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 us 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, our results of operations, future plans and growth strategies. Our 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 our Annual Report on Form 10-K for the year ended December 31, 2008.

We were 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. We have since expanded our 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. Our overall strategic plan is to enhance the value of our brands by distributing our gourmet products through multiple channels of distribution.

Our product distribution to grocery and club stores increased from approximately 25 stores as of December 1989, to over 11,000 stores by September 30, 2009. During recent years we added retail and club distribution through internal growth and through Isabella's Kitchen, Emerald Valley Kitchen, CIBO Naturals, and Sonoma Cheese acquisitions. In 2004, our stockholders approved the change of the name of the Company to Monterey Gourmet Foods, Inc. The name change was made to more accurately define our 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, we have 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. We have 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, we acquired CIBO Naturals, a maker of sauces, dips and spreads. In January 2005 we acquired Casual Gourmet Foods, Inc. and we recently announced that we have shuttered this operation due to lack of sales and lack of profits. 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. We believe that the convenient gourmet food segment is growing rapidly as time-starved consumers seek high quality quick-meal solutions and that we, with our staff of culinary personnel, our food consultants, and our flexible manufacturing facilities, are well positioned to bring new products to these consumers.

In 2006, we focused on expanding distribution of our current products, consolidating production facilities in Salinas, improving the quality of our current products, hiring experts in product development and creativity to better utilize our production equipment, improving the synergies between our different brands, and reorganizing our brands into one operating unit. Also in September 2006, the Board of the Company appointed Eric Eddings as President and Chief Executive Officer of the Company.

In 2007, we 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 our production facilities, and one unified goal to improve our profitability. We focused on brand building with an emphasis on natural and/or organic products by expanding our product offerings of organic or made with organic ingredients as these products are being well received in the market place.

In 2008, we addressed the capacity and efficiency constraints of our fragmented former Seattle, Washington facility by securing a ten year lease on a new facility in Kent, Washington, approximately 20 miles from the former location. We spent approximately $4.5 million preparing this new facility and moving equipment into it before occupying it in December 2008. The improvements added capacity to our sauce production and made other important changes in our production processes. In addition, we saw increases in the prices of many of our raw ingredients such as cheese, eggs, corn, flour, oil, pine nuts, and dairy products, and in our transportation costs, but we were not able to increase our prices sufficiently to offset these increased costs during the year.

Also during 2008, we launched new items across all product lines, with the main focus on organic and made with organic products. Our goal is to gain incremental distribution points as soon as possible using promotional and sampling programs as vehicles. We also focused on Sonoma Foods and Casual Gourmet Foods because these two brands have become significantly less profitable during the last two years. In March 2008, we reviewed the low margins and decreasing revenues being generated from the Sonoma Cheese products and determined, among other things, to buy out the minority interest and the employment contracts of the minority stockholders.

In 2009, we finished shuttering the Further Processed Protein Segment as it had declining sales and has not been able to generate a profit for several years. For the nine months ended September 30, 2009, we recorded an income before tax loss of $42,000 to dispose of the remaining inventory and other expenses attributed to its closure. During 2009, we have focused on cost reduction initiatives including reducing employee counts, reducing costs, and discontinuing unprofitable products. We have also reacted to the current economic downturn by freezing salaries and wages, eliminating our 401k matching contribution and taking other cost cutting initiatives.

The success of our 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 our products, (2) whether we can continue to increase the number of grocery and club store chains offering our products, (3) whether we can continue to introduce new products that meet consumer acceptance,
(4) whether we, by diversifying into other complementary businesses through new product offerings or acquisitions can leverage our strengths and continue to grow revenues at levels attractive to our investors, (5) whether our acquisitions perform as we planned, (6) whether we can maintain and increase the number of items we are selling to our two largest customers, and (7) whether we can successfully deter new competitors from 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 our product will continue to do so in the future.

We believe that access to capital resources and increasing sales to offset higher fixed overhead, coupled with continued reduction of our administrative and production costs as a percent of sales revenue, will be key requirements in our efforts to enhance our competitive position and increase our market share. In order to support our expansion program, we continue to develop new products for consumers and revise advertising and promotional activities for our retail grocery and club store accounts. There can be no assurance that we will be able to increase our net revenues from grocery and club stores. Because we will continue to make expenditures associated with the expansion of our business, our results of operations may be affected.

Our overall objective is to be the nationally recognized leader in distinctively-flavored, premium-quality gourmet foods. The key elements of our 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 our margins, we will design new products that can be manufactured and distributed out of our Salinas, California or Kent, Washington facilities or through co-packer arrangement where we can introduce new products quickly to meet customer requests.

† Ensure that we have the proper and sufficient staff to accomplish our goals in a timely manner including enhancing our 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. We will consider additional capital improvements in order to increase production efficiencies and capacities, and to reduce our 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 we provide flavorful and nutritious lines of products, and promote repeat business by reinforcing positive experiences.

† Utilize the existing distribution, customer service and selling capabilities we have for the products of new acquisitions in order to grow sales and maximize the results of all brands.

We will continue to direct our advertising and promotional activities to specific programs customized to suit our 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 we will be able to increase our net revenues from grocery and club stores.

Results of Operations

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


                                  Three Months Ended                              Nine Months Ended

                      September 30, 2009      September 30, 2008     September 30, 2009      September 30, 2008


Net Revenues         $             20,399    $             21,678    $            60,654    $             67,277
Percent Change in
Net Revenues from
prior period                           -6 %                    -5 %                  -10 %                    -3 %

These results and comparisons are for continuing operations only. The quarterly decrease in third quarter 2009 revenues compared with third quarter 2008 revenues is due to a 72% decline in tamale revenues as a result of additional competition, together with a 9% decline in sales to our largest customer, and a 19% reduction in our revenues to our retail customers. These reductions in revenues are offset by a 32% increase from our co-branded and private label brands and a 30% increase in revenues to our second largest customer. We are also experiencing increases in our foodservice revenues.

The decrease in the nine months of 2009 revenues compared with the nine months of 2008 revenues is due to a 49% decline in tamale revenues as a result of additional competition, together with a 15% decline in sales to our second largest customer.

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

                                    Three Months Ended                              Nine Months Ended

                        September 30, 2009      September 30, 2008     September 30, 2009      September 30, 2008

Gross profit            $             5,161    $              5,506    $            16,050    $             17,356
Gross margin percent                   25.3 %                  25.4 %                 26.5 %                  25.8 %

Gross margin percent for the year ended December 31, 2008 was 24.9%. The gross margin percent for the third quarter of 2009 decreased compared to the third quarter of 2008 due to a 6% reduction in net revenues and $228,000 of expenses associated with the closure of the Eugene, Oregon facility which is captured in our cost of goods sold and impacts our gross margin percent. Other costs associated with the Eugene, Oregon facility are captured elsewhere in the Statement of Operations. The costs were incurred mostly in September 2009 and we have had insufficient time to recover these costs through production in our Kent, Washington facility. Adding back these costs, our gross margin percent for the third quarter 2009 would have been 26.4%.

The gross margin percent for the nine months of 2009 increased compared to the nine months of 2008.This increase in gross margin percent is due to lower raw material costs and the cost reduction initiatives we have taken. The reduced costs are partially offset by lower revenues which reduced the facility overhead absorption rate.

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

                                 Three Months Ended                              Nine Months Ended

                     September 30, 2009      September 30, 2008     September 30, 2009      September 30, 2008

SG&A Expense         $             5,077    $              5,852    $            14,999    $             17,859
SG&A Expense as a
percent of net
revenues                            24.9 %                  27.0 %                 24.7 %                  26.5 %

For the calendar year ended December 31, 2008, SG&A expenses were 27.6% of net revenues. SG&A as a percent of net revenues for the three months ended September 30, 2009 was 24.9% which is down from 27.0% for the three months ended September 30, 2008. The decrease compared to the third quarter of 2008 is related to decreased costs from our initiatives to reduce costs and lower freight costs. SG&A expense in dollars was reduced by 13% or $775,000. The main components of the SG&A decrease are reductions in costs of freight ($260,000) and salaries and benefits ($272,000). We also spent $149,000 researching, developing, printing and introducing new presentation labels for our retail product line. During the three months ended September 30, 2009, we incurred $499,000 in legal fees, mostly associated with the merger transaction described in Footnote 11. SG&A as a percent of net revenues, excluding the legal fees, would have been 22.4% for the three months ended September 30, 2009.

Freight to customers is included in SG&A costs. Our freight costs for the three months and nine months ended September 30, 2009 were $907,000 and $2,492,000, respectively. Our freight costs for the three months and nine months ended September 30, 2008 were $1,167,000 and $3,716,000, respectively.

Depreciation and amortization expense, included in cost of sales and SG&A, was $2,334,000, or 3.8% of net revenues for the nine months ended September 30, 2009, compared to $2,245,000, or 3.3% of net revenues for the nine months ended September 30, 2008. The increase in depreciation expense in 2009 is associated with additional equipment and leasehold improvements associated with the new production facility in Kent, Washington and other capital expenditures during 2009.

Gain or loss on disposition of fixed assets represents the write-off of $118,000 of leasehold improvements associated with the closure of the Eugene, Oregon facility offset by the cash sale of other fixed assets. The net of the two transactions equates to a net loss of the disposition of assets of $97,000.

Net interest income was $1,000 for the third quarter ended September 30, 2009, compared to net interest income of $15,000 for the same quarter in 2008. For the nine months ended September 30, 2009, net interest income was $3,000 compared to net interest income of $63,000 for the same period in 2008. The reduced income is a result of the lower interest rate being paid on the Company's excess cash.

Income taxes for the third quarter of 2009 reflect a tax expense of $0, which reflects a 0% tax rate compared with income tax expense of $0 or approximately 0% of pretax income for the same period in 2008. Income taxes for the first nine months of 2009 reflect an income tax expense of $41,000, which reflects a 4% tax rate compared with an income tax expense of $3,000 for the same period in 2008. We determine our quarterly tax provision based on the expected annual effective tax rate by tax filing entities and jurisdictions. Overall we are projecting a profit for 2009, and because we have an NOL carryover, we will only pay Alternative Minimum Taxes for federal tax purposes and certain state taxes

We continue to have a valuation allowance of 100% of our deferred tax assets at September 30, 2009. The full valuation allowance was established during the fourth quarter of 2008 as a result of the reassessment of the realizability of deferred tax assets.

We operate in two segments: Gourmet Foods Products and Sonoma Cheese Products.

     Gourmet Foods Products Results:


                              Three Months Ended                            Nine Months Ended

                   September 30, 2009     September 30, 2008    September 30, 2009     September 30, 2008

Gourmet Foods
Products
Net Revenues      $             18,861   $             20,095   $            56,262   $             62,690
Gross Profit      $              4,804   $              5,337   $            15,030   $             17,354
Operating
Profit            $                (81 ) $               (115 ) $               755   $                795

Gross profit
percentage                        25.5 %                 26.6 %                26.7 %                 27.7 %
SGA percentage                    25.9 %                 27.1 %                25.4 %                 26.4 %

† Our tamale sales declined 72% or $802,000 less than the revenues for the same quarter last year. This is due to increased competition for our sales of this item to Costco Wholesale.
† Our pasta sales declined 4%, due in part to slower sales to our largest customer.
† Our second largest customer switched from a branded product to a private labeled product. Even though this switch occurred during the third quarter of 2009, revenues to this customer were up 30% compared to the same quarter of 2008.
† The gross margin percent of 25.5% for the three months ended September 30, 2009 decreased compared to 26.6% for the three months ended September 30, 2008 due mainly to lower production volume through our facilities, especially our facility where our refrigerated pasta and our tamales are produced and to the costs of $228,000 associated with closing the Eugene, Oregon facility.
† SG&A as a percent of net revenues for the three months ended September 30, 2009 was 25.9% compared to 27.1% for the three months ended September 30, 2008. The decrease in SG&A as a percent of net revenues for 2009 compared to 2008 is due to lower salaries and operating costs associated with our cost reduction initiatives, offset by legal fees associated with the merger transaction described in Footnote 11.We also spent $149,000 researching, developing, printing and introducing new presentation labels for our retail product line.

Highlights for the nine months ended September 30, 2009:

† Our tamale sales declined 49% or $1,735,000 less than revenues reported for the same nine months of 2008. This is due to increased competition for our sales of this item to Costco
† Our pasta sales declined 11% partially due to our second largest customer switching from a branded product to a private labeled product. Our sales are down as this customer transitions its product line up.
† The gross margin percent of 26.7% for the nine months ended September 30, 2009 decreased compared to 27.7% for the same nine months of 2008 due mainly to lower net revenues and its impact on our overhead absorption.
† SG&A as a percent of net revenues for the nine months ended September 30, 2009 was 25.4% compared to 26.4% for the nine months ended September 30, 2008. The decrease in SG&A as a percent of net revenues for 2009 compared to 2008 is due to lower salaries and operating costs associated with our cost reduction initiatives offset by a decline in net revenues.

Sonoma Cheese Products results:

                              Three Months Ended                            Nine Months Ended

                  September 30, 2009      September 30, 2008    September 30, 2009     September 30, 2008

Sonoma Cheese
Products
Net revenues      $             1,538    $              1,583   $             4,392   $              4,587
Gross profit      $               357    $                169   $             1,020   $                  2
Impairment        $                 -    $                  -   $                 -   $             (1,606 )
Operating
profit (loss)     $                58    $               (231 ) $               199   $             (2,912 )

Gross profit
percentage                       23.2 %                  10.7 %                23.2 %                  0.1 %
SGA percentage                   19.4 %                  25.2 %                18.7 %                 28.5 %

Highlights for the three months ended September 30, 2009:

† Packaged cheese products revenues declined $45,000 when comparing the three months ended September 30, 2009 with the three months ended September 30, 2008. This is the first quarter for this year in which revenues are similar to those for the prior year. We have increased our distribution and our promotions are improving our sales.
† The gross margin percent increased to 23.2% for the quarter ended September 30, 2009, as compared to 10.7% for the three months ended September 30, 2008, which reflects lower cheese and milk prices.
† SG&A as a percent of net revenues for the quarter ended September 30, 2009 was 19.4% compared to 25.2% for the same period ended September 30, 2008. The decrease in SG&A for 2009 compared to 2008 reflects the absence of any unusual charges during the quarter.

Highlights for the nine months ended September 30, 2009:

† Packaged cheese products revenues declined 4% when comparing the nine months ended September 30, 2009 with the nine months ended September 30, 2008. The decline is attributable to consumers purchasing lower priced items as opposed to specialty cheeses in the first part of the year.
† The gross margin percent of 23.2% for the nine months ended September 30, 2009 increased significantly compared to 0.1% for the nine months ended September 30, 2008, and reflects lower cheese and milk prices. In addition, in March 2008, we set up inventory reserves for items from processed cheeses and lower margin items which we discontinued.
† SG&A as a percent of net revenues for the nine months ended September 30, 2009 was 18.7% compared to 28.5% for the same period ended September 30, 2008. The decrease in SG&A for 2009 compared to 2008 is due to the fact that in 2008 we experienced higher selling expenses, higher freight costs, higher legal fees, and an accrual for severance payments.

Also, in the first quarter of 2008, we saw a significant reduction in sales in the Sonoma Cheese Products Segment. Due to the reduced sales in March 2008 and the accelerating losses from this segment, we determined that a triggering event under SFAS 142 occurred and therefore tested for the impairment of goodwill and other intangible assets during the first quarter of 2008. As a result of the impairment test, we recorded a pre-tax, non-cash charge of $1.1 million in the first quarter of 2008 related to the impairment of intangible assets associated with the Sonoma Foods, Inc. acquisition on April 7, 2005.

In addition, on April 18, 2008, the Company, Sonoma Foods, Inc., and the stockholders of Sonoma Foods, Inc. entered into an amendment to the Purchase Agreement dated April 7, 2005, pursuant to which we acquired all of the outstanding shares of Sonoma. Pursuant to the amendment, our purchase of the remaining 20% of Sonoma Foods, Inc.'s outstanding shares not already owned by us was accelerated and the purchase price was set at $50,000, plus a potential earn-out based upon an agreed formula. At the same time, the Company and the stockholders terminated existing employment agreements with the stockholders and entered into severance arrangements which provide for payments and benefits substantially equivalent to those provided by the former employment agreements. From the purchase of minority interest, we recorded a gain of $109,000 in the three months ended September 30, 2008. The gain was reported in other income in our statement of operations.

Liquidity and Capital Resources

During the nine months ended September 30, 2009, we provided $2,470,000 of cash from operations compared to $3,701,000 in cash provided by operations for the nine months ended September 30, 2008. As illustrated in the following table, adjusting for working capital which was impacted by the timing of cash payments and cash receipts, we provided $3,554,000 cash from operating activities compared to $1,776,000 of cash for the same nine months in 2008, a 100% increase.