gourmet food segment is growing rapidly as time-starved consumers seek high quality quick-meal solutions and that the Company, with its staff of culinary personnel, its food consultants, and its flexible manufacturing facilities, is well positioned to bring new products to these consumers.

In 2007, the Company focused on strategic growth, improving the synergies that are possible with one sales force for all brands, one marketing department, one finance department, one information systems department, one manager in charge of all the Company's plants, and one unified goal to improve the profitability of the Company. The Company focused on brand building with an emphasis on natural and/or organic products by expanding its product offerings of organic or made with organic ingredients as these products are being well received in the market place.

In 2008, the Company recognized that it was out of capacity at its Seattle, Washington facility. Therefore, it signed a ten year lease on a new facility in Kent, Washington, approximately 20 miles from the current facility. The Company has spent approximately $4 million preparing this new facility and moving equipment from the old facility into the new facility. Occupancy is scheduled to take place during the fourth quarter of 2008. The improvement will add capacity to the Company's sauce production and improve important production processes. In addition, the Company saw increases in the prices of many of its raw ingredients such as cheese, eggs, corn, flour, oil, and dairy products. The Company was not able to raise prices to its customers to offset these increased raw ingredient costs during 2007. However, price increases were taken to customers during the first quarter of 2008.

During 2008, the Company launched new items across all product lines, with the main focus on organic and made with organic products. In addition, the Company hired Michael P. Schall as a Senior Vice-President of Sales and Marketing. Mr. Schall had previously served on the Board of Directors of Monterey Gourmet Foods and has a background in selling and marketing products to the retail trade. Under Mr. Schall's leadership, management grouped sales into four categories: US retail, natural foods, club/warehouse stores and specialty food services. The goal is to gain incremental distribution points as soon as possible using promotional and sampling programs as vehicles.

The success of the Company's efforts to increase revenue will depend on several key factors: (1) whether grocery and club store chains will continue to increase the number of their stores offering the Company's products, (2) whether the Company can continue to increase the number of grocery and club store chains offering its products, (3) whether the Company can continue to introduce new products that meet consumer acceptance, (4) whether the Company, by diversifying into other complementary businesses through new product offerings or acquisitions can leverage its strengths and continue to grow revenues at levels attractive to its investors, (5) whether the newly acquired acquisitions perform as planned when purchased, (6) whether the Company can maintain and increase the number of items it is selling to its two largest customers, and (7) whether the Company can fend off new competitors entering the U.S. retail market from international sources. Grocery and club store chains continually re-evaluate the products carried in their stores, and no assurances can be given that the chains currently offering the Company's product will continue to do so in the future.

Club stores such as Costco and Sam's Club have been the Company's largest customers, and management believes there is an opportunity to expand this business. In pursuit of this opportunity, the Company increased its attention to these accounts to ensure timely delivery of store favorites and exciting new products in each region.

For US retail and Natural Foods, a sales lead has been assigned by region:
East, Central and West. In addition, the Company set up a specialty food services category which is new for the Company and designates the historical work of placing CIBO Naturals at specialty chains such as Starbucks and Panera Bread. The Company believes that with persistence and time, these and similar outlets will be a viable channel for sale of the Company's gourmet food products.

In March 2008, the Company's management met to discuss the low margins and decreasing revenues being generated from the Sonoma Cheese products. At that meeting, management reviewed the discrete financial information for the Sonoma Cheese products and made the decision to take action such as dedicating sales resources specifically to Sonoma Cheese products, buying out the minority interest, buying out the employment contracts of the minority shareholders and other strategic business decisions. As a result, the Company concluded that Sonoma Foods constituted an operating segment and reporting unit and therefore, the Company is reporting Sonoma Cheese products as a separate reporting segment.

The sales growth of the Company may also be impacted by a large competing Italian pasta maker (Giovanni Rana) that is freezing its product, shipping it to the United States in a frozen state, thawing the product and then selling it to consumers in a refrigerated section of grocers.

The Company's overall objective is to be the nationally recognized leader in distinctively-flavored, premium-quality gourmet foods. The key elements of the Company's strategy include the following targeted goals:

• Expand market share through same-store revenue growth, addition of new grocery and club stores, geographic diversification, and product line expansion, including creation of additional meal solutions using Monterey Gourmet Foods products.

• Introduce new products on a timely basis to maintain customer interest and to respond to changing consumer tastes. In order to maximize its margins, the Company will design new products that can be manufactured and distributed out of its Salinas, California, Eugene, Oregon, or Seattle, Washington facilities, or through co-packer arrangement where the Company can introduce new products quickly to meet customer requests.

• Ensure that the Company has the proper and sufficient staff to accomplish its goals in a timely manner including the enhancement of its marketing department.

• Reduce operating costs as a percentage of sales through continual evaluation of administrative and production staffing and procedures and consolidation of back office functions. The Company will consider additional capital improvements in order to increase production efficiencies and capacities, and to reduce the Company's cost of goods on a per unit basis.

• Except for the Sonoma Cheese Products, operate as one reporting unit with a centralized sales force, marketing department, finance department and operational management.

• Create brand awareness by communicating to the consumer that Monterey Gourmet Foods provides flavorful and nutritious lines of products, and promote repeat business by reinforcing positive experiences with the Company's products.

• Introduce new products to the Company's major customers in order to demonstrate the innovative nature of the Company, keep the product line updated with new ideas from the Company's creative chefs and outside culinary experts, and increase the number of items on the shelves from which consumers can choose.

• Utilize the existing distribution, customer service and selling capabilities of Monterey Gourmet Foods for the products of new acquisitions in order to grow sales and maximize the results of all brands.

• Consider the acquisition of other compatible companies or product lines to expand retail distribution, or the range of product offerings, or to accomplish other synergies where the acquisition could create long-term stockholder value, and be accretive to earnings in the first year.

The Company will continue to direct its advertising and promotional activities to specific programs customized to suit its retail grocery and club store accounts as well as to reach target consumers. These will include in-store demonstrations, coupon programs, temporary price reduction promotions, and other related activities. There can be no assurance that the Company will be able to increase its net revenues from grocery and club stores.

The success of the Company's acquisition strategy will depend upon its ability to generate cash from current operations, attract new capital, find suitable acquisition candidates, and successfully integrate new businesses and operations. There is no assurance that acquisitions can be financed from current cash flow, and, if not, that outside sources of capital will be available to supplement internally-generated funds. There is no assurance that management can successfully select suitable acquisition candidates, that bank creditors would approve such acquisitions, or that these new businesses could be successfully integrated to create long term stockholder value.

Results of Operations

     Net revenues from operations were as follows (in thousands):


                                 Three Months Ended                                Nine Months Ended

                     September 30, 2008       September 30, 2007      September 30, 2008       September 30, 2007


Net Revenues        $              23,190    $             24,458    $              72,722    $             73,702
Percent Change in
Net Revenues from
prior period                         -5.2 %                  10.7 %                   -1.3 %                   8.9 %

The quarterly decrease in third quarter 2008 revenues compared with third quarter 2007 revenues is due to a 20% decline in tamale revenues as a result of additional competition, together with a 18% decline in Sonoma cheese sales as a result of discontinuing certain processed cheese spreads under the Sonoma Cheese brand, and a 49% decline in sales to our second largest customer, offset by a 15% increase in revenues to our largest customer as a result of the introduction of new flavors and new products. In addition, net sales were reduced when the Company increased its allowances to its customers during the quarter to help facilitate the transition to higher prices.

The year to date decrease in net revenue is due to a 46% decline in tamale revenues as a result of additional competition, together with a 22% decline in Sonoma cheese sales as a result of discontinuing certain processed cheese spreads under the Sonoma Cheese brand, and a 36% decline in sales to our second largest customer, offset by a 17% increase in revenues to our largest customer as a result of the introduction of new flavors and new products. In addition, net sales were reduced when the Company increased its allowances to its customers during the year to help facilitate the transition to higher prices.

Gross profit and gross margin were as follows (in thousands):

                                     Three Months Ended                                Nine Months Ended

                        September 30, 2008       September 30, 2007       September 30, 2008       September 30, 2007

Gross profit           $              5,854    $                6,623    $              18,962    $             20,293
Gross margin percent                   25.2 %                    27.1 %                   26.1 %                  27.5 %

Gross margin percent for the year ended December 31, 2007 was 27.4%. The gross margin percent for the third quarter of 2008 decreased compared to the third quarter of 2007 due to low revenues which reduced the plant overhead absorption and increased pricing allowances because of increased competition. Promotional activities were $863,000 higher in the third quarter of 2008 compared to the third quarter of 2007. These promotional activities reduced the per unit selling price of products sold which reduced the Company's gross margins.

The gross profit dollars and the gross margin percentage for the nine months ended September 30, 2008 decreased compared to the nine months ended September 30, 2007 due mainly to the increased costs of commodities and increased promotional activities. In addition, the Company discontinued the Sonoma processed cheeses product line and established inventory reserves of $504,000 for the processed cheese products and other raw materials stored at separate co-packers. The Sonoma Cheese segment reported a gross profit percentage of 0.05% for the nine months ended September 30, 2008 compared to a positive gross profit percentage of 18% for the nine months ended September 30, 2007. In addition, the Company paid $247,000 in slotting costs to introduce its new organic pasta line and family pack sizes which also reduced overall gross margins. The Company is also experiencing record high commodity prices in flour, eggs, corn, protein, olive and other types of oil, pine nuts, and dairy products including all types of cheese, cream, and milk, which have impacted gross margins. Some commodity prices started to decline at the end of the third quarter 2008; however, the full effect of the declines will not impact the Company's gross margins until the fourth quarter.

Selling, general and administrative expenses or SG&A were as follows (in thousands):

                                  Three Months Ended                                Nine Months Ended

                     September 30, 2008       September 30, 2007       September 30, 2008       September 30, 2007

SG&A Expense        $              6,393    $                6,184    $              19,742    $             18,641

SG&A Expense as a
percent of net
revenues                            27.6 %                    25.3 %                   27.1 %                  25.3 %

For the calendar year ended December 31, 2007, SG&A expenses were 25.2% of net revenues. SG&A as a percent of net revenues for the three months ended September 30, 2008 was 27.6%. The increase compared to the third quarter of 2007 is related to reduced revenues and additional severance expense of $137,000. The Company is continuing to refine its management team and reduce overhead associated with the business.

Depreciation and amortization expense, included in cost of sales and SG&A, was $2,245,000 or 3.1% of net revenues for the nine months ended September 30, 2008 compared to $2,185,000 or 3.0% of net revenues for the nine months ended September 30, 2007. The increase in depreciation expense of $35,000 for the nine month period is associated with additional equipment purchases in calendar year 2007 and 2008. In addition, amortization expense increased $25,000 which is part of the Company's ongoing review of the useful lives of its intangible assets.

Net interest income was $15,000 for the quarter ended September 30, 2008, compared to net interest income of $43,000 for the same quarter in 2007. For the nine months ended September 30, 2008, net interest income was $63,000 compared to net interest income of $109,000 for the same period in 2007. The reduced income is a result of the lower interest rate being paid on the Company's excess cash and lower excess cash.

Income taxes for the third quarter of 2008 reflect a tax expense of $0, which reflects a 0% tax rate compared with income tax expense of $181,000 or approximately 39% of pretax income for the same period in 2007. For the nine months ended September 30, 2008 income taxes reflect a tax expense of $3,000, which reflects a 0% tax rate compared with income tax expense of $690,000 or approximately 40% of pretax income for the same period in 2007. The income tax rate calculation is based upon the cutoff method under FIN 18 which recommends the use of the cut-off method where a small change in a Company's estimated income could produce a large change in the estimated annual effective tax rate. Under the cutoff method year to date results are taken into account in an interim tax provision and therefore additional valuation allowances were established. During the first quarter of 2008, the Company increased its valuation allowance by $138,000 in conjunction with the impairment of Sonoma Foods' intangible assets and an additional $771,000 in the second and third quarters of 2008 due to the volatility surrounding the Company. The Company now has a valuation allowance of $1,756,000 at September 30, 2008.

As a result of a significant reduction in sales at Sonoma Foods, particularly in March 2008, the Company determined that indicators of impairment existed for the Sonoma Foods intangible assets. Accordingly, in accordance with Statement of Financial Accounting Standard ("SFAS") No. 142, "Goodwill and Other Intangible Assets" and SFAS No. 144 "Accounting for the Impairment of Disposal of Long-Lived Assets," the Company applied impairment tests to its intangible assets, including goodwill during the first quarter of 2008. The Company determined its reporting units to be the same as its operating segments. See Note 8. As a result of this testing and in accordance with SFAS No. 142, the Company recorded a pre-tax, non-cash charge of approximately $1.1 million in the first quarter of 2008 related to the impairment of intangible assets and goodwill associated with the acquisition of Sonoma Foods in April 2005. In addition to management's evaluation of the Sonoma Foods reporting unit, the Company agreed to terminate the employment agreements with the minority shareholders of Sonoma Foods and enter into separate severance agreements (Note 10). The Company recorded severance charges of $466,000 related to the severance agreements during the first quarter of 2008. The Company expects to make such severance payments between April 1, 2008 and April 7, 2009. The Company has paid approximately $251,000 of the severance as of September 30, 2008.

As part of the restructuring, on April 18, 2008, the Company, Sonoma Foods, Inc. ("Sonoma"), and the shareholders of Sonoma entered into an agreement amending the Purchase Agreement dated April 7, 2005, pursuant to which the Company agreed to acquire all of the outstanding shares of Sonoma. Pursuant to the Amendment, the Company's purchase of the remaining 20% of Sonoma's outstanding shares not already owned by the Company was accelerated and the purchase price was set at $50,000, plus a potential earn-out based upon an agreed formula and each party agreed to waive all rights to indemnification under the original Purchase Agreement. At the same time, the Company and the Shareholders terminated existing employment agreements with the Shareholders and entered into severance arrangements which provide for payments and benefits substantially equivalent to those provided by the former employment agreements. All costs associated with these transactions were expensed in the period in which they occurred. The Company had on its books, minority interest attributable to the minority shareholders of $159,000. As a result of the acquisition of the minority interests, the Company purchased the minority interest for $50,000 in cash and the difference between the amount on the balance sheet and the cash paid is $109,000 and is reported as other income.

The Company operates in two segments: Gourmet Foods Products and Sonoma Cheese Products.

     Gourmet Foods Products Results:


                                       Three Months Ended                                Nine Months Ended

                           September 30, 2008       September 30, 2007      September 30, 2008       September 30, 2007

Gourmet Foods Products
Net Revenues              $              21,607    $             22,532    $              68,135    $             67,819
Gross Profit              $               5,675    $              6,292    $              18,960    $             19,246
Operating Profit          $                (318 )  $                707    $                 507    $              2,339

Gross profit percentage                    26.3 %                  27.9 %                   27.8 %                  28.4 %
SGA Percentage                             27.7 %                  24.8 %                   27.1 %                  24.9 %

Highlights for the third quarter of 2008:

• Emerald Valley Kitchen Salsa revenues grew 47% when comparing the third quarter 2008 with the third quarter of 2007.

• The revenue for Casual Gourmet branded products grew by 6%.

• Tamale revenues declined 20%

• The gross margin percentage of 26.3% for the third quarter of 2008 decreased compared to 27.9% for the third quarter of 2007 due mainly to an $863,000 increase in promotional allowances. This increase reduced the effect of the price increase implemented in the second quarter to offset increased costs of commodities.

• SG&A as a percent of net revenues for the third quarter ended September 30, 2008 was 27.7% compared to 24.8% for the third quarter ended September 30, 2007. The increase in SG&A as a percent of net revenues for 2008 compared to 2007 is due to lower revenue and additional severance expense of $137,000.

Highlights for the first nine months of 2008:

• Pasta branded products revenues grew 21% when comparing the nine months of 2008 with the nine months of 2007.

• The revenue for Casual Gourmet branded products grew by 29%.

• Tamale revenues declined 46%

• The gross margin percentage of 27.8% for the nine months of 2008 compared to 28.4% for the nine months of 2007 which reflects higher commodity prices and higher allowances which offset the price increase taken to offset higher commodity prices. The Company did not implement price increases until late March 2008.

• SG&A as a percent of net revenues for the nine months ended September 30, 2008 was 27.1% compared to 24.9% for the nine months ended September . . .