Edgar Filing: DERMA SCIENCES, INC.

Unassociated Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2010

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

For the transition period from ____________ to ____________

Commission file number 1-31070

Derma Sciences, Inc.

(Exact name of registrant as specified in its charter)

Pennsylvania	23-2328753
(State or other jurisdiction of Incorporation)	(IRS employer identification number)

214 Carnegie Center, Suite 300

Princeton, NJ 08540

(Address of principal executive offices)

(609) 514-4744

(Issuer’s telephone number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer	¨				Accelerated filer	¨
Non-accelerated filer	¨		(Do not check if a smaller reporting company)		Smaller reporting company	x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Date: November 11, 2010	Class:	Common Stock, par value $.01 per share
		Shares Outstanding: 6,561,826

PART I – FINANCIAL INFORMATION

DERMA SCIENCES, INC.

FORM 10-Q

INDEX

Description		Page

Part I – Financial Information

Item 1. Financial Statements

Condensed Consolidated Balance Sheets – September 30, 2010 (Unaudited) and December 31, 2009		3

Condensed Consolidated Statements of Operations – Three months ended September 30, 2010 and September 30, 2009 (Unaudited)		4

Condensed Consolidated Statements of Operations – Nine months ended September 30, 2010 and September 30, 2009 (Unaudited)		5

Condensed Consolidated Statements of Cash Flows – Nine months ended September 30, 2010 and September 30, 2009 (Unaudited)		6

Notes to Condensed Consolidated Financial Statements (Unaudited)		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		17

Item 4. Controls and Procedures		30

Part II - Other Information

Item 1A. Risk Factors		31

Item 6. Exhibits		32

Forward Looking Statements

This document includes certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s current expectations and are subject to uncertainty and changes in circumstances. Actual results may differ materially from these expectations due to changes in political, economic, business, competitive, market and regulatory factors.

Part I – Financial Information

Item 1. FINANCIAL STATEMENTS

DERMA SCIENCES, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

	September 30, 2010 (Unaudited)			December 31, 2009
ASSETS
Current Assets
Cash and cash equivalents	$	409,505		$	243,524
Accounts receivable, net		5,361,264			3,372,712
Inventories		13,579,298			11,489,724
Prepaid expenses and other current assets		456,337			456,675
Total current assets		19,806,404			15,562,635
Cash – restricted		-			2,032,164
Equipment and improvements, net		3,412,650			3,741,347
Goodwill		7,119,726			7,119,726
Other intangible assets, net		7,254,725			3,994,250
Other assets, net		341,110			849,753
Total Assets	$	37,934,615		$	33,299,875
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities
Line of credit borrowings		3,658,625			2,306,306
Current maturities of long-term debt		14,503			1,759,185
Accounts payable		4,240,277			3,363,096
Accrued expenses and other current liabilities		2,305,193			1,342,467
Total current liabilities		10,218,598			8,771,054
Long-term debt		-			2,305,851
Other long-term liabilities		69,671			96,564
Deferred tax liability		321,323			355,349
Total Liabilities		10,609,592			11,528,818
Shareholders’ Equity
Convertible preferred stock, $.01 par value; 1,468,750 shares authorized; issued and outstanding: 284,844 shares (liquidation preference of $4,201,426 at September 30, 2010)		2,848			2,851
Common stock, $.01 par value; 18,750,000 authorized; issued and outstanding: 6,561,826 at September 30, 2010; 5,039,468 at December 31, 2009		65,618			50,395
Additional paid-in capital		48,620,586			41,221,613
Accumulated other comprehensive income – cumulative translation adjustments		1,413,377			1,303,293
Accumulated deficit		(22,777,406	)		(20,807,095	)
Total Shareholders’ Equity		27,325,023			21,771,057
Total Liabilities and Shareholders’ Equity	$	37,934,615		$	33,299,875

See accompanying consolidated notes.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (Unaudited)

	Three Months ended September 30,
	2010			2009
Net Sales	$	15,096,134		$	12,882,425
Cost of sales		10,666,204			8,838,154
Gross Profit		4,429,930			4,044,271
Operating Expenses
Selling, general and administrative		4,690,054			3,677,182
Research and development		175,380			70,412
Total operating expenses		4,865,434			3,747,594
Operating (loss) income		(435,504	)		296,677
Other expense, net:
Interest expense		119,521			220,839
Other income		(75,530	)		(69,002	)
Total other expense		43,991			151,837
(Loss) income before provision for income taxes		(479,495	)		144,840
Provision for income taxes		23,057			5,237
Net (Loss) Income	$	(502,552	)	$	139,603
Net (loss) income per common share – basic and diluted	$	(0.08	)	$	0.03
Shares used in computing net (loss) income per common share – basic		6,561,826			5,039,468
Shares used in computing net (loss) income per common share – diluted		6,561,826			5,366,413

See accompanying consolidated notes.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (Unaudited)

	Nine Months ended September 30,
	2010			2009
Net Sales	$	41,170,621		$	34,877,658
Cost of sales		28,687,388			24,051,984
Gross Profit		12,483,233			10,825,674
Operating Expenses
Selling, general and administrative		13,603,071			11,244,347
Research and development		415,232			288,338
Total operating expenses		14,018,303			11,532,685
Operating loss		(1,535,070	)		(707,011	)
Other expense, net:
Interest expense		414,120			631,909
Loss on debt extinguishment		114,072			-
Other income		(253,661	)		(112,791	)
Total other expense		274,531			519,118
Loss before provision (benefit) for income taxes		(1,809,601	)		(1,226,129	)
Provision (benefit) for income taxes		160,709			(47,151	)
Net Loss	$	(1,970,310	)	$	(1,178,978	)
Net loss per common share – basic and diluted	$	(0.31	)	$	(0.23	)
Shares used in computing net loss per common share – basic and diluted		6,259,205			5,028,891

See accompanying consolidated notes.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (Unaudited)

	Nine Months Ended September 30,
	2010			2009
Operating Activities
Net Loss	$	(1,970,310	)	$	(1,178,978	)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
Depreciation of equipment and improvements		712,622			622,171
Amortization of intangible assets		1,248,525			987,380
Amortization of deferred financing costs		87,501			108,512
Loss on debt extinguishment		114,072			-
Provision for (recovery of) bad debts		22,269			(87,044	)
Allowance for sales adjustments		54,446			630,679
Provision for inventory obsolescence		399,355			257,702
Deferred rent expense		(16,425	)		51,529
Compensation charge for employee stock options		618,278			668,658
Compensation charge for restricted stock		42,666			18,148
Gain on sale of equipment		-			(59,031	)
Deferred income taxes		(41,109	)		(21,363	)
Changes in operating assets and liabilities:
Accounts receivable		(2,065,267	)		(394,402	)
Inventories		(2,405,249	)		1,630,394
Prepaid expenses and other current assets		5,556			(70,629	)
Other assets		310,505			(452	)
Accounts payable		814,506			(802,634	)
Accrued expenses and other current liabilities		882,080			(763,821	)
Other long-term liabilities		(8,862	)		8,788
Net cash (used in) provided by operating activities		(1,194,841	)		1,605,607
Investing Activities
Purchase of equipment and improvements		(337,011	)		(185,222	)
Purchase of intangible asset		(2,250,000	)		-
Proceeds from sale of equipment		-			61,000
Net cash used in investing activities		(2,587,011	)		(124,222	)
Financing Activities
Net change in bank line of credit		1,352,319			(611,016	)
Long-term debt repayments		(4,050,533	)		(975,339	)
Net change in restricted cash		2,032,164			(15,142	)
Proceeds from issuance of stock, net of costs		4,491,279			(9,290	)
Net cash provided by (used in) financing activities		3,825,229			(1,610,787	)
Effect of exchange rate changes on cash		122,604			138,362
Net increase in cash and cash equivalents		165,981			8,960
Cash and cash equivalents
Beginning of period		243,524			391,038
End of period	$	409,505		$	399,998
Supplemental disclosures of cash flow information:
Issuance of common stock and warrants for purchase of intangible asset	$	2,259,000		$	-
Cash paid during the period for:
Interest	$	346,443		$	494,704

See accompanying consolidated notes.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.	Organization and Summary of Significant Accounting Policies

Derma Sciences, Inc. and its subsidiaries (the “Company”) is a full line provider of wound care, wound closure and specialty securement devices and skin care products. The Company markets its products principally through independent distributors servicing the long-term care, home health and acute care markets in the United States, Canada and other select international markets. The Company’s U.S. distribution facilities are located in St. Louis, Missouri and Houston, Texas, while the Company’s Canadian distribution facility is located in Toronto. The Company has manufacturing facilities in Toronto, Canada and Nantong, China.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2010, are not necessarily indicative of the results that may be expected for the year ending December 31, 2010. Information included in the condensed balance sheet as of December 31, 2009 has been derived from the consolidated financial statements and footnotes thereto for the year ended December 31, 2009, included in Form 10-K previously filed with the Securities and Exchange Commission. For further information, refer to that Form 10-K.

Reverse Stock Split – The accompanying financial statements reflect a 1-for-8 reverse split of the Company’s common and preferred stock approved by the board of directors and stockholders of the Company and made effective by an amendment to the Company’s articles of incorporation on February 1, 2010. All share and per share information herein that relates to the Company’s common and preferred stock has been retroactively restated to reflect the reverse stock split.

Net (Loss) Income per Share – Net (loss) income per common share – basic is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Net (loss) income per common share – diluted reflects the potential dilution of earnings by including the effects of the assumed exercise, conversion or issuance of potentially issuable shares of common stock (“potentially dilutive securities”), including those attributable to stock options, warrants, convertible preferred stock and restricted common stock in the weighted average number of common shares outstanding for a period, if dilutive. The effects of the assumed exercise of warrants and stock options are determined using the treasury stock method. Potentially dilutive securities have not been included in the computation of diluted loss per share for the three and nine months ended September 30, 2010 and the nine months ended September 30, 2009 as the effect would be anti-dilutive.

Total dilutive shares that have or would have been used to compute diluted income per common share for the three and nine months ended September 30, 2010 and 2009 are outlined below:

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009

Weighted average common shares outstanding – basic		6,561,826		5,039,468		6,259,205		5,028,891
Dilutive shares attributable to:
Convertible preferred stock		–		285,051		–		–
Warrants		–		1,575		–		–
Stock options		–		40,319		–		–

Sub-total dilutive shares		–		326,945		–		–

Weighted average common shares outstanding – diluted		6,561,826		5,366,413		6,259,205		5,028,891

Potentially dilutive shares excluded as a result of the effects being anti-dilutive are as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009
Dilutive shares:
Convertible preferred stock		284,844		–		284,844		285,051
Restricted common stock		20,000		–		20,000		–
Warrants		1,734,531		1,097,833		1,734,531		1,099,407
Stock options		1,265,600		1,138,821		1,265,600		1,179,141

Total dilutive shares		3,304,975		2,236,654		3,304,975		2,563,599

2.	Inventories

Inventories include the following:

	September 30, 2010		December 31, 2009

Finished goods	$	9,070,100	$	7,804,339
Work in process		965,226		466,365
Packaging materials		873,994		722,148
Raw materials		2,669,978		2,496,872

Total inventory	$	13,579,298	$	11,489,724

3.	Line of Credit Borrowings

In November 2007, the Company entered into a five-year revolving credit agreement providing for maximum borrowings of $8,000,000 with a U.S. lender. The revolving credit agreement was amended from time to time, the latest of which was March 26, 2010. Advances under the revolving credit agreement, as amended may be drawn, up to 85% of eligible receivables (as defined) and 44% of eligible inventory (as defined) less a minimum excess availability reserve of $1,000,000. Interest on outstanding advances under the amended revolving credit agreement is payable at the three month LIBOR rate subject to a 1.50% floor plus 4.25% . In addition, the Company pays a monthly unused line fee of 0.5% per annum on the difference between the daily average amount of advances outstanding under the amended agreement and $8,000,000 together with a monthly collateral management fee of $2,000. At September 30, 2010 the effective interest rate was 5.75% and the outstanding balance was $3,658,625.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

Outstanding balances under the amended agreement are secured by all of the Company’s and its subsidiaries’ existing and after-acquired tangible and intangible assets located in the United States and Canada.

The revolving credit agreement, as amended, is subject to financial covenants which require maintaining a minimum of fixed charge coverage and total leverage ratios (as defined). Additional covenants governing permitted investments, indebtedness and liens, together with payments of dividends and protection of collateral, are also included in the agreement. The amended revolving credit agreement contains a subjective acceleration provision whereby the lender can declare a default upon a material adverse change in the Company’s business operations.

4.	Long-Term Debt

Long-term debt consists of the following:

	September 30, 2010		December 31, 2009

U.S. term loan	$	-	$	3,500,000
Promissory note		-		500,000
Capital lease obligation		14,503		65,036

Total debt		14,503		4,065,036

Less: current maturities		14,503		1,759,185

Long-term debt	$	-	$	2,305,851

U.S. Term Loan

In November 2007, the Company entered into a five-year $6,000,000 term loan agreement with a U.S. lender. On February 23, 2010 the term loan was paid off which resulted in a $114,072 loss on debt extinguishment.

Promissory Note

In connection with an April, 2006 acquisition a portion of the purchase price was paid via a 12% unsecured promissory note issued to the seller. The promissory note provided for quarterly interest installments of $15,000 and a final payment of the outstanding principal balance of $500,000 plus interest. The promissory note was paid off on March 31, 2010.

Capital Lease Obligations

The Company has an outstanding capital lease obligation for certain office furniture totaling $14,503 as of September 30, 2010. The capital lease obligation bears interest at 6.8% with the lease term expiring in February 2011.

5.	Shareholders’ Equity

Preferred Stock

There are 18,598 shares of series A convertible preferred stock outstanding at September 30, 2010. The series A preferred stock is convertible into common stock on a one-for-one basis, bears no dividend, maintains a liquidation preference of $32.00 per share, votes as a class on matters affecting the series A preferred stock and maintains voting rights identical to the common stock on all other matters.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

There are 54,943 shares of series B convertible preferred stock outstanding at September 30, 2010. The series B preferred stock is convertible into common stock on a one-for-one basis, bears no dividend, maintains a liquidation preference of $48.00 per share, votes as a class on matters affecting the series B preferred stock and maintains voting rights identical to the common stock on all other matters.

There are 77,384 shares of series C convertible preferred stock outstanding at September 30, 2010. The series C preferred stock is convertible into common stock on a one-for-one basis, bears no dividend, maintains a liquidation preference averaging $5.60 per share, votes as a class on matters affecting the series C preferred stock and maintains voting rights identical to the common stock on all other matters.

There are 133,919 shares of series D convertible preferred stock outstanding at September 30, 2010. The series D preferred stock is convertible into common stock on a one-for-one basis, bears no dividend, maintains a liquidation preference averaging $4.00 per share, votes as a class on matters affecting the series D preferred stock and maintains voting rights identical to the common stock on all other matters.

Common Stock

In April, 2010 the Company issued 220 common stock shares for the conversion of series A and series B preferred stock shares and 626 shares upon the exercise of stock options. Additionally, in June, 2010, 3,125 common stock shares were issued upon the exercise of stock options.

In February 2010, the Company raised $4,478,801 (net of $1,110,199 in commission and other offering expenses) from the sale of 1,117,800 shares of common stock at a price of $5.00 per share, together with 372,600 five-year warrants to purchase common stock at $5.50 per share. In addition, the placement agent received 29,160 five-year warrants to purchase common stock at $6.25 per share. A portion of the proceeds along with restricted cash of $2,032,164 were used to acquire the perpetual worldwide Medihoney® licensing rights from Comvita (Note 9) and pay off the outstanding U.S. term loan balance of $3,300,000 and the $500,000 promissory note.

Also in February 2010, the Company issued 400,000 shares of its common stock together with 133,333 warrants to purchase its common stock at an exercise price of $5.50 per share and 100,000 warrants to purchase its common stock at an exercise price of $6.25 per share in connection with the purchase of the world-wide Medihoney license rights (see Note 9).

Effective May 12, 2009, 21,875 shares of common stock were issued to outside directors upon vesting of compensatory restricted stock granted on May 12, 2006.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

Stock Purchase Warrants

At September 30, 2010, the Company had warrants outstanding to purchase 1,734,531 shares of the Company’s common stock as outlined below:

Series	Number of Warrants		Exercise Price		Expiration Date

H		331,915	$	8.00	April 30, 2011
I		94,351	$	5.76	April 30, 2011
J		267,858	$	6.16	May 31, 2013
K		399,064	$	9.60	April 1, 2013
L		6,250	$	3.12	March 31, 2014
N		100,000	$	6.25	February 22, 2015
O		372,600	$	5.50	February 22, 2015
P		29,160	$	6.25	February 16, 2015
Q		133,333	$	5.50	February 22, 2015

Total		1,734,531

Stock Options

The Company has a stock option plan under which options to purchase a maximum of 1,250,000 shares of common stock may be issued (“plan options”). The plan permits the granting of both incentive stock options and nonqualified stock options to employees and directors of the Company and certain outside consultants and advisors to the Company. The option exercise price may not be less than the fair market value of the stock on the date of the grant of the option. The duration of each option may not exceed 10 years from the date of grant. Plan options to purchase 243,625 and 207,813 shares of common stock were granted to officers, directors, agents and employees during the nine months ended September 30, 2010 and 2009, respectively, with exercise prices ranging from $3.12 to $5.12 per share. During the nine months ended September 30, 2010 and 2009, 16,249 and 1,875 plan options were forfeited, respectively, and during the nine months ended September 30, 2010, 3,751 were exercised. As of September 30, 2010, options to purchase 1,082,974 shares of the Company’s common stock were issued and outstanding under the plan.

The Company has previously granted nonqualified stock options to officers, directors, agents and employees outside of the stock option plan (“non-plan options”). All non-plan options were granted at the fair market value at the date of grant. During the nine months ended September 30, 2010 and 2009, 24,375 and 29,625 non-plan options expired. As of September 30, 2010, non-plan options to purchase 182,626 shares of the Company’s common stock were issued and outstanding.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

A summary of the Company’s stock option activity and related information for the nine months ended September 30, 2010 and 2009 follows:

	2010					2009
	Options			Weighted Average Exercise Price		Options			Weighted Average Exercise Price

Outstanding – January 1		1,066,350		$	5.08		1,002,828		$	5.52
Granted		243,625		$	5.09		207,813		$	3.04
Forfeited		(16,249	)	$	4.43		(1,875	)	$	5.60
Expired		(24,375	)	$	6.00		(29,625	)	$	8.88
Exercised		(3,751	)	$	3.33		-

Outstanding – September 30		1,265,600		$	5.08		1,179,141		$	5.04

Exercisable at September 30		986,498		$	5.19		848,906		$	5.36

During the nine months ended September 30, 2010 and 2009 the fair value of each service and performance based option award was estimated at the date of grant using the Black-Scholes option pricing model. The weighted-average assumptions used during the three and nine months ended September 30, 2010 and 2009 were as follows:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009

Risk-free interest rate		1.78	%		2.88	%		2.54	%		2.31	%
Volatility factor		107.5	%		83.73	%		79.97	%		92.16	%
Dividend yield		0	%		0	%		0	%		0	%
Expected option life (years)		6.25			6.25			6.25			6.25
Contractual life (years)		10			10			10			10

In both 2010 and 2009, the risk-free rate utilized represents the U.S. Treasury yield curve rate which approximates the risk-free rate for the expected option life at the time of grant. In 2010 and 2009, the volatility factor was calculated based on the seventy-five month-end closing prices of the Company’s common stock preceding the month of stock option grant. The Company uses a seventy-five month volatility period to coincide with the expected stock option life. The dividend yield is 0% since the Company does not anticipate paying dividends in the near future. Based on the Company’s historical experience of options that expire or are cancelled before becoming fully vested, the Company assumed an annualized forfeiture rate of 1.0% for all options. The Company will record additional expense if the actual forfeiture rate is lower than estimated, and will record a recovery of prior expense if the actual forfeiture rate is higher than estimated.

The weighted average fair value per share of options granted during the nine months ended September 30, 2010 and 2009 was $3.59 and $2.34, respectively. During the three and nine months ended September 30, 2010 and 2009, stock option compensation expense was recorded as follows:

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2010		2009		2010		2009

Cost of sales	$	18,885	$	23,327	$	58,383	$	73,764
Selling, general and administrative expenses		182,262		169,461		559,895		594,894

Total stock option compensation expense	$	201,147	$	192,788	$	618,278	$	668,658

As of September 30, 2010, there was $591,703 of unrecognized compensation cost related to non-vested service and $59,565 non-vested performance based awards granted under the plan. These costs are expected to be recognized over the options’ remaining weighted average vesting period of 1.46 years for the service and .25 years for the performance based awards.

For the nine months ended September 30, 2010 and 2009, no income tax benefit was recognized related to stock option activity.

Restricted Common Stock

The Company has a restricted common stock plan in which 312,500 shares of common stock are reserved for issuance.

In May, 2010, 20,000 shares of restricted common stock were granted under the plan to non-employee members of the Company’s board of directors and vest one year from date of the grant. The fair market value at the date of grant, determined by the quoted market price, was $102,400 or $5.12 per share. For the nine months ended September 30, 2010, $42,666 was recorded in operating expense for these grants.

In May, 2006, 21,875 shares of restricted common stock were granted to non-employee members of the Company’s board of directors and vested three years from the date of the grant. The fair market value at the date of grant, determined by the quoted market price, was $145,250 or $6.64 per share. The fair market value of the grant was recognized as compensation expense over the three-year service period. For the nine months ended September 30, 2009, $18,148 was recorded in operating expense for these grants.

Shares Reserved for Future Issuance

At September 30, 2010, the Company had reserved the following shares of common stock for future issuance:

Convertible preferred shares (series A – D)			284,844
Common stock options available for grant			167,026
Common stock options outstanding			1,265,600
Common stock warrants outstanding (series H – Q)			1,734,531
Restricted common stock available for grant			270,625
Restricted common stock grants			20,000

Total common stock shares reserved			3,742,626

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

6.	Comprehensive (Loss) Income

The Company’s comprehensive (loss) income was as follows:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2010			2009		2010			2009

Net (loss) income as reported	$	(502,552	)	$	139,603	$	(1,970,310	)	$	(1,178,978	)
Other comprehensive income:
Foreign currency translation adjustment		181,751			363,948		110,084			610,150

Comprehensive (loss) income	$	(320,801	)	$	503,551	$	(1,860,226	)	$	(568,828	)

7.	Operating Segments

The Company consists of three operating segments: wound care, wound closure – specialty securement devices and skin care. Products in the wound care segment consist of basic and advanced dressings, adhesive strips, ointments and sprays. Wound closure and specialty securement device products include wound closure strips, nasal tube fasteners and a variety of catheter fasteners. The skin care segment consists of antibacterial skin cleansers, hair and body soaps, lotions and moisturizers.

Products in all three operating segments are marketed to long-term care facilities, hospitals, physicians, clinics, home health care agencies and other healthcare institutions. Basic and advanced wound care products are manufactured both internally and outsourced, while the manufacture of skin care products is completely outsourced. Wound closure-specialty securement devices are significantly manufactured in-house. Internally, the segments are managed at the gross profit level. The aggregation or allocation of other costs by segment is not practical.

Segment sales, gross profit and other related information for 2010 and 2009 are as follows:

Three Months Ended September 30, 2010

	Wound Care		Wound Closure- Specialty Securement Devices		Skin Care		Other			Total Company

Net sales	$	14,511,806	$	428,476	$	155,852		-		$	15,096,134

Gross profit		4,165,478		228,010		36,442		-			4,429,930
Total expenses		-		-		-	$	(4,932,482	)		(4,932,482	)

Net loss										$	(502,552	)

Three Months Ended September 30, 2009

Net sales	$	12,289,311	$	409,565	$	183,549		-		$	12,882,425

Gross profit		3,765,137		231,070		48,064		-			4,044,271
Total expenses		-		-		-	$	(3,904,668	)		(3,904,668	)

Net income										$	139,603

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

Nine Months Ended September 30, 2010

	Wound Care		Wound Closure- Specialty Securement Devices		Skin Care		Other			Total Company

Net sales	$	39,451,842	$	1,303,627	$	415,152		-		$	41,170,621

Gross profit		11,675,826		705,387		102,020		-			12,483,233
Total expenses		-		-		-	$	(14,453,543	)		(14,453,543	)

Net loss										$	(1,970,310	)

Nine Months Ended September 30, 2009

Net sales	$	33,023,590	$	1,307,327	$	546,741		-		$	34,877,658

Gross profit		9,969,307		714,272		142,095		-			10,825,674
Total expenses		-		-		-	$	(12,004,652	)		(12,004,652	)

Net loss										$	(1,178,978	)

The following table presents net sales by geographic region.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2010			2009			2010			2009

United States		72	%		72	%		69	%		72	%
Canada		22	%		23	%		25	%		22	%
Other		6	%		5	%		6	%		6	%

For the nine months ended September 30, 2010, one U.S. customer was responsible for 13% of U.S. sales. The Company’s wholly owned Canadian subsidiary sells to one customer who serves as its exclusive third party distributor and comprises 100% of Canada operations trade accounts receivable at September 30, 2010.

8.	Income Taxes

The Company recorded a $160,709 foreign income tax provision for the nine months ended September 30, 2010 and a $47,151 foreign income tax benefit for the nine months ended September 30, 2009 based on the operating results of the Company’s wholly owned Canadian subsidiary. The 2010 provision was comprised of $201,818 current foreign tax payable and $41,109 deferred foreign tax benefit while the 2009 benefit was comprised of $25,788 current foreign tax and $21,363 deferred foreign tax benefits. No benefit was realized for the Company’s net loss from U.S. operations in the nine months ended September 30, 2010 and 2009 due to uncertainties surrounding the Company’s ability to utilize its net operating loss carry forwards.

Due to uncertainties surrounding the Company’s ability to use its U.S. net operating loss carry forwards and net deferred assets, a full valuation allowance has been provided. The Company’s wholly owned Canadian subsidiary, based on recent operating profitability and the prospect of future profitable operations, realized its net operating loss carry forward and deferred tax assets and liabilities.

DERMA SCIENCES, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial Statements (Unaudited)

9.	Comvita Licensing, Manufacturing and Sales Agreement

On February 23, 2010, the Company entered into various agreements with Comvita in which the Company principally received perpetual and exclusive worldwide licensing rights for Medihoney® professional wound and skin care products covering distribution and sales to all markets outside of the consumer market. In connection with the agreements the Company paid $2,250,000 and issued Comvita 400,000 shares of its common stock together with 133,333 warrants to purchase its common stock at an exercise price of $5.50 per share and 100,000 warrants to purchase its common stock at a price of $6.25 per share. The total consideration paid to Comvita was valued at $4,509,000. The $4,509,000 cost of the perpetual and worldwide licensing rights has been recorded as an intangible asset and will be amortized over an estimated useful life of 10 years.

The agreement calls for royalty payments on all sales and additional payments to Comvita if certain Medihoney® net sales milestones are achieved over the course of the license. The license rights may be terminated or rendered non-exclusive by Comvita if the Company fails to meet certain minimum royalty requirements.

10. Subsequent Events

On November 2, 2010, the Company was notified that it had been awarded a $244,479 grant from the U. S. government under the HR: 3590 – Patient Protection and Affordable Care Act (the “Act”) in connection with DSC127 its novel pharmaceutical product currently undergoing its Phase II trial. Applicants were required to submit detailed information demonstrating that their research conformed to the parameters of the Act, along with a summary of qualifying expenditures that formed the basis for the award.

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

Quarter Ended September 30, 2010 Compared to Quarter Ended September 30, 2009

Overview

The following table highlights the quarter ended September 30, 2010 versus 2009 operating results:

	Quarter Ended September 30,						Variance
	2010			2009
Gross Sales	$	17,653,812		$	15,356,917		$	2,296,895		15.0	%
Sales adjustments		(2,557,678	)		(2,474,492	)		(83,186	)	3.4	%
Net sales		15,096,134			12,882,425			2,213,709		17.2	%
Cost of sales		10,666,204			8,838,154			1,828,050		20.7	%
Gross profit		4,429,930			4,044,271			385,659		9.5	%
Selling, general and administrative expense		4,690,054			3,677,182			1,012,872		27.5	%
Research and development expense		175,380			70,412			104,968		149.1	%
Interest expense		119,521			220,839			(101,318	)	(45.9	)%
Other income, net		(75,530	)		(69,002	)		(6,528	)	9.5	%
Total expenses		4,909,425			3,899,431			1,009,994		25.9	%
(Loss) income before income taxes		(479,495	)		144,840			(624,335	)	431.1	%
Provision for income taxes		23,057			5,237			17,820
Net (loss) income	$	(502,552	)	$	139,603		$	(642,155	)

Gross to Net Sales Adjustments

Gross to net sales adjustments comprise the following:

	Quarter Ended September 30,
	2010			2009
Gross Sales	$	17,653,812		$	15,356,917
Trade rebates		(1,868,953	)		(1,820,697	)
Distributor fees		(301,711	)		(266,783	)
Sales incentives		(185,638	)		(164,711	)
Returns and allowances		(79,910	)		(118,355	)
Cash discounts		(121,466	)		(103,946	)
Total adjustments		(2,557,678	)		(2,474,492	)
Net sales	$	15,096,134		$	12,882,425

Trade rebates increased in 2010 versus 2009 due principally to higher Canadian sales subject to rebate, partially offset by the discontinuation of a significant U.S. private label customer rebate program effective November 1, 2009. The increase in distribution fee expense is commensurate with the increase in Canadian net sales upon which it is based. The increase in sales incentive expense reflects a increase in the number of the traditional wound care and private label sales incentive programs, partially offset by lower first aid products sales incentive programs in 2010 versus 2009. The sales returns and allowances decrease is due to a lower incidence of advanced wound care, private label and first aid product returns in 2010 versus 2009. The increase in cash discounts reflects higher U.S. sales subject to cash discount.

Rebate Reserve Roll Forward

A three month roll forward of the trade rebate accruals at September 30, 2010 and 2009 is outlined below:

	Quarter Ended September 30,
	2010			2009
Beginning balance – June 30	$	2,385,569		$	2,309,304
Rebates paid		(1,874,922	)		(1,759,195	)
Rebates accrued		1,868,953			1,820,697
Ending balance – September 30	$	2,379,600		$	2,370,806

The $5,969 decrease in the trade rebate reserve balance for the three months ended September 30, 2010 is due to timing. There has been no other discernable change in the nature of our business in 2010 as it relates to the accrual and subsequent payment of rebates.

Net Sales and Gross Margin

The following table highlights the September 30, 2010 versus 2009 product line net sales and gross profit:

	Quarter Ended September 30,						Variance
	2010			2009
Net Sales	$	15,096,134		$	12,882,425		$	2,213,709	17.2	%
Cost of sales		10,666,204			8,838,154			1,828,050	20.7	%
Gross Profit	$	4,429,930		$	4,044,271		$	385,659	9.5	%

Gross Profit %		29.3	%		31.4	%

Consolidated net sales increased $2,213,709, or 17.2% (16.0% adjusted for exchange), in 2010 versus 2009. Canadian net sales increased $251,138, or 8.7%, to $3,144,667 in 2010 from $2,893,529 in 2009. This increase was driven by favorable exchange of $152,221 associated with a 5.3% strengthening of the Canadian dollar, coupled with sales growth of $98,917. The sales growth reflects the impact of real growth of $499,229, or 17.3% due to higher demand, partially offset by an inventory decrease on the part of our exclusive Canadian distributor of $400,312 during the quarter. U.S. net sales increased $1,622,782, or 16.2%, to $11,611,678 in 2010 from $9,988,896 in 2009. The increase was principally driven by higher first aid product sales of $1,413,528, or 42.7%, and advanced wound care sales of $458,754, or 21.3%, partially offset by lower private label sales of $279,539, or 12.5%. The balance of U.S. sales consisting of traditional wound care, specialty fixation, burn care and skin care and bathing sales were up 1.3% quarter to quarter. The increase in first aid products sales reflects new business, improving demand and the spot sale of slow moving inventory. The higher advanced wound care sales reflect continued growth of our new products in response to expanded sales and marketing efforts. The decrease in private label sales reflects the loss of business and timing. Advanced wound care sales of $339,789 associated with our recently initiated international growth strategy also contributed to the consolidated net sales increase.

Consolidated advanced wound care sales increased $852,311, or 38.1%, to $3,087,831 in 2010 from $2,235,520 in 2009. All other sales (core sales) increased $1,361,398, or 12.8%, to $12,008,303 in 2010 from $10,646,905 in 2009.

Consolidated gross profit increased $385,659, or 9.5%, in 2010 versus 2009. The consolidated gross profit margin percentage decreased to 29.3% in 2010 from 31.4% in 2009. The increase in gross profit dollars reflects the higher sales, partially offset by the lower gross profit margin percentage. The lower gross margin profit percentage reflects the increase in lower margined core sales, coupled with increasing product costs and higher obsolescence and transportation expenses, partially offset by the benefit of increasing higher margined advanced wound care sales.

Selling, General and Administrative Expenses

The following table highlights September 30, 2010 versus 2009 selling, general and administrative expenses by type:

	Quarter Ended September 30,				Variance
	2010		2009
Distribution	$	436,772	$	443,592	$	(6,820	)	(1.5	)%
Marketing		405,516		371,624		33,892		9.1	%
Sales		1,819,067		1,306,140		512,927		39.3	%
General and administrative		2,028,699		1,555,826		472,873		30.4	%
Total	$	4,690,054	$	3,677,182	$	1,012,872		27.5	%

Selling, general and administrative expenses increased $1,012,872, or 27.5% (26.7% adjusted for exchange), in 2010 versus 2009, including an increase of $32,349 in Canadian selling, general and administrative expenses attributable to exchange.

Distribution expense decreased $6,820, or 1.5% (2.2% adjusted for exchange), in 2010 versus 2009, including an increase of $2,925 due to exchange. This decrease reflects lower labor requirements in the Houston distribution center, partially offset by higher labor requirements in St. Louis coupled with lower operating expenses.

Marketing expense increased $33,892, or 9.1% (8.8% adjusted for exchange), in 2010 versus 2009, including an increase of $549 due to exchange. The increase is principally attributable to higher U.S. compensation and recruiting costs in support of our growth initiatives. Lower overall first aid product spending also contributed.

Sales expense increased $512,927, or 39.3% (38.5% adjusted for exchange), in 2010 versus 2009. Expenses in Canada increased $10,752 (including a $9,871 increase related to exchange) due to higher compensation and benefit and commission costs, partially offset by lower group purchasing organization fees. Expenses in the U.S. increased $304,149. This increase is principally attributable to incremental expense associated with the planned expansion of the U.S. sales force from ten to twenty representatives that was completed by the end of June, partially offset by lower first aid products compensation and benefits associated with a position eliminated in the first quarter and not replaced. Incremental international expenses of $198,026 for compensation and benefits, travel, recruiting and sample expenses associated with the start up of our international growth initiative also contributed.

General and administrative expense increased $472,873, or 30.4% (29.2% adjusted for exchange), in 2010 versus 2009. Expenses in Canada increased $31,510 (including a $19,004 increase related to exchange). Net of exchange, expenses were up $12,506 driven principally by compensation and benefits associated with inflationary increases and one new position, coupled with higher insurance and audit expenses. Expenses in the U. S. increased $414,878. This increase reflects incremental amortization expense of $112,700 associated with the worldwide Medihoney license agreement signed in February 2010, higher legal expense of $89,600 principally associated with intellectual property maintenance expenses, higher board related expense of $72,900, higher planned investor relations expenses of $43,200 designed to increase investor awareness and improve our stock’s trading volume, bad debt expense of $35,900, together with higher travel, professional service and inflation driven compensation and benefit expenses. Incremental international expenses of $26,485 consisting of transition related management, legal and travel expenses associated with the start up of our international growth initiative also contributed.

Research and Development Expense

Research and development expense increased $104,968 to $175,380 in 2010 from $70,412 in 2009. The increase reflects incremental patient enrollment costs leading up to the close out of trial enrollment in September, 2010 together with ongoing monthly data management expenses that began in October 2009.

Interest Expense

Interest expense decreased $101,318 to $119,521 in 2010 from $220,839 in 2009. The decrease is principally attributable to lower term and promissory note interest associated with the payoff of these loans in February 2010, lower timing related loan related fees and lower deferred financing expense due to the write-off of a portion of the outstanding deferred financing balance in connection with the payoff of the term loan. Ongoing line of credit interest was higher quarter to quarter due to higher borrowing levels and slightly higher interest rates.

Other Income

Other income increased $6,528 to $75,530 in 2010 from $69,002 in 2009. The main drivers for the net quarter to quarter increase were higher royalty and miscellaneous income, partially offset by lower exchange income.

Income Taxes

We recorded a $23,057 foreign income tax provision for 2010 consisting of a $25,174 current foreign tax provision and a $2,117 deferred foreign tax benefit based on our Canadian subsidiary’s operating results. No tax benefit was recorded for our U.S. operations in 2010 or 2009 due to uncertainty surrounding our ability to use available net operating loss carry forwards and net deferred tax assets. In 2009, we recorded a $5,237 foreign income tax provision consisting of a $3,896 current foreign tax provision and a $1,341 deferred foreign tax provision based on our Canadian subsidiary’s operating results.

Due to uncertainties surrounding our ability to use our U.S. net operating loss carry forwards and net deferred tax assets, a full valuation allowance for the U.S. net deferred tax assets has been provided.

Net (Loss) Income

We generated a net loss of $502,552, or ($0.08) per share (basic and diluted), in 2010 compared to a net income of $139,603, or $0.03 per share (basic and diluted), in 2009.

Nine Months Ended September 30, 2010 Compared to Nine Months Ended September 30, 2009

Overview

The following table highlights the nine months ended September 30, 2010 versus 2009 operating results:

	Nine Months Ended September 30,						Variance
	2010			2009
Gross Sales	$	48,918,341		$	41,668,350		$	7,249,991		17.4	%
Sales adjustments		(7,747,720	)		(6,790,692	)		(957,028	)	14.1	%
Net sales		41,170,621			34,877,658			6,292,963		18.0	%
Cost of sales		28,687,388			24,051,984			4,635,404		19.3	%
Gross profit		12,483,233			10,825,674			1,657,559		15.3	%

Selling, general and administrative expense		13,603,071			11,244,347			2,358,724		21.0	%
Research and development expense		415,232			288,338			126,894		44.0	%
Interest expense		414,120			631,909			(217,789	)	(34.5	)%
Loss on debt extinguishment		114,072			-			114,072
Other income, net		(253,661	)		(112,791	)		(140,870	)	124.9	%
Total expenses		14,292,834			12,051,803			2,241,031		18.6	%
Loss before income taxes