Summary of SPAN AMERICA MEDICAL SYSTEMS INC

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

OVERVIEW
Span-America's operations are divided into two primary business units or segments: medical and custom products. Our revenues, profits and cash flows are derived from the development, manufacture and sale of products for these two market segments. In the medical segment, we manufacture and market a comprehensive selection of pressure management products, including Geo-Matt®, PressureGuard®, Geo-Mattress®, Span-Aids®, Isch-Dish®, and Selan® products. In the custom products segment, we manufacture consumer mattress pads and pillows for the retail bedding market and various engineered foam products for the industrial market. Our consumer mattress pads and pillows are marketed by our exclusive distributor, Louisville Bedding Company. We sell the industrial product line directly to our customers. Prior to fiscal year 2008, we had a third business unit involving the development, manufacture and sale of safety catheters. In October 2007, we decided to exit the safety catheter business because we had not been able to generate sufficient sales volume to make the segment a viable business. Consequently, we recorded a $2.9 million impairment charge in fiscal 2007 to eliminate the book value of the safety catheter assets. Revenues and expenses related to the safety catheter business in fiscal year 2008 are shown in our financial statements as a discontinued operation.

Results of operations for fiscal years 2007 and 2006 have been restated to show the safety catheter segment as a discontinued operation.

RESULTS OF OPERATIONS FISCAL 2008 VS. 2007

Summary
Total sales in fiscal 2008 declined 2% to $59.3 million compared with $60.5 million in fiscal 2007 because of lower sales volume in both our medical and custom products segments. Medical sales were down 2% to $42.5 million due mainly to a decline in sales of private label therapeutic support surfaces. Custom products sales for fiscal 2008 decreased 3% to $16.8 million due to lower sales of consumer bedding products compared with fiscal year 2007.

Income from continuing operations declined 11% in fiscal 2008 to $4.9 million, or $1.71 per diluted share, because of lower sales levels, higher raw material costs in the medical segment, a slight increase in selling expenses and a decline in non-operating income.

Net income, which includes results from the discontinued safety catheter segment, was up 69% in fiscal 2008 to $4.9 million, or $1.70 per diluted share. The increase in fiscal 2008 net income was caused by our exit from the safety catheter segment in early fiscal 2008 and the resulting decrease in losses from the now discontinued operation.

Sales
Total sales in our core medical business declined 2% to $42.5 million in fiscal 2008 compared with $43.2 million in fiscal 2007. The decline in medical sales was caused mostly by lower volume of private-label therapeutic support surfaces manufactured for Hill-Rom. Sales to Hill-Rom declined by $2.7 million in fiscal 2008. See below for further discussion of our Hill-Rom relationship. Sales of therapeutic support surfaces, including private label and branded products, declined by 2% during fiscal 2008. Therapeutic support surfaces, or mattresses, are our largest medical product line, making up 75% of our medical segment sales in both fiscal 2008 and fiscal 2007. We sell these specialty mattresses to hospitals, long-term care facilities and home care dealers throughout the United States and Canada. Excluding sales to Hill-Rom, sales of our therapeutic support surfaces were up 8% in fiscal 2008, reflecting solid growth in our branded mattress products. Growth leaders among our branded support surfaces included the PressureGuard APM2 alternating pressure mattress and the Geo-Mattress line of all-foam support surfaces. We had mixed results in sales of our other medical product lines during fiscal 2008. Sales of our Span-Aids patient positioners declined by 4% due mostly to lower export business. Sales of mattress overlays increased 3%, Selan skin care sales rose 4% and sales of seating products declined 1% during fiscal 2008. Medical sales accounted for 72% of total net sales in fiscal year 2008 compared with 71% in fiscal 2007.

We expect medical sales for fiscal 2009 to be affected by the expiration in May 2008 of our previous manufacturing agreement with Hill-Rom. Hill-Rom was our largest medical customer in fiscal 2008, representing sales of approximately $7.0 million, which made up 17% of medical sales and 12% of total Company sales. We signed a new agreement with Hill-Rom in July 2008 to continue providing it with therapeutic support surfaces on a private label basis. The new agreement establishes pricing through December 31, 2008, and provides us with protection against inventory obsolescence for products supplied to Hill-Rom. The initial term of the agreement is one year, expiring July 10, 2009, but it will automatically renew for successive one-year periods. Either party may cancel the agreement for any reason with 60 days written notice. The agreement contains no minimum sales volume commitments and no exclusivity provisions for either party. Hill-Rom has expanded the number of competing products it offers in this category. Consequently, we expect our sales to Hill-Rom in fiscal 2009 to be lower than they were in fiscal 2008. However, since we do not receive sales forecasts from Hill-Rom, we cannot accurately predict future sales to Hill-Rom.

We remain optimistic about the growth prospects for the branded products in our medical business in fiscal 2009 and beyond. We expect steady growth in our branded medical business during fiscal 2009, which should at least partially offset anticipated declines in sales to Hill-Rom; however, there can be no assurance to this effect. We plan to expand our sales and marketing efforts to distribute our therapeutic support surfaces in the acute care market in fiscal 2009. In addition, we plan to continue our new-product development efforts, which have contributed significantly to our past sales growth.

Our custom products segment consists of consumer bedding products and specialty foam products for the industrial market. Sales in the custom products segment declined 3% during fiscal 2008 to $16.8 million from $17.3 million in fiscal 2007. The entire decline occurred in the consumer part of the custom products segment, where sales were down 5% to $13.0 million compared with $13.7 million in fiscal 2007. The consumer sales decrease was caused mostly by the loss of one customer due to bankruptcy and loss of another due to an acquisition by a competitor. This lost business was partially offset by an increase in sales of consumer mattress overlays and pillows to Wal-Mart, our largest customer in the custom products segment. All of our consumer products are sold through our marketing and distribution partner, Louisville Bedding Company. We expect consumer sales in fiscal 2009 to be higher than they were in fiscal 2008.

In the other part of the custom products segment, industrial sales increased 5% in fiscal 2008 to $3.8 million compared with $3.6 million in fiscal 2007. The growth in industrial sales came from a combination of new and existing customers primarily in the automotive and water sports markets. We believe industrial sales in fiscal 2009 will be slightly lower than those of fiscal 2008 due to the current weakness in the U. S. economy.

Gross Profit
Our gross profit decreased by 3% during fiscal 2008 to $20.4 million compared with $21.0 million in fiscal 2007. Gross margin declined slightly to 34.4% for fiscal 2008 from 34.6% in fiscal 2007. The decreases in gross profit and gross margin were caused by lower sales volume in the medical and custom products segments and higher raw material costs in the medical segment. The increase in medical material cost was affected by higher foam costs and an increase in warranty expense related to performance problems with two electronic components within our therapeutic support surface product lines. The problems were resolved in the fourth quarter of fiscal 2008. See Note 7 in the Notes to Financial Statements for more information on warranty expense.

We implemented several lean manufacturing techniques during fiscal 2008, which improved our labor usage and efficiency, particularly in the custom products segment. As a result, our number of employees declined and labor costs declined both in absolute dollars and as a percentage of sales. The decline in labor costs partially offset higher raw material costs during the year. Manufacturing overhead expenses remained level in fiscal years 2008 and 2007. We expect our gross margin during fiscal 2009 to be similar to that of fiscal 2008. However, our 2009 gross profit and margin performance will depend heavily on sales volume, product mix and raw material costs.

Selling, Research & Development and Administrative Expenses Selling and marketing expenses increased 1% to $9.0 million and 15.2% of net sales in fiscal 2008 compared with $8.9 million and 14.7% of net sales in fiscal 2007. The increase occurred in the medical segment and was mostly in the categories of sales commissions, evaluation samples and shipping costs. Those expenses increased even though sales declined because we mostly replaced declining private-label sales, which have no commission and shipping costs, with increasing branded product sales, which carry standard commission and shipping costs. We will likely see this trend continue in fiscal 2009. Consequently, we believe that total selling and marketing expenses for fiscal 2009 will increase over 2008 levels.

Total research and development expenses declined 9% to $657,000 in fiscal 2008 compared with $724,000 in fiscal 2007. Almost all of our research and development expenses are incurred in the medical segment and are related to the development of new products, new features of existing products and design improvements. The expense decline in fiscal 2008 was caused by the completion of product development projects in fiscal 2008 that were ongoing in fiscal 2007 and by lower incentive compensation expense. R&D expenses will likely fluctuate from quarter to quarter and from year to year, depending on the nature of the development projects being pursued. We expect total R&D expenses in fiscal 2009 to be higher than those of fiscal 2008.

Administrative expenses increased 1% to $3.23 million in fiscal 2008 from $3.21 million in fiscal 2007. The expense increase was caused mainly by a decline in the cash value of corporate-owned life insurance. A decrease in the cash value of life insurance is shown as an administrative expense, while an increase is shown as a reduction in administrative expenses. Please see "Item 7A. Quantitative and Qualitative Disclosures about Market Risk" below and Notes 5 and 9 in the Notes to Financial Statements for additional information on the cash value of life insurance. The increase in administrative expenses also reflected higher cost for property and casualty insurance. These expense increases were mostly offset by a decline in incentive compensation expense in fiscal 2008. We expect administrative expenses for fiscal 2009 to be slightly higher than they were in fiscal 2008.

Operating Income
In the medical segment, operating income for fiscal 2008 declined by 17% to $7.6 million compared with $9.1 million in fiscal 2007. The decrease was caused by lower medical sales volume, higher raw material costs and higher medical selling expenses in fiscal 2008 compared with last fiscal year.

The custom products segment showed a significant improvement in operating income, which rose to $801,000 in fiscal 2008 compared with an operating loss of $267,000 in fiscal 2007. The increase in custom products operating income was caused by across-the-board expense reductions in that segment as well as an increase in industrial sales volume. Within the custom products segment, we achieved cost reductions during the year in the categories of raw materials, labor and manufacturing overhead as a result of ongoing efforts to improve material usage and yields and to increase manufacturing efficiencies. We also adopted lean manufacturing techniques to reduce the number of employees required to meet production requirements.

Operating income for the total Company declined 7% in fiscal 2008 to $7.5 million compared with $8.1 million in fiscal 2007. As discussed above, the decline in medical operating income was greater than the improvement in custom products operating income.

Non-Operating Income
Investment income declined by 82% to $51,000 in fiscal 2008 compared with $277,000 in fiscal 2007. The decrease was caused by a significant reduction in the level of short-term investments, which in turn was related to our $5.00 per share special dividend paid in June 2007. The $13.9 million special dividend was funded by liquidation of our short-term investments and the addition of $5.7 million in long-term debt during fiscal 2007. We expect investment income for fiscal 2009 to be similar to the fiscal 2008 level.

Interest Expense
Interest expense in fiscal 2008 increased 5% to $108,000 compared with $103,000 in fiscal 2007. The increase was caused by a higher average balance of long-term debt in fiscal 2008 compared with 2007. Since the addition of long-term debt took place in June 2007 as described above, the debt was outstanding for only four months during fiscal year 2007. Although we steadily reduced the debt level during fiscal 2008, the average balance was higher in fiscal 2008 than in 2007. See "Liquidity and Capital Resources" below for further discussion about our revolving credit facility.

Income from Continuing Operations, Net Income and Dividends Income from continuing operations in fiscal 2008 declined 11% to $4.9 million, or $1.71 per diluted share, compared with $5.5 million, or $1.92 per diluted share, in fiscal 2007. The decrease was caused by lower medical and custom products sales volume, higher raw material costs in the medical segment, higher medical selling expenses and lower investment income in fiscal 2008 compared with fiscal 2007.

Net income, which includes results from the discontinued safety catheter segment, increased 69% in fiscal 2008 to $4.9 million, or $1.70 per diluted share, compared with $2.9 million, or $1.00 per diluted share, in fiscal 2007. The increase in net income was the result of discontinuing the safety catheter segment, which reduced our after-tax loss from discontinued operations to $50,000 in fiscal 2008 from $2.6 million in fiscal 2007.

During fiscal 2008, we paid dividends of $943,000, or 19% of net income for the year. This amount consisted of two quarterly dividends of $0.08 per share and two quarterly dividends of $0.09 per share. In April 2008, the board of directors increased our quarterly dividend by 12.5%, from $0.08 to $0.09 per share.

RESULTS OF OPERATIONS FISCAL 2007 VS. 2006

Summary
Results of operations for fiscal years 2007 and 2006 have been restated to show revenues and expenses of the safety catheter segment as a discontinued operation.

Net sales in fiscal 2007 increased 18% to $60.5 million compared with $51.4 million in fiscal 2006. The sales increase was the result of higher sales volumes in both the medical and custom products segments. Medical sales increased 18% to $43.2 million. Sales in the custom products segment rose by 17% to $17.3 million.

Income from continuing operations in fiscal 2007 increased 46% to $5.5 million, or $1.92 per diluted share, compared with $3.8 million, or $1.36 per diluted share, in fiscal 2006. The increase was due mostly to higher sales volume. However, improved manufacturing efficiencies, a more profitable product mix and slower rates of growth in operating expenses also contributed to the increase in earnings from continuing operations.

Net income, which includes results from the discontinued safety catheter segment, declined 6% in fiscal 2007 to $2.9 million, or $1.00 per diluted share, compared with $3.1 million, or $1.10 per diluted share, in fiscal 2006. The decrease in net income was caused by a larger loss from discontinued operations in fiscal year 2007 compared with 2006. The 2007 loss from discontinued operations includes a non-cash, after-tax impairment charge of $1.9 million, or $0.67 per share, related to the exit and proposed sale of our safety catheter business.

Sales
Total sales in the medical business grew 18% to $43.2 million in fiscal 2007 compared with $36.7 million in fiscal 2006. Sales of therapeutic support surfaces (our largest medical product line) rose 21% in fiscal 2007 to $32.6 million and represented 75% of total medical sales. We sell these specialty mattresses to hospitals, long-term care facilities and home care dealers throughout the United States and Canada. Medical sales accounted for 71% of total net sales in each of fiscal years 2007 and 2006. Product line growth leaders within the therapeutic support surface group were the PressureGuard CFT, which includes private label products manufactured for Hill-Rom, the Geo-Mattress line of all-foam support surfaces and the PressureGuard Easy Air low-air-loss support surfaces. In other medical product lines, sales of wheelchair seating products increased by 23%, patient positioners were up by 7% and overlays and Selan skin care products each rose by 2%.

Our custom products segment consists of consumer bedding products and specialty foam products for the industrial market. Sales in the custom products segment increased 17% during fiscal 2007 to $17.3 million from $14.8 million in fiscal 2006. All of the sales growth was attributable to consumer bedding products, which were up 23% to $13.7 million compared with $11.2 million last year. This increase was the result of sales of the new fusion mattress overlays to Wal-Mart and other retailers through our marketing partner, Louisville Bedding Company. The fusion overlays combine the performance of traditional foam with the feel and features of visco foam to give customers a unique bedding choice.

In the other part of the custom products segment, industrial sales were flat at $3.6 million as sales growth from existing and new customers was offset by lost business from a key customer related to price competition.

Gross Profit
Our gross profit increased by 27% during fiscal 2007 to $21.0 million compared with $16.4 million in fiscal 2006. Gross margin rose to 34.6% for fiscal 2007 from 32.0% in fiscal 2006. The increase in gross profit level was due to higher sales volumes and lower manufacturing costs as a percent of sales. The reduction in manufacturing costs as a percent of sales was due to improved production efficiencies, cost savings from various process improvement projects, and from closing our California manufacturing plant and replacing it with a distribution center in Utah. We also benefitted from the relative stability of raw material costs during fiscal 2007.

Selling, Research & Development and Administrative Expenses Selling and marketing expenses increased 10% to $8.9 million, but declined to 14.7% of net sales in fiscal 2007 compared with $8.1 million and 15.7% of net sales million in fiscal 2006. Most of the dollar increase occurred in the medical segment and was due to costs related to our new distribution center in Utah and higher commissions and shipping expenses related to higher medical sales volumes.

Total research and development expenses increased 39% to $724,000 in fiscal 2007 compared with $522,000 in fiscal 2006. A large majority of our R&D expenses from continuing operations are incurred by the medical segment. The expense increase in fiscal 2007 compared with 2006 is related to an increase in new product development efforts in the medical segment during fiscal 2007.

Administrative expenses increased 17% to $3.2 million in fiscal 2007 from $2.8 million in fiscal 2006. The increase was mainly the result of higher incentive compensation, professional fees and bad debt expense during fiscal 2007.

Operating Income
Operating income in the medical segment rose 33% in fiscal 2007 to $9.1 million compared with $6.8 million in fiscal 2006. The increase was caused by higher medical sales volume, improved manufacturing efficiencies, a more profitable sales mix within the medical segment and comparatively slower growth rates in medical segment operating expenses.

The custom products segment showed an operating loss in fiscal 2007. However, the loss decreased 75% to $267,000 ($0.06 per diluted share after taxes) compared with $1.1 million ($0.26 per diluted share after taxes) in fiscal 2006. The decrease in the custom products operating loss was primarily caused by the increase in sales volume of consumer bedding products and improved manufacturing efficiencies. The custom products segment is allocated a portion of our total manufacturing overhead and administrative expenses. Since these allocated expenses are largely fixed within a reasonable range of sales volume, a sales decline within the segment can result in a proportionally larger decline in segment operating income. However, we believe that the custom products segment makes a positive contribution to our earnings because it absorbs overhead and administrative expenses that would otherwise be reallocated to the medical segment if we exited the custom products business. If that occurred and nothing else changed, the medical segment and the total Company would be less profitable.

Operating income for the total Company rose 60% to $8.1 million compared with $5.1 million in fiscal 2006 for the reasons described above.

Non-Operating Income
Investment and other income declined by 10% in fiscal 2007 to $277,000 compared with $308,000 in fiscal 2006. The decline was caused by a lower gain on the sale of assets in fiscal 2007 compared with fiscal 2006. The gain on the sale of assets in fiscal 2007 was $9,000, down 91% from $99,000 in fiscal 2006.

Investment income in fiscal 2007 increased 28% to $261,000 compared with $204,000 in fiscal 2006. The increase was due to higher interest rates and slightly higher average balances of marketable securities during fiscal 2007 compared with fiscal 2006.

We received no royalty income in fiscal 2007 as a result of the expiration in December 2005 of our license agreement for the Safety-Lok® shielded syringe product formerly licensed to Becton Dickinson and Company (BD). The license agreement ended due to the expiration of the related patents. We received the final royalty payment from BD in February 2006 and recorded $247,000 of royalty income in fiscal 2006.

Interest Expense
Fiscal 2007 results included $103,000 in interest expense incurred from the addition of $5.7 million in debt to partially fund the $5.00 per share special dividend paid on June 6, 2007. No comparable interest expense was incurred in fiscal 2006. See "Liquidity and Capital Resources" below for further discussion about our revolving credit facility.

Income from Continuing Operations, Net Income and Dividends Income from continuing operations rose 46% in fiscal 2007 to $5.5 million, or $1.92 per diluted share, compared with $3.8 million, or $1.36 per diluted share, in fiscal 2006. The increase in earnings was due to higher sales volume, improved manufacturing efficiencies, a more profitable product mix and slower rates of growth in operating expenses.

Net income declined 6% in fiscal 2007 to $2.9 million, or $1.00 per diluted share, compared with $3.1 million, or $1.10 per diluted share, in fiscal 2006. The decrease in net income was caused by an increase in the loss from discontinued operations in fiscal year 2007 compared with 2006. The loss from the discontinued safety catheter segment increased 263% from $724,000 in fiscal 2006 to $2.6 million in fiscal 2007. The 2007 loss from discontinued operations of $2.6 million includes a non-cash, after-tax impairment charge of $1.9 million, or $0.67 per share, related to the exit and proposed sale of our safety catheter business.

During fiscal 2007, we paid dividends of approximately $14.7 million, or 511% of net income, for the year. This amount consisted of a special dividend of $5.00 per share, one quarterly dividend of $0.06 per share and three quarterly dividends of $0.08 per share.

LIQUIDITY AND CAPITAL RESOURCES
We generated cash from operations of $5.3 million during fiscal 2008, which was down 17% compared with record cash flow of $6.3 million in fiscal 2007. The major positive factors affecting cash flow from operations in fiscal 2008 were decreases in our deferred tax asset and inventory levels compared with increases in those two line items in fiscal 2007. The main factors causing a reduction in operating cash flow during fiscal 2008 were a decrease in accounts payable and accrued expenses, a decrease in earnings as adjusted for the non-cash impairment charge in fiscal 2007 and an increase in accounts receivable during the year. The balance sheet components of these changes are described below.

The main uses of cash provided by operations in fiscal 2008 were repayment of $3.0 million of long-term debt, payment of dividends of $943,000, stock repurchases of $748,000 and equipment purchases of $692,000.

Working capital increased by $602,000, or 8%, to $8.0 million during fiscal 2008. The increase in working capital was primarily caused by a higher balance in accounts receivable and a decrease in accrued and sundry liabilities. In addition, our current ratio increased to 2.5 at fiscal year-end 2008 from 2.3 at fiscal year-end 2007.

Accounts receivable, net of allowances, increased 10% to $7.8 million at the end of fiscal 2008 compared with $7.1 million at the end of fiscal 2007. The increase was the result of a slower average collection time for accounts receivable during fiscal 2008 compared with fiscal 2007. The days sales outstanding (or average collection time), calculated using a 12-month average for accounts receivable balances, increased to 46 days in 2008 compared with 43 days in 2007. The longer collection time is due to normal month-to-month fluctuations in the timing of payments received and a slight shift in the mix of medical sales toward slower paying customers due to a decline in sales of private-label medical products. All of our accounts receivable are unsecured.

Inventory, net of reserves, decreased by $7,000 to $4.0 million at fiscal year-end 2008 compared with fiscal year-end 2007. The slight change was the result of normal fluctuations in inventory levels. The most significant changes, which were largely offsetting, were a decrease in medical finished goods inventory and increases in consumer and industrial raw materials inventory. Inventory turns from continuing operations decreased slightly to 9.7 times in fiscal 2008 compared with 10.6 times in fiscal 2007. We expect inventory levels in fiscal 2009 to be similar to 2008 fiscal year-end levels.

Our deferred income tax asset decreased 31% during fiscal 2008 to $683,000 from $997,000 due mostly to a decrease in accrued incentive compensation and, to a lesser extent, a decrease in the non-deductible inventory reserve. The decline in accrued incentive compensation was caused by a decrease in management bonuses in fiscal 2008 compared with fiscal 2007.

Prepaid expenses decreased 47% to $52,000 during fiscal 2008 from $97,000 at the end of fiscal 2007. The decrease was the result of normal monthly fluctuations in prepaid accounts.

Net property and equipment increased by $32,000, less than 1%, during fiscal 2008. The change resulted from the combination of $656,000 in depreciation . . .