MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Statements Regarding Forward Looking Information

Certain statements in this report contain or may contain forward-looking statements that are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.  These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause the Company's actual results to differ materially from those in the forward-looking statements.  These factors include, but are not limited to, the Company's ability to operate as a going concern and to raise sufficient capital to fund its operations, its ability to satisfy its obligations as they become due, acceptance of the Company's products, the Company's dependence on distributors and a few significant customers, risks associated with international operations and international distribution and other factors.  Most of these factors are difficult to predict accurately and are generally beyond our control.  You should consider the areas of risk described in connection with any forward-looking statements that may be made herein.  Readers are cautioned not to place undue reliance on these forward-looking statements and readers should carefully review this report in its entirety.  Except for the Company's ongoing obligations to disclose material information under the Federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. These forward-looking statements speak only as of the date of this report and you should not rely on these statements without also considering the risks and uncertainties associated with these statements and our business.

Overview

Sales of the Company’s products, the pura DYN ^® bypass oil filtration system (the "Puradyn" ) and replaceable filter elements will depend principally upon end user demand for such products and acceptance of the Company’s products by original equipment manufacturers (“OEMs”).  The oil filtration industry has historically been competitive and, as is typically the case with innovative products, the ultimate level of demand for the Company’s products is subject to a high degree of uncertainty. Developing market acceptance for the Company’s existing and proposed products will require substantial marketing and sales efforts and the expenditure of a significant amount of funds to inform customers of the perceived benefits and cost advantages of its products.  As a result of our limited resources, to date we have not had adequate funds available to undertake these necessary marketing efforts.

Currently no bypass oil filtration system has captured a substantial share of the estimated recurring $15 billion potential market, based upon figures supplied by The Rhein Report, a diesel engine industry consulting, publishing and market research company.  We believe we are in a unique position to capitalize on the growing acceptance of bypass oil filtration given that our product and our Company are positioned as, including, but not limited to:

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A competitively priced, value-added product, delivering cost savings, equipment life extension and down time reduction based on an advanced, patented technology;

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An alternative solution to the rising costs and national concerns over dependence on foreign oil; and

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Providing an operational maintenance solution to end users in conjunction with existing and reasonably foreseeable federal environmental legislation such as new regulation affecting diesel engines and diesel fuels, mandating cleaner diesel engines which first went into effect January 1, 2007, with additional and more stringent legislation in 2010.

We focus our sales strategy on direct sales and distribution efforts as well as on the development of a strong nationwide distribution network that will not only sell but also install and support our product.  We currently have more than 100 active distributors in the U.S. and internationally.  The number of distributors will constantly change as we add new distributors as well as when OEMs come onboard with their distribution network.

We continue to focus our sales and marketing efforts to target industries more open to innovative methods to reduce oil maintenance operating costs.  These industries are searching for new and progressive ways, including bypass oil filtration, to maintain their equipment.

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This strategy includes focus on:

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The expansion of existing strategic relationships we have with John Deere, Avis, and others;

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Continued development and expansion of our distribution network with distributors who are trained by us and stock inventory in order to establish a sales- and service-oriented nationwide infrastructure;

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Continuing to target existing and new industrial/construction equipment fleets and major diesel engine and generator set OEMs;

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Creating customer ‘pull-through’, a sustained level of request for our product on the OEM level; and

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Converting customer evaluations into sales, both immediate and long term.

While this is a long-term and ongoing commitment, we believe we have achieved growing industry acceptance based on recent accomplishments:

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Increased activity in South and Central America, Europe and Asia.  

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Increased activity in the open pit mining industry for bypass oil filtration.

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Extended retrofit programs with domestic and international industrial service companies.

We believe that the renewed interest shown in the technology of bypass oil filtration as an economic alternative to significantly rising oil prices, dependence upon foreign oil, coupled with the added benefits of being environmentally beneficial and a means to conserve oil, has timely and favorably positioned the Company as a manufacturer of a cost efficient “green” product.

We also believe, drawing upon feedback received from potential customers, that industry acceptance will continue to grow in 2011, but at a slower pace than what we expected in the first quarter of 2011. There can be no assurance that any of our sales efforts or strategic relationships will meet management’s expectations or result in actual revenues.

The Company’s sales effort not only involves educating the potential customer on the benefits of our product, but also allowing the end-user to test and evaluate the Puradyn system on its fleet equipment.  While set for a specific period of time, typically ranging from three to twelve months, evaluations are often influenced by a number of variables including equipment type and applications downtime or servicing, which may extend the evaluation period.  Consequently, the sales cycle can be relatively long.  

We believe international sales are especially well suited to our product given that much of the equipment is located in remote areas, therefore, due solely to logistics of manpower resources and physically being able to reach the equipment in a timely manner to perform the necessary oil related maintenance.  In addition, in certain countries, fuel and emission regulations are not as stringent as in North America, causing engines to operate under more severe conditions.  Certain applications representing a higher and more immediate return on investment are prevalent in use outside of North America and end-users consequently are more receptive to the total maintenance package including the use of oil analysis, which the Puradyn system requires to verify oil condition.  

Our focus on specific industries, which began in 2009, has shown to pay dividends into 2011, with these certain niche industries representing over 50% of sales as compared to 20% in the base period in 2009.

Key to accomplishing our goals will be optimizing our limited resources and obtaining sufficient capital.  We will need to remain focused on working with OEMs, continue developing the independent distributors we have onboard and maintain growth within the major accounts using our system.  To accomplish these tasks, we will need to obtain capital funding and add appropriate sales and marketing support to be sure our distributors and customers are served.  We will evaluate further manpower needs as we grow our OEM account list.  The expansion into the OEM area is rewarding in the aspect that it provides a steady flow of material requirements for our manufacturing facility.  Additionally, OEM business allows us more stability in retaining trained manufacturing personnel, a stronger supply chain with steady production, economies of scale, and the ability to better utilize our overhead with higher average material turn rates.

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We continue to address our liquidity and working capital issues as we continue to seek additional capital from institutional and private investors and current stockholders.  Historically, we have faced difficulties in raising adequate capital and we anticipate that those efforts will continue given the current uncertainties facing the capital markets in the U.S.  We also continue to implement cost reductions in an effort to improve margins, including securing alternative suppliers for raw materials and manufacturing and anticipate these costs reductions will positively impact our results of operations during the balance of 2011 and beyond.  To facilitate improved cost reductions, during the fourth quarter of 2010 we added a buyer whose focus is on better material acquisition costs and more efficient purchasing methods. Although our product costs have increased over the past few years, we have not fully passed on these cost increases. We announced a price increase effective in the third quarter of 2011, to recoup a portion of the increased costs we have previously absorbed.  

Going Concern

Our financial statements have been prepared on the basis that we will operate as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  We have incurred net losses each year since inception and have relied on the sale of our stock from time to time and loans from third parties and from related parties to fund our operations.  These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder have led our independent registered public accounting firm Webb & Company P.A. to include a statement in its audit report relating to audited consolidated financial statements for the years ended December 31, 2010 and 2009 expressing substantial doubt about our ability to continue as a going concern.  Our ability to continue as a going concern is dependent upon our ability to obtain the necessary financing to meet our obligations and repay our liabilities when they become due and to generate profitable operations in the future.  We plan to continue to provide for our capital requirements through the sale of equity securities, however, we have no firm commitments from any third party to provide this financing and we cannot assure you we will be successful in raising working capital as needed.  There are no assurances that we will have sufficient funds to execute our business plan, pay our obligations as they become due, or generate positive operating results.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, financing operations, warranty obligations and contingencies and litigation.  We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

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Net Sales

Net sales decreased 34.4% in the three months ending June 30, 2011 compared to the three months ending June 30, 2010.  The decrease in sales was attributable to two international customers who scaled down their purchases to approximately 30% of their purchases for the same period in 2010.

Sales to four customers accounted for 13%, 13%, 13% and 12% (for a total of 51%) of net sales for the three-months ended June 30, 2011. Sales to two customers accounted for 28% and 17% (for a total of 45%) of net sales for the three-months ended June 30, 2010.  

During the three months ended June 30, 2011, we experienced a decline in sales as companies indicated to us that they were postponing purchases to conserve resources. However, we believe that eventually these deferred purchase decisions will result in improved sales as strategic plans are changed by the management of our customers, although there can be no assurances that this will occur or, it it occurs, during which periods.

Cost of Products Sold

Gross profit, as a percentage of sales, decreased from 29.6% in the three months ending June 30, 2010 to 20.5% in the three months ending June 30, 2011.  The increase in cost of goods sold, which generates a lower gross profit, is primarily attributable to the fixed manufacturing overhead costs that aren’t absorbed under lower sales volumes. Other increases in cost of products sold included higher costs of raw materials (particularly steel and cotton), rework charges and increased wages and benefit costs.  Further, for the three months ended June 30, 2010, there was an adjustment to inventory reserves that reduced cost of sales; there was no such adjustment during the same period in 2011. We have announced a price increase effective September 15, 2011, which we anticipate will improve our gross profit margins in the future.

Salaries and Wages

Salaries and wages decreased 0.8% for the three months ending June 30, 2011 compared to the three months ending June 30, 2010.  This minor variance resulted from the addition of one engineer (a former consultant to the company) and a buyer that occurred after June 30, 2010, offset by the departure of one sales person in the first quarter of 2011 and accounting personnel changes that occurred in the second quarter of 2010.

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Salaries and wages, as a percentage of sales, were 53.8% for the three months ending June 30, 2011 and 35.6% for the three months ending June 30, 2010. The increase in salaries and wages as a percentage of sales was due primarily to the decrease in sales for the three months ending June 30, 2011 compared to the same period in 2010.

Management does not anticipate any changes to our salaries and wages at our current sales volume.

Selling and Administrative Expenses

Selling and administrative expenses decreased by 30.2% for the three months ended June 30, 2011 from the comparable period in 2010.  The reduced expense resulted from restructuring the commission costs in 2011, write off in 2010 of sample units, conversion of a contract engineer to an employee in 2011 and reduced professional fees in 2011. These expense reductions were slightly offset by an increase in patent expenses for new patent applications.

The following table lists the major categories of expenses included in Selling and Administrative expenses:

Travel & Marketing expenses include the costs of providing evaluation units to potential customers. During 2010, we changed our policy requiring potential customers to purchase or place a deposit on test units. As a result of this change in policy, in 2010 we expensed units that were sent out for promotional and test purposes that we believe will not be returned. We did not have this cost in 2011. Additionally, during 2010 we incurred higher travel expenses in sending engineers to assist with installation issues, sales personnel travel to trade shows and international travel by sales and management to reach targeted niche industry customers.

Engineering expenses decreased substantially as a contract engineer was converted to an employee in the first quarter of 2011. The expense of this former contractor is currently included in Salaries and Wages and a reduction in contract engineering expense resulted from this change.

Professional fees decreased during the three months ended June 30, 2011 compared to 2010 primarily due to legal expenses that were incurred in 2010 which were associated with a former employee’s dispute on wages.  Additionally, we incurred consulting expenses in the United Kingdom subsidiary in 2010 that were not incurred in 2011, and additional financial consulting fees during the three month period ending June 30, 2010.

We terminated the month to month agreement with our investor relations firm in March, 2011. Accordingly, we did not incur any investor relations expense during the three months ending June 30, 2011.  Patent expenses increased 59% during the three months ending June 30, 2011 as compared to the three months ending June 30, 2010 as a result of US and international patent applications submitted during the first six months of 2011.

We anticipate expenses for the remainder of 2011 should be similar to those incurred in the three months ending June 30, 2011.

Interest Expense

Interest expense remained relatively constant for the three months ending June 30, 2011 compared to the three months ending June 30, 2010. The Company pays interest monthly on the notes payable to an executive officer, director and stockholder at prime rate less one-half percent, which was 2.54% as of June 30, 2011 as opposed to 2.64% as of June 30, 2010.  

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Net Sales

Net sales decreased 3.7% in the six months ending June 30, 2011 compared to the six months ending June 30, 2010.  The majority of our sales decrease occurred in the months of April and June of this year as we believe this to be a result of our customers’ hesitation to commit their resources in an unknown economic environment. We anticipate that our future sales will also be influenced by the overall spending patterns of our major customers.

Sales to three customers individually accounted for 19%, 15% and 11% (for a total of 45%) for the six months ending June 30, 2011, while sales to two customers individually accounted for 22% and 19% (for a total 41%) of net sales for the six-months ended June 30, 2010.  

Cost of Products Sold

Gross profit, as a percentage of sales, decreased from 34.7% in the six months ending June 30, 2010 to 28.7% in the six months ending June 30, 2011.  Although sales decreased 3.7% as noted above, cost of products sold increased 5.1%. The increase in cost of goods sold, which generates a lower gross profit, is primarily attributable to the fixed manufacturing overhead costs that aren’t absorbed under lower sales volumes. Other increases in cost of products sold during the six months ended June 30, 2011 included rework charges and increased wages and benefit costs.  Additionally, an adjustment to inventory reserves in the first quarter of 2010 reduced cost of sales; there was no adjustment recorded in 2011. We have announced a price increase effective September 15, 2011, which we anticipate will improve our gross profit margins in the future.

Salaries and Wages

Salaries and wages increased 6.3% for the six months ending June 30, 2011 compared to the six months ending June 30, 2010.  This increase was primarily due to the addition of a buyer in November 2010 and, as previously described, the conversion of a contract engineer to employee status. Salaries and wages, as a percentage of sales, were 39.3% for the six months ending June 30, 2011 and 35.6% for the six months ending June 30, 2010. Management does not anticipate any changes to our salaries and wages at our current sales volume.

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In February 2011 we issued stock options to employees, which accounts for the majority of the increased employee benefits costs for the six months ending June 30, 2011 compared to the same period in 2010. Increased medical insurance premiums also contributed to the increase in employee benefits for the six months ending June 30, 2011 compared to the six months ending June 30, 2010.

Travel & Marketing decreased 47% for the six months ending June 30, 2011 compared to the six months ending June 30, 2010. As previously mentioned, the write off of promotional units in 2010 increased our marketing expenses during the six months ending June 30, 2010 compared to the six months ending June 30, 2011. Additionally, we changed the commission structure during 2010 which resulted in lower sales and marketing costs in the six months ending June 30, 2011 when compared to the same period in 2010.

Engineering expenses decreased substantially as a contract engineer was converted to an employee in the first quarter of 2011. The expense of this former contractor is currently included in Salaries and Wages and a reduction in contract engineering expense resulted from this change.  Additionally, we reduced travel and trade show attendance during 2011 compared to the same period in 2010.

Professional fees decreased 25.8% for the six months ending June 30, 2011 compared to the six months ending June 30, 2010. We incurred higher professional fees in 2010 as a result of legal expenses associated with former employees. We also incurred additional accounting fees in 2010 relating to our United Kingdom subsidiary which was closed in 2009.  During 2010 we incurred additional expenses as a result of higher utilization of outsourced services, such as accounting and finance support.

Our investor relations expense decreased as a result of the cancellation of our contract with Emerging Markets. We are currently evaluating our investor relations program to identify what areas provide the most benefit to our shareholders. We anticipate that our expenses for investor relations will remain at or below 2010 levels for the remainder of the current year.

Patent expense for the six months ending June 30, 2011 compared to the six months ending June 30, 2010 was substantially higher as a result of several new patent applications and submission of certain existing patents for international recognition. We anticipate that these costs will remain at 2010 levels for the balance of the year.

In February, 2010 we paid a consultant for services with stock options. During 2011 we did not have this expense, and accordingly, there was a reduction in stock compensation during the six months ending June 30, 2011 compared to the six months ending June 30, 2010.  In May 2011 we entered into an agreement with Monarch Communications, Inc., to pay a portion of our public relations firm fees in stock. This amount has been reported as a

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marketing expense. Amounts reported as stock compensation for 2011 represent the value of options issued to Directors pursuant to our 2000 Non-Employee Directors Stock Option Plan. We do not anticipate issuing stock for services other than for those marketing services and Director compensation through the end of the current year.

Interest Expense

Interest expense remained relatively constant for the period ending June 30, 2011 as compared to the period ending June 30, 2010 and was incurred primarily on the outstanding balance of the notes payable to an executive officer, director and stockholder. The Company pays interest monthly on the notes payable at the prime rate less one-half percent, which was a weighted average of 2.54% as of June 30, 2011 as opposed to 2.64% as of June 30, 2010.  

Liquidity and Capital Resources

Liquidity is the ability of a company to generate adequate amounts of cash to meet its obligations. As of June 30, 2011, the Company had cash and cash equivalents of $70,483, as compared to $49,813 at December 31, 2010. At June 30, 2011, we had negative working capital of ($706,921) and our current ratio (current assets to current liabilities) was 0.62 to 1. At December 31, 2010 we had negative working capital of ($440,952) and our current ratio was 0.70 to 1. The increase in our working capital deficit and the decrease in our current ratio is primarily attributable to the increase in accounts payable, notes payable to stockholders and accrued liabilities.  

We have incurred net losses each year since inception and at June 30, 2011 we had an accumulated deficit of $52,892,377.  Our net sales are not sufficient to fund our operating expenses.  Historically, we have relied on the sale of our stock from time to time and loans from third parties and from related parties to fund our operations.  During 2010, we raised a total of $445,100 in capital from an institutional investor and current stockholders and during the six months ended June 30, 2011 we raised an additional $100,000.  In addition, as of June 30, 2011, we owed our stockholder approximately $6.6 million for funds he has advanced to us from time to time for working capital under a line of credit facility.  In addition, a Director has advanced $100,000 due October 1, 2011 which bears interest at 5% per annum. Interest expense on both loans totaled $81,190 for the six months ended June 30, 2011.

We do not currently have any commitments for capital expenditures. Our current cash position is insufficient to cover our current operating needs. While we anticipate cash flows from 2011 sales activity, additional cash will still be needed to support operations, meet our working capital needs and satisfy our obligations as they become due. While we are actively seeking additional equity investments, we have no firm commitments from any third parties and there are no assurances we will be successful in attracting additional capital. In addition, as set forth above, we owe our stockholder $6.6 million which is due on December 31, 2012 or (i) at such time as we have raised an additional $7 million over the $3.5 million raised in prior offerings, or (ii) at such time as we are operating within sufficient cash flow parameters to sustain operations, or (iii) until a disposition of our company, such as an acquisition or merger, occurs. We do not have sufficient funds to pay this loan when it becomes due and there are no assurances the note holder will extend the due date.  

We have implemented measures to preserve our ability to operate, including organizational changes, a reduction and/or deferral of salaries, reduction in personnel and renegotiating creditor and collection arrangements. If we are not successful in raising additional capital in the near future, it is possible we will be required to accelerate our contingent plans to more aggressively reduce spending, including drastic reductions in our work force, severe cutbacks in our production facilities and elimination of overhead costs that do not contribute to our level of sales activity. If budgeted sales levels are not achieved and/or significant unanticipated expenditures occur, or if we are not able to raise additional investment capital, we may have to modify our business plan, reduce or discontinue some of our operations or seek a buyer for part of our assets to continue as a going concern through 2011. There can be no assurance that we will be able to raise additional capital or that sales will increase to the level required to generate profitable operations to provide positive cash flow from operations. In that event, it is possible that stockholders could lose their entire investment in our company.  These factors raise substantial doubt about our ability to continue as a going concern.

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Operating activities

For the six-month period ended June 30, 2011 net cash used in operating activities was $421,256, which primarily resulted from the net loss of $777,966.  The negative effect of the net loss on working capital is offset by an increase in accounts payable in the amount of $136,004, an increase in accrued liabilities of $86,200 and a positive effect on working capital resulted from a decrease in prepaid expenses in the amount of $50,611.

Investing activities

For the six months ending June 30, 2011, $6,190 cash was used in investing activities for the purchase of property and equipment.

Financing activities

Net cash provided by financing activities was $448,011 for the six months ending June 30, 2011, composed of $100,000 of net proceeds received from stock issued for cash and $350,000 in advances under the line of credit from our stockholder as described above less $1,989 in payment of capital lease obligations.

Critical Accounting Policy

General

The preparation of financial statements requires management to utilize estimates and make judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. These estimates are based on historical experience and on various other assumptions that management believes to be reasonable under the circumstances. The estimates are evaluated by management on an ongoing basis, and the results of these evaluations form a basis for making decisions about the carrying value of assets and liabilities that are not readily apparent from other sources. Although actual results may differ from these estimates under different assumptions or conditions, management believes that the estimates used in the preparation of our financial statements are reasonable. The critical accounting policies affecting our financial reporting are summarized in Note 1 to the consolidated financial statements included elsewhere.

Impact of Inflation and Foreign Currency Translation

Inflation has not had a significant impact on the Company's operations. However, any significant decrease in the price for oil or labor, environmental compliance costs, and engine replacement costs could adversely impact the Company's end users cost/benefit analysis as to the use of the Company's products. While we no longer have operations in Great Britain, we maintain a small amount of cash on deposit in a bank account related to Ltd.’s previous operations and we continue to collect outstanding accounts receivable. These activities resulted in a minor foreign currency translation adjustment during the six month period ending June 30, 2011. The impact of fluctuations in foreign currency has not been significant during the six month period ended June 30, 2010.  The exchange rate, the Great British pound to the U.S. dollar fluctuated from 1.59 on December 31, 2010 to 1.60 on June 30, 2011.

Off Balance Sheet Financing

None. The Company has not entered into any other financial guarantees or other commitments to guarantee the payment obligations of any third parties, nor has it entered into any derivative contracts that are indexed to our shares and classified as stockholder’s equity or that are not reflected in our consolidated financial statements. Furthermore, the Company does not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing or hedging services with us.

ITEM 3.