**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

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**FORM 10-K**

 

**Annual Report Pursuant toSection 13 or 15(d) of theSecurities Exchange Act of 1934**

 

**Forthe fiscal year ended December 31, 2003**

 

**CommissionFile Number: 33-7106-A**

 

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| **NATURADE,  INC**.                                                               |
|-----------------------------------------------------------------------------------|
| (Exact name of registrant as specified in  its charter)                           |
|                                                                              |
| **Delaware**                                                                      |   | **23-2442709** |
| (State or other jurisdiction of  incorporation or organization)                   |   | (I.R.S. Employer Identification No.) |
|                                                                              |   |   |
| **14370 Myford Road, Irvine, CA**                                                 |   | **92606** |
| (Address of principal executive offices)                                          |   | (Zip code) |
|                                                                              |
| Registrant’s telephone number, including  area code: **(714) 573-4800** |
|                                                                              |
| Securities registered pursuant to  Section 12(b) of the Act:                 |
| **None**                                                                          |
|                                                                              |
| Securities registered pursuant to  Section 12 (g) of the Act:           |
| **None**                                                                          |

 

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Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý  No o

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. ý

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Act).  Yes oNo ý

 

As of June 30,2003, the last business day of the registrant’s most recently completed secondfiscal quarter, the aggregate market value of such Common Stock held bynon-affiliates was $54,713 based on the average of the bid and asked price onthat date.

 

As of March26, 2004, 44,533,866 shares of the registrant’s Common Stock were outstanding.

 

 

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**TABLE OF CONTENTS**

 
| PART I     |                                                                                            |   |
|------------|-------------------------------------------------------------------------------------------------|--------|
|       |                                                                                            |   |
| Item 1.    | Business                                                                                        |   |
|       |                                                                                            |   |
| Item 2.    | Properties                                                                                      |   |
|       |                                                                                            |   |
| Item 3.    | Legal Proceedings                                                                               |   |
|       |                                                                                            |   |
| Item 4.    | Submission of Matters to a Vote of Security  Holders                                            |   |
|       |                                                                                            |   |
| PART II    |                                                                                            |   |
|       |                                                                                            |   |
| Item 5.    | Market for the Registrant’s Common Equity  and Related Stockholder Matters                 |   |
|       |                                                                                            |   |
| Item 6.    | Selected Financial Data                                                                         |   |
|       |                                                                                            |   |
| Item 7.    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations     |   |
|       |                                                                                            |   |
| Item 7A.   | Quantitative and Qualitative Disclosures  About Market Risk                                     |   |
|       |                                                                                            |   |
| Item 8.    | Financial Statements and Supplementary Data                                                     |   |
|       |                                                                                            |   |
| Item 9.    | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure           |   |
|       |                                                                                            |   |
| Item9A.    | Controls and Procedures                                                                         |   |
|       |                                                                                            |   |
| PART  III. |                                                                                            |   |
|       |                                                                                            |   |
| Item 10.   | Directors and Executive Officers of the  Registrant                                             |   |
|       |                                                                                            |   |
| Item 11.   | Executive Compensation                                                                          |   |
|       |                                                                                            |   |
| Item 12.   | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters |   |
|       |                                                                                            |   |
| Item 13.   | Certain Relationships and Related  Transactions                                                 |   |
|       |                                                                                            |   |
| Item 14.   | Principal Accountant Fees and Services                                                          |   |
|       |                                                                                            |   |
| PART  IV.  |                                                                                            |   |
|       |                                                                                            |   |
| Item 15.   | Exhibits, Financial Statement Schedules and  Reports on Form 8-K                           |   |

 

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ForwardLooking Information

 

This Annual Report on Form 10-K containsforward-looking statements within the meaning of that term in the PrivateSecurities Litigation Reform Act of 1995 (Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934).  Additional written or oral forward-lookingstatements may be made by the Company from time to time, in filings with theSecurities Exchange Commission or otherwise. Statements contained herein that are not historical facts areforward-looking statements.  Inaddition, the reader may identify forward-looking statements by the use of thewords “anticipates,” “expects,” “intends,” “plans,” variations thereof andsimilar expressions.  All suchforward-looking statements are made pursuant to the safe harbor provisions ofthe Private Securities Litigation Reform Act of 1995.

 

Forward-lookingstatements are inherently subject to risks and uncertainties, some of whichcannot be predicted or quantified. Consequently, future events and actualresults could differ materially from those set forth in, contemplated by, orunderlying the forward-looking statements contained in this Annual Report.Statements in this Annual Report on Form 10-K, particularly in “Item 1.Business,” “Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of Operations,” and the “Notes to Financials Statements” describecertain factors that could contribute to or cause such differences, including,but not limited to, unanticipated developments in any one or more of thefollowing areas: the fact that our accountants have expressed doubt about theCompany’s ability to continue as a going concern, the Company’s expectation offurther losses, the Company’s need for additional financing and access toborrowing, the Company’s dependence on key customers, the Company’s dependenceon third-party manufacturers, government regulations that could affect theCompany’s products, the Company’s ability to identify suitable strategicpartners, competition, the Company’s dependence on key personnel, labeling orpromotion risks associated with the mass market, the effect of closelycontrolled stock, the pace of technological change, possible interruptions inthe Company’s business resulting from the U.S. Government’s response toterrorism, variability of quarterly results, product liability exposure,reduced sales in the dietary supplement industry, the effect of adversepublicity, the Company’s ability to protect the Company’s intellectualproperty, the rate of consumer acceptance of new product introductions, stockprice volatility, and other risk factors which may be detailed from time to timein the Company’s Securities and Exchange Commission filings.

 

Readers arecautioned not to place undue reliance on any forward-looking statementcontained herein, which speak only as of the date hereof. The Companyundertakes no obligation to update any these forward-looking statements toreflect events or circumstances after the date hereof or to reflect theoccurrence of unexpected events.

 

NATURADE®, NATURADE TOTAL SOY®,THE DELICIOUS WAY TO GIVE HEART DISEASE THE SHAKETM THE DELICIOUS CHOLESTEROLFIGHTER! ®, NATURADE 100% SOYTM, NATURADE 100% WHEYTM, NATURADE VEGTM, NATURADESOY-FREE VEGTM, NATURADE MILK & EGGTM, NATURADE N-R-GTM, NATURADE ORGANICSOYTM, ALOE VERA 80®, DIET LEANTM, POWER SHAKE®, QUICK FIZZTM, RIBOTEINTM, andEXPEC® are trademarks or service marks of Naturade, Inc.

 

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**PARTI**

 

**Item 1. Business**

 

**General**

 

Naturade, Inc.(the “Company” or “Naturade”) was founded in 1926. The Company is a leadingmarketer of scientifically supported natural products formulated to improve thehealth and well-being of consumers and sold to supermarkets, massmerchandisers, club stores and drug stores (collectively, the “mass market”),health food stores and natural food supermarkets (collectively, the “healthfood market”) and the military. The Company’s products are generally marketedunder the trademarks Naturade®, Naturade Total Soy®, Diet LeanTM and Aloe Vera80®. The Company also markets its products in the health food market and massmarket in Canada and selectively in other international markets.

 

Weight loss isa major marketing focus for the Company encompassing its Naturade Total Soy®line of meal replacements for cholesterol reduction and weight management andits Naturade® line of protein boosters for low carbohydrate dieters.  In 2003, the Company introduced Diet LeanTMcarb blocker, a product to help block absorption of starch calories.  Naturade is well known for its expertise insoy protein based products, having pioneered the soy protein powder category in1950.  It has long held the leadingmarket share of soy protein booster powders sold through health fooddistributors. In 1999, Naturade introduced its Naturade Total Soy® mealreplacement powders and by 2000 had become a leading brand name in soy proteinpowders for all trade classes combined, capitalizing on the 1999 FDAannouncement of a heart disease health claim for soy protein.

 

The Company’sAloe Vera 80® brand is widely distributed in virtually all of the over 5,000independent retailers serviced by Naturade’s U.S. health food distributors.Aloe Vera 80® is the only complete line of hair, skin and personal care to usealoe vera gel as the main ingredient. In addition, the Company marketsall-natural lines of aloe vera gel concentrate drinks, sports nutritionpowders, cough/cold products, laxative/digestive aids and effervescent supplements.

 

**History and Recent Developments**

 

Until 1999,the Company focused on sales in health food stores and naturalsupermarkets.  In 1999, Naturade enteredthe mass market with the introduction of its first line of meal replacementproducts, Naturade Total Soy®.

 

In 1999,the U.S. Food and Drug Administration (“FDA”) authorized a heart health claimfor soy protein which allows qualifying products to claim on their label that“25 grams of soy protein daily, in a diet low in saturated fat and cholesterol,may reduce the risk of heart disease.” Naturade began shipping products thatprominently featured this claim on the first day allowed by the FDA andbelieves that it has materially benefited from the FDA decision throughincreased shelf distribution and increased consumer trials. Naturade currentlymarkets 30 different SKUs featuring this claim.

 

In 2002,Naturade broadened its focus to target the large and rapidly growingopportunity in weight loss.  Initially,this was accomplished by repositioning its Naturade Total Soy® mealreplacements under the slogan “reduce cholesterol and manage your weight.”

 

In 2003, theweight loss focus was accelerated as the Company repositioned its longestablished line of high protein boosters to target low carbohydrate dieters.  In 2003, the Company also introduced theDiet LeanTM brand name through the introduction of a white kidney bean extractingredient shown in clinical studies to help people lose weight by blockingabsorption of starch calories.

 

**Business Strategy**

 

The mission ofthe Company is to market innovative natural products that nourish and improvethe health and well being of consumers. Naturade focuses on building consumerbrands that can be marketed in both the mass market and the health food marketand for which there is strong scientific support of efficacy. Naturade’smanagement is committed to profitable growth through the following businessstrategies.

 

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***Increase focus onweight loss***

 

Naturade is strongly focused on the growthpotential of the weight loss category, including high consumer interest in lowcarbohydrate diets. More than ten human clinical studies demonstrate weightmanagement benefits for soy protein as part of a reduced calorie diet includingimproved satiety (feeling of fullness), increased lean muscle mass andprotection against oxidative stress (a particular concern to people involved inathletic performance).  The Company’snew Diet LeanTM brand of products, which includes products, which assist weightloss by helping to block the absorption of starch calories, offers a launchingpad for new, complementary healthy weight loss products.

 

***Maintain leadershipin heart health***

 

The Company believes significant growthpotential exists in the meal replacement category with over 50 clinical studiesdemonstrating that soy protein reduces cholesterol, while consumer awareness ofthis important benefit remains well below 50%. The FDA, the American HeartAssociation and the Mayo Clinic all support daily intake of 25 grams of soyprotein as part of a diet low in saturated fat and cholesterol.

 

###### ***Excelin relationships with consumers and retailers***

###### *** ***

The Companyhas used its expertise in consumer packaged goods to build a strongrelationship with its retail customers. Naturade complements its broad salesand marketing efforts with programs focused on direct-to-consumer communicationto generate trial, cross-promote products and build brand loyalty.

 

***Pursue innovationthrough science-based new products***

 

Naturadecontinues to emphasize new products as a long-term growth strategy.  These include further exploitation of soyprotein’s demonstrated ability to lower cholesterol, support weight loss, reducebone loss, reduce hot flashes and enhance performance. In addition futureproducts will be released based on other promising health benefits verified byscientific investigations including whey based sports nutrition products andephedra free weight management capsules and tablets. The Company’s marketingand research and development departments spearhead new product development;overseeing product formulation, testing and sample production runs carried outby the Company’s third party manufacturers.

 

***Focus promotionalspending to improve profitability by account***

 

Account byaccount profit and loss budgets are maintained to improve the efficiency ofpromotional spending.  Spending plansare tied to each account’s potential, and promotional programs are thendeveloped that will optimize sales growth while limiting Naturade’s brandexpense.  In 2003, this effort led to a$1.4 million increase in gross profit versus 2002 and a $52,000 reduction inbrand expenses as net sales increased 13%. New distribution is pursued selectively where initial investment instart-up costs has a strong expectation of delivering a near-term payback.  Similarly, management has elected to exitaccounts where minimum profit standards cannot be met.  As a result, Naturade is currently sellingto a consolidated U.S. account base of approximately 11,000 stores compared toapproximately 15,000 in 2002 and 33,000 in 2001. Expansion into the Canadianmarket with a streamlined offering of best selling products is being pursuedwith the same-targeted spending strategy.

 

***Identify and solicitstrategic partners for growth***

 

Externalgrowth continues to be a focus for the Company, making use of the resources ofits major investors to help identify beneficial strategic alliances.  The Company is currently pursuing astrategic alliance in natural sports nutrition products.  The effort to identify additional funding insupport of internal growth is ongoing.

 

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**Industry**

 

Naturade hassought to position itself for long-term growth by designing products thataddress specific conditions where strong scientific evidence of tangible healthbenefits has created marketing opportunities. There are also a number ofdemographic trends that support the Company’s belief that the current growthfor the categories in which it competes will be long-lived, including thefollowing:

 

•                                          Obesityepidemic in the U.S. with 24% of the population being obese and 64% overweight

 

•                                          Highinterest in low carbohydrate dieting with 59 million Americans controllingcarbohydrate intake

 

•                                          Continuingthreat of heart disease as the number one killer of men *and*women in the U.S.

 

•                                          100million Americans have high cholesterol

 

•                                          Significanthealth risks associated with obesity, including heart disease, high bloodpressure and diabetes

 

•                                          Trendtowards healthier, more active lifestyles

 

•                                          Increasingpopularity of preventative/alternative medicines and therapies

 

•                                          Increasingnumber and credibility of scientific studies and clinical trials supporting theefficacy of non-drug health products

 

There can,however, be no assurance that these trends will result in greater sales revenuefor the Company.

 

Naturadecompetes in the overall category for natural, nutritional supplement andfunctional food products. *Nutrition Business Journal* (“NBJ”), a SanDiego-based research publication that specializes in this industry, projectsthat sales for the overall $62 billion “Nutrition” category will be up 6.5%versus 2002.  Naturade primarilycompetes in the $14.3 billion segment defined by NBJ as Sports Nutrition andWeight Loss (SNWL). Projected growth for this category is 12% in 2003, brokendown as follows:

 
|                                                           |   | **2003 Sales  ($ Billions)** |   |                                                                        |
|----------------------------------------------------------------|--------|------------------------------|--------|-----------------------------------------------------------------------------|
|                                                           |   |                         |   |                                                                        |
| Isotonic/  Energy Beverages                                    |   | $                            | 4.8    |                                                                        | Includes  Gatorade and AllSport |
| Weight Loss  Meal Supplements                                  |   | 2.5                          |   | Includes  Naturade Total Soy® and Slim Fast powders and ready-to-drink |
| Nutrition  Bars                                                |   | 2.4                          |   | Includes  Power Bar, Cliff and Naturade Total Soy® bars                |
| Sports  Nutrition Powders/ Supplements                         |   | 1.9                          |   | Includes  EAS, MetRx and Naturade® low carb and sports powders         |
| Weight Loss Pills                                              |   | 1.7                          |   | Includes  Metabolife, Xenadrine and Diet LeanTM carb blocker            |
| Sports Pills  and Hardcore Beverages                           |   | 0.2                          |   | Includes  hormone precursors                                                |
| Low Carb Foods (not including bars and  drinks included above) |   | 0.8                          |   | Includes  Atkins, Carb Solutions and numerous food brands                   |
| Total                                                          |   | $                            | 14.3   |                                                                        | +12% Growth  over 2002 |

 

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Obesity is anepidemic that creates ongoing front page news through the major mediaoutlets.  According to the Centers forDisease Control, two-thirds of the U.S. population is overweight and, of that,one-third is considered obese.  Both thenature of the problem and the continuing news coverage support the perspectivethat demand for weight loss products will continue to increase for years tocome.  The FDA’s 2003 decision to banthe sale of ephedra is expected to heighten demand from retailers and consumersfor healthy weight loss aid  productsthat are both effective and safe.  Athird converging factor is the increased marketplace demand for products tosupport people who are trying to control their carbohydrate intake.  While some suggest that this may be ashort-term trend, there is a strong case to suggest that carbohydrate controlmay have an impact on the market comparable to the impact of “low fat” productsin the ‘90’s.  NBJ projects 2003 growthof low carbohydrate foods at +90% creating a $1.4 billion category that hasgrown from less than $50 million in 2000. NBJ also projects continuing double-digit growth of the overall SNWLmarket through 2006 with low carbohydrate food products driving the growth

 

In addition toweight control, Naturade competes in the soyfoods market.  In 2002, that category grew by 12.8% to anestimated $3.65 billion according to Spins/Soyatech.  According to the report entitled “Soyfoods: The U.S. Market2003,” soyfoods have been growing at a rate of more than 14% per year for thepast 10 years. The report points out that sales of soy-based products weregrowing more quickly in mass market than in natural product stores.

 

**Brands & ProductLines**

 

***Weight loss brands***

 

Approximately73% of net sales in 2003 were derived from brands positioned for weightloss.  In 2002, the Company repositionedits Naturade Total Soy® brand of meal replacement products to include weightloss benefits.  Naturade Total Soy® isthe largest selling Naturade brand and is distributed in virtually all of theretail outlets serviced by Naturade or its distributors. These products includethree shake mix powder products (original Naturade Total Soy® powder, CalciumShakeTM and Naturade Total Soy Menopause ReliefTM), and two ready-to-drinkflavors.

 

First introduced in 1950, Naturade protein boosters are lowcarbohydrate powders offering consumers a range of protein choices.  These powders are typically added to smoothiesto make high protein drinks, but are also used to add protein to other foodsprepared at home such as cereal, sauces or casseroles.  In 2003, the Company repositioned theseproducts for weight loss by emphasizing their low carbohydrate content.  This was accomplished through a new Naturadetrademark using the word “carb” and the international slash symbol meaning “donot.”  The Company offers a broadselection of protein booster powders based on alternate protein sources,including Naturade 100% SoyTM, Naturade VegTM, Naturade N-R-GTM, Naturade 100% WheyTM,Naturade Soy-Free VegTM and Naturade Milk & EggTM.

 

Diet LeanTM isa new Naturade weight loss brand introduced in 2003.  The only Diet LeanTM product offered during 2003 is a carbohydrateblocker product that blocks the absorption of starch calories.  Naturade uses Phase 2® brand white kidneybean extract in the production of its Diet LeanTM Carb Blocker.  Phase 2® is supported by clinical studiesthat confirm safety and show increased weight loss with more inches lost aroundthe waist when given Phase 2®, compared to placebo.  This product fits the imagery envisioned for a full line of DietLeanTM products that offer healthy solutions for weight loss.  The introduction of this brand addresses theneeds of consumers who will no longer be able to purchase ephedra-basedproducts and will be looking for safe and effective dietary supplements thatwill help them lose weight.

 

***Soy protein-basedproducts for heart health***

 

In 1999, theFDA authorized a heart health claim for soy protein.  Naturade markets 30 different soy protein SKU’s that qualify tocarry the FDA approved claim that ***“25 grams of soy protein daily, in a diet low in saturated fat andcholesterol, may reduce the risk of heart disease.”***  These products accounted for approximately70% of Naturade net sales in 2003. Naturade Total Soy® was the first soy protein powder brand in the U.S.to carry this claim on the front of retail package labels and differentiatesitself from competitors by continuing to emphasize this life-saving healthmessage on its packages as well as in its advertising and promotional messagesas “the delicious cholesterol fighter®.” Naturade offers two soy protein-basednutritional supplement products positioned as energy enhancers, Power Shake®and Ribo-teinTM, plus Naturade Pure SoyTM, the only widely distributed mealreplacement powder made with certified organic ingredients.  In addition, three of the six lowcarbohydrate protein boosters are made with soy protein and carry the FDA hearthealth claim.

 

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***Aloevera-based products***

 

Aloe verabased products accounted for approximately 10% of Naturade 2003 net sales. TheCompany seeks to distinguish itself from its competitors by offering a widerrange of aloe vera products for topical use as well as for oral ingestion. TheAloe Vera 80® line offers topical products for hair care, facial care, hand andbody care and bath and cleansing care. It is the only broad aloe vera-basedline of personal care products available in retail stores in which every itemin the line uses aloe vera gel in place of water as the main ingredient. Unlikemost competitive juice products, Naturade aloe gel drink dietary supplementsare concentrated, with higher levels of active solids per serving (less water).Naturade Stomach Formula is a best seller in the aloe drink category throughhealth food distributors and the leading item in the Naturade aloe vera geldrink line. The line also includes Naturade Joint Formula with Glucosamine,Naturade Energy Formula and Naturade Detox Formula. The aloe vera lines aresold almost exclusively in independent health food stores and naturalsupermarkets.

 

***Other products andprivate label***

 

The Company offersadditional all-natural brands and product lines including sports nutrition powders,laxatives, meal replacement bars, digestive aids, cough/cold products and aQuick FizzTM line of effervescent supplements, which, cumulatively, accounts forapproximately 17% of 2003 net sales. These are distributed almost exclusivelythrough independent health food stores and natural supermarkets. In addition,the Company provides private label products to a limited number of customers.

 

**Competition**

 

Two brands aremajor Naturade competitors in the mass market powder sector, Slim Fast® fromUnilever, Inc. and Genisoy® from MLO Products, Inc. Many other companies haveentered the category in the last three years but hold only small market shares,including, Health Source (Abbott Labs), Twinlab, Amerifit, Kashi, Balance, EAS,Natrol, Rexall Sundown, Schiff (Weider) and Country Life (Hain).  Naturade also competes with Genisoy® andKashi in the health food segment where the Company believes that it holds theleading share.  In the health foodsector Naturade competes indirectly with Spiru-tein®, a brand from Nature’sPlus, Inc.  Unlike Naturade Total Soy®,Spiru-tein® does not emphasize soy protein content in marketing its productsand positions them as energy boosters rather than products for weight loss orcholesterol reduction.  Spiru-tein®holds a substantial lead over Naturade’s entries in the energy category, PowerShake® and Ribo-teinTM.

 

While no otherpersonal care brand offers a complete aloe-vera-based line like Aloe Vera 80®,several competitors vie for the natural product consumer’s attention in healthfood stores including Jason, Kiss My Face, Avalon, Rachel Perry and Nature’sGate. Other brands offering aloe gel concentrate drinks include Nature’s Gateand Lily of the Desert.

 

**Sales, Marketing and Distribution**

 

In fiscal2003, the breakdown of Naturade sales by channel was 52.2% to the mass market,46.4% to the health food market and 1.4% in international channels. Naturade’sproducts are sold to both the health food market and the mass market using asales management team augmented by independent brokers. Health food sales areprimarily through distributors, while most mass market sales are direct toretailers. Naturade sales and distribution in Canada is also handled throughdistributors and brokers. The Company’s major customers include:

 

Major Customers by Channel

 
| **Mass Market**                               |   | **Health  Food Market**             |
|-----------------------------------------------|--------|-------------------------------------|
| Kroger, Fred  Meyer, Safeway                  |   | The Vitamin  Shoppe, Whole Foods    |
| Albertson’s,  American Drug              |   | Wild Oats,  Nature’s Best      |
| Sam’s Club,  Costco, BJ’s Wholesale |   | Tree of  Life, United Natural Foods |

 

Naturade’sdirect sales force supervises broker sales organizations in the health foodmarket and mass market. While headquarters sales calls are primarily theresponsibility of Naturade’s sales management, over 60 health food brokerpersonnel and an additional 50 mass market broker personnel carry out follow-upcalls and retail activity. Naturade maintains brokerage agreements with itshealth food and mass market brokers throughout the U. S. These agreements havea term of one year and may be terminated on 30 days prior written noticeby either party. In addition, these agreements grant the brokers exclusiveterritories to represent Naturade and receive commissions on sales generated inthese territories. Brokers do not take title to the Company’s products.

 

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Naturade sellsits products in the health food market through a network of 20 key distributorsand approximately 15 smaller distributors, who together service approximately5,000 retail health food stores and natural supermarkets in the United States.These distributors take title to the Company’s products, combining theseproducts with other companies’ products to serve the health food stores intheir geographic area. Eight of these key distributors are divisions of UnitedNatural Foods, Inc. (UNFI), a national health food distributor, whoseaggregate purchases during fiscal 2003 represented approximately 13% of theCompany’s total sales. Seven other distributors are divisions of Tree of Life,Inc, another national health food distributor, whose aggregate purchases during2003, represented approximately 15% of the Company’s total sales. Often theCompany’s direct sales force, along with brokers, will solicit business fromhealth food stores who then acquire the Company’s products from thesedistributors. While each of these national health food distributors is acorporate legal entity, their divisions independently make purchasing decisionson the Company’s products and are separately invoiced by the Company. Accordingly,in “Item 7. Management’s Discussion and Analysis of Financial Condition andResults of Operations,” the Company treats these divisions as separatecustomers for purposes of determining the top 40 customers.

 

Mass marketproducts are sold directly to mass market retailers or their designateddistributors. One mass market customer, Wal*Mart-Sam’s Clubs, representedapproximately 23% of Company total sales in 2003. While Wal*Mart and Sam’sClubs are part of a single corporate legal entity, they are independentoperations, have separate buying departments and are separately invoiced by theCompany.  Thus, in “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” theCompany treats them as separate customers for purposes of determining the top40 customers.  In second half 2003, theWal*Mart stores division revamped its weight loss shelving to make room foradditional low carbohydrate products. In the process, they eliminated their entire soy protein powder offeringincluding both Naturade and the major competitor, Slim Fast.  The lost business accounts for less than 6%of 2003 sales.  Company management isworking to re-establish distribution in the Wal*Mart division.  In the meantime, volume continues to grow inthe Sam’s Club division.  An additionalmass market customer, Costco represented approximately 11% of the Company’stotal sales in 2003.

 

The loss ofany one of the major customers including Tree of Life, UNFI, Sam’s Club orCostco could have a material adverse effect on the Company.

 

**Third-PartyManufacturers**

** **

Since theCompany began to outsource the production of its products in 1999, the Companyhas become significantly dependent on third-party manufacturers. The decisionto outsource was based upon the Company’s desire to concentrate its financialresources on product development, sales, marketing and distribution. Naturadecurrently contracts with third-party manufacturers who specialize in powder,liquid, tablet/capsule, bar and over-the counter pharmaceutical (“OTC”)production. Naturade selects its third-party manufacturers based upon severalcriteria, including quality, capacity, location and cost. Under the directionof the Company’s product development team, these third-party manufacturerscreate product formulations and develop sample production runs of prototypeproducts. Naturade requires that a certificate of analysis that indicatestested levels of key microbiological measures accompany every batch of productreceived from a third-party manufacturer.

 

**Raw Material Supplies**

 

Due tooutsourcing of production, Naturade has eliminated most of its raw materialinventory, which at December 31, 2003, approximated $208,615. This amountincludes bottles, labels, corrugated boxes and shippers. The Company believesthat the raw materials used by its third-party manufacturers are readilyavailable from multiple supply sources. The Company has not experienced significant delays due to supplyproblems.

 

**QualityControl**

** **

The Companyhas established quality control standards for its third-party manufacturers,including lists of approved raw material suppliers, agreed upon productionbatch sizes, microbiological and other contaminant testing criteria,utilization of industry-specific independent laboratories for sample analysisand a formal incubation period for finished products, among other requirements.In addition, the Company has on retainer a former FDA examiner to inspectthird-party manufacturing production facilities and to draft new qualitycontrol procedures to adhere to evolving FDA guidelines.

 

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**SeasonalFluctuations**

 

As theNaturade Total Soy® brand has emphasized weight loss in connection with itsmeal replacement products, sales have become somewhat more seasonal, affectedby higher December and first quarter demand due to intense consumer interest indieting and healthy lifestyle following the holiday season, with a softening ofsales in the beginning of the fourth quarter. Because individual products have seasonal variations, as the Company’sproduct mix changes, the Company may experience more seasonality in the future.In addition, international sales tend to fluctuate depending upon economicconditions, seasonal patterns and cultural differences within each country.

 

**Trademarks,Copyrights and Other Intellectual Property**

 

Naturade maintainsregistrations on 23 trademarks with the United States Patent and TrademarkOffice, in addition to a California registration on one trademark. Naturadealso maintains trademark registrations for a variety of marks in approximatelyeleven foreign countries. In addition, Naturade holds other intellectualproperty rights. Federally registered trademarks have perpetual life, providedthey are renewed on a timely basis and used properly as trademarks, subject tothe rights of third parties to seek cancellation of the marks.  The Company regards its trademarks and otherproprietary rights as valuable assets and believes that they have significantvalue in the marketing of its products. Because of its limited financialresources, the Company cannot in all cases exhaustively monitor the marketplacefor trademark violations. It will evaluate and pursue potential infringementson a case-by-case basis in accordance with its business needs and financialresources. If the Company is not aware of some infringing uses or elects not topursue them, the value of its trademarks could be substantially weakened.

 

**Private EquityTransaction**

 

In January 2002, the Company (i) sold Series B ConvertiblePreferred Stock and Warrants to Westgate Equity Partners, L.P. (“Westgate”) fora total of $2.5 million, (ii) issued 36 million shares of Common Stock and(iii) amended its bank credit facility. The Series B Convertible Preferred Stock is convertible into13.5 million shares of Common Stock (subject to adjustment) and bearsdividends at the rate of 10% per annum. The Warrants, which expire on December 31, 2004, entitle the holder topurchase additional shares of Series B Convertible Preferred Stock convertibleinto 33.6 million shares of Common Stock (subject to adjustment ) for $3.5million.

 

In April 2003, the Company entered into a loan agreement (the“Loan Agreement”), with Health Holdings and Botanicals, LLC, a principalshareholder of the Company, and certain other lenders (the “Lender Group”),pursuant to which the Lender Group has agreed to lend the Company $450,000 andsubject to the discretion of the Lender Group, up to an additional$300,000.  All advances under the LoanAgreement bear interest at the rate of 15% per annum, are due on December 31,2004, are secured by substantially all of the assets of the Company, and aresubordinated to Company’s indebtedness to Wells Fargo Business Credit, Inc.(“Wells Fargo”).  The net proceeds fromthe sale of Series B Convertible Preferred Stock and Warrants, and the advancesunder the Loan Agreement, have been used for the Company for working capitaland general corporate purposes.  For amore complete description of these transactio0ns see Notes 4 and 5 of Notes toFinancial Statements.

 

**Regulatory Matters**

 

The Company’sproducts are subject to regulation by numerous governmental agencies,principally the U.S. Food and Drug Administration (the “FDA”). The Company’sproducts are also subject to regulation by the Consumer Product SafetyCommission, the U.S. Department of Agriculture, and the EnvironmentalProtection Agency. Advertising of the Company’s products is subject toregulation by the U.S. Federal Trade Commission. Various state and local agencies,as well as each foreign country in which the Company distributes its productsalso regulate the Company’s products.

 

Many Naturadeproducts, including Naturade Total Soy® and protein powders, are food productsthat are not subject to regulation by the FDA’s drug regulations or the DSHEAof 1994. These food products are regulated under the general FDA foodregulations and may use “structure/function” claims or health claims underappropriate circumstances, but unlike dietary supplements, are not required tocarry a disclaimer regarding an FDA evaluation or disease. EffectiveOctober 26, 1999, the FDA approved a health claim for soy protein allowingthe following product label claim:

 

10

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**“25 grams of soyprotein daily, in a diet low in saturated fat and cholesterol, may reduce therisk of heart disease.”**

 

To carry thisclaim, one serving of a product must deliver at least 6.25 grams of soy proteinwith no more than three grams of fat and no more than one gram of saturatedfat. The Company is currently shipping products that carry this heart diseaseclaim under the brand names of Naturade Total Soy®, Naturade 100% SoyTM,Naturade VegTM, Naturade N-R-GTM, Naturade Organic SoyTM, Ribo-teinTM and PowerShake®.

 

Beginning in2002, the FDA implemented a new regulation requiring non-prescription,over-the-counter (“OTC”) drugs to include a “Drug Facts” box on the label. Thisregulation was designed to make OTC drug labels easier to read. This regulationhas now been implemented on all of Naturade’s OTC products where requiredincluding, Herbal Expectorant, Sugar-Free Herbal Expectorant, Children’s HerbalExpectorant and Herbal Laxative.

 

The USDAimplemented new labeling regulations on all organic products beginning inNovember 2002.  Naturade revised thelabels on all applicable products containing organic ingredients and believesthat it is in substantial compliance with these new regulations.

 

The Company believes that its products currently are in substantialcompliance with the latest regulations in product labeling, including food(Nutritional Labeling Education Act of 1991 or NLEA), dietary supplement(DSHEA), over-the-counter drug (OTC Monographs) and cosmetic packagingguidelines. In addition, the Company has implemented registration andcompliance procedures as required by the recently enacted FDA Bioterrorism Act.The Company retains control of all labels in-house and manages labeldevelopment and usage as an element of quality assurance. In addition, all formulaspecifications are developed under the direction of Naturade’s management.

 

**Backlog**

 

Naturadetypically does not carry significant backlog orders and generally maintains asufficient supply of its products to meet customer demands. The Company’s policyis to ship product within seven days of the order being placed.

 

**ProductResearch and Development**

** **

The Companydevotes substantial resources to new product development and reformulation. TheCompany initiates new product development efforts with third-partymanufacturers who create product formulations, test and develop sampleproduction runs of prototype products. Due to industry practice, these costsare often absorbed by the third-party manufacturers who then negotiate with theCompany on final lot sizes and production costs. Consequently, the Company’sdirect expenses in this area do not reflect the full cost of product researchand development.

 

Naturade’sdirect product research and development expenses were $216,185,  $210,985 and $196,456 in the fiscal yearsended December 31, 2003, 2002 and 2001, respectively.

 

The Companyintroduced a carbohydrate blocker in September 2003 under the brand name DietLeanTM.  The active ingredient in theproduct is a white kidney bean extract developed by Pharmachem Labs andmarketed under the brand name Phase 2®. Diet Lean Carb Blocker is intended to be the first in a series ofproducts to target the weight loss category and to be marketed by Naturadeunder the Diet Lean name.

 

**Employees**

 

As of December 31, 2003, Naturade employed 28 people, includingtwo in administration, ten in sales and marketing, three in productdevelopment, eight in finance, accounting and information technology and fivein warehouse and distribution. The Company considers its relations with itsemployees to be good.

 

11

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**Risk Factors**

 

The short andlong-term success of the Company is subject to certain risks, many of which aresubstantial in nature. Shareholders and prospective shareholders in the Companyshould consider carefully the following risk factors, in addition to otherinformation contained herein. This Annual Report on Form 10-K containsforward-looking statements, which are subject to a variety of risks anduncertainties. The Company’s actual results could differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including those set forth below.

 

***Future losses andability to continue as a going concern***

 

AtDecember 31, 2003, the Company had an accumulated deficit of $21,853,561net working capital deficit of $1,789,482 and a stockholders’ capitaldeficiency of $2,861,638. The Company anticipates that it will incur net lossesfor the foreseeable future and will need access to additional financing forworking capital and to expand its business. If unsuccessful in those efforts, Naturade could be forced to ceaseoperations and investors in Naturade’s Common Stock could lose their entireinvestment. Based on this situation, the Company’s independent accountantsqualified their opinion on the Company’s December 31, 2003 financial statementsby including an explanatory paragraph in which they expressed substantial doubtabout the Company’s ability to continue as a going concern.  The financial statements provided with thisreport have been prepared on the assumption that the Company will continue as agoing concern and do not include material adjustments that would be necessaryif it were to cease operation.

 

***Dependence oncurrent and ongoing financing***

 

The Company’ssuccess is dependent on its current financing as well as new financing tosupport its working capital requirements and fund its operating losses. As ofDecember 31, 2003, the Company was in compliance with all covenants of theCredit and Security Agreement with its principal lender.  See “Item 7. Management’s Discussion and Analysisof Financing Condition and Results of Operations—Liquidity and CapitalResources” and Notes 4 and 5 to the Financial Statements.

 

***Dependence oncontinued business from the Company’s key customers***

 

The Company’sfour largest customers together account for 61.6% of sales revenue. Two massmarket customers, represented approximately 33.5% of Naturade’s total sales in2003, and two health food distributors accounted for 28.1% of total sales in2003. The loss of any of these customers could have a material adverse effecton the Company’s results of operations. From time to time, major customers ofNaturade have experienced financial difficulties. Naturade does not havelong-term contracts with any of its customers and, accordingly, there can be noassurance that any customer will continue to place orders with Naturade to thesame extent it has in the past, or at all.

 

***Dependence onthird-party manufacturers***

 

The use ofcontract manufacturers and the resulting loss of direct control over productioncould result in the Company’s failure to receive timely delivery of products ofacceptable quality. Although the Company believes that alternative sources ofcontract manufacturing services are available, the loss of one or more contractmanufacturers could have a material adverse effect on the Company’s results ofoperations until an alternative source is located and has commenced producingthe Company’s products.

 

Although theCompany requires that its contract manufacturers comply with FDA manufacturingguidelines, Naturade cannot assure that these third-party companies will alwaysact in accordance to these regulations. If the manufacturing facilities used bythe Company’s third-party manufacturers did not meet those standards, theproduction of the Company’s products could be delayed until the necessary modificationsare made to comply with those standards or alternate manufacturers are located.Furthermore, the potential exists for circumstances to arise which wouldrequire Naturade to seek out alternate manufacturers who operate in compliancewith the FDA’s requirements.

 

12

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***Impact of governmentregulation***

 

The Company’soperations, properties and products are subject to regulation by variousforeign, federal, state and local government entities and agencies, includingthe FDA and FTC. See “Regulatory Matters.” Among other matters, such regulationis concerned with statements and claims made in connection with the packaging,labeling, marketing and advertising of the Company’s products. The governmentalagencies have a variety of processes and remedies available to them, includinginitiating investigations, issuing warning letters and cease and desist orders,requiring corrective labeling or advertising, requiring consumer redress,seeking injunctive relief or product seizure, imposing civil penalties andcommencing criminal prosecution.

 

As a result ofthe Company’s efforts to comply with changes in applicable statutes andregulations, the Company has from time to time reformulated, eliminated orrelabeled certain of its products and revised certain aspects of its sales,marketing and advertising programs. The Company may be subject in the future toadditional laws or regulations administered by federal, state, local or foreignregulatory authorities, the repeal or amendment of laws or regulations whichthe Company considers favorable, such as DSHEA, or more stringentinterpretations of current laws or regulations. The Company cannot predict thenature of future laws, regulations, interpretations or applications, nor canthe Company predict what effect additional governmental regulations oradministrative orders, when and if promulgated, would have on the Company’sbusiness in the future. Such future laws and regulations could, however,require the reformulation of products to meet new standards, the recall ordiscontinuance of products that cannot be reformulated, the imposition ofadditional record keeping requirements, expanded documentation of productefficacy, expanded or modified labeling and scientific substantiation,including health warnings or restrictions on benefits described for theCompany’s products. Any of or all of such requirements could hurt sales of theCompany’s products or increase the Company’s costs, resulting in material harmto the Company’s results of operations and financial condition. See “RegulatoryMatters.”

 

***Naturade may not beable to identify suitable strategic partners to realize the Company’s growthstrategy.***

 

In addition tointernal expansion of its existing business, The Company has a strategy toexpand its business externally by identifying compatible companies forstrategic alliances and strategic investments in The Company. The Company maynot succeed in identifying these potential strategic partners or may be unableto conclude agreements with them. If so, The Company’s future growth may belimited, and it may be unable to achieve profitability.

 

***Competition***

 

The market fornutraceutical products is highly competitive. Many of the Company’s competitorshave substantially greater capital resources, research and developmentcapabilities, and manufacturing and marketing resources, capabilities andexperience than the Company. The Company’s competitors may succeed indeveloping products that are more effective or less costly than any productsthat may be developed by the Company.

 

***Future sales ofequity securities could dilute the Company’s Common Stock***

 

The Companymay seek to obtain new financing from various sources, including the sale ofits securities. Future sales of Common Stock or securities convertible intoCommon Stock at or below recent market prices could result in dilution of theCommon Stock. In addition, the conversion of the 13.5 million shares ofSeries B Convertible Preferred Stock originally sold to Westgate Equity Partners,L.P. (“Westgate”), for $2 million, together with conversion of the35,989,555 shares of Series B Convertible Preferred Stock issuable onexercise of warrants, which expire on December 31, 2004, held by Westgate,which have an exercise price of approximately $0.104 per share (and, includingthe original cost of the warrant, a total consideration of approximately $0.119per share), has resulted in dilution of the Common Stock. The perceived risk ofdilution may cause some of the Company’s stockholders to sell their shares,which could further reduce the market price of the Common Stock.

 

***Dependence onqualified personnel***

 

The Company’ssuccess depends upon its ability to attract and retain qualified sales,marketing, scientific and executive management personnel. To commercialize itsproducts and product candidates, the Company must maintain and expand itspersonnel, particularly in the areas of product sales and marketing. TheCompany faces intense competition for such personnel from other companies,academic institutions, government entities and other research organizations.There can be no assurance that the Company will be successful in hiring orretaining qualified personnel. Moreover, managing the integration of such newpersonnel could pose significant risks to the Company’s development andprogress and increase its operating expenses.

 

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***Expanding theCompany’s sales in the mass market has increased branding costs and resulted inless stable demand for the Company’s products.***

 

The Company,traditionally a marketer for the health food market, has recently built apresence in the mass market. While yielding increased revenue, selling to themass market has also resulted in significant risks for The Company.  Compared to sales in the health food market,the aggregate volume of mass market orders can vary significantly from periodto period and tends to be more sensitive to short term or local variations inmarket conditions. The instability can make planning difficult and can causeunexpected reductions in sales, or in orders that exceed The Company’sshort-term capacity, in either case resulting in lost revenue. Failure tomanage the costs and risks associated with the mass market could cause materialadverse harm to The Company’s business.

 

***Closely controlledstock***

 

At March 22,2004, Westgate Equity Partners, L.P. beneficially owned approximately 51.0 % ofthe Company’s Common Stock, Health Holdings beneficially owned 92.2 % of theCompany’s Common Stock, and executive officers and directors of the Company asa group beneficially owned 97.6% of the Company’s Common Stock. Shares“beneficially owned” include shares that a person owns or has a right toacquire within 60 days, either directly or through affiliates.Accordingly, Westgate Equity Partners, LLC and Health Holdings have the abilityto control the outcome on all matters requiring stockholder approval,including, but not limited to, the election and removal of directors, anymerger, sale, consolidation or sale of substantially all of the assets of theCompany, and to control the Company’s management and affairs.

 

***Technologicalchanges***

 

The Companycurrently is engaged in developing nutraceuticals, which are characterized byextensive and costly research efforts and rapid technological progress andchange. New process developments are expected to continue at a rapid pace inboth industry and academia. The Company’s future success will depend on itsability to develop and commercialize its existing product candidates and todevelop new products. There can be no assurance that the Company willsuccessfully complete the development of any of its existing product candidatesor that any of its future products will be commercially viable or achieve marketacceptance. In addition, research and development and discoveries by otherscould render some or all of the Company’s programs or potential productcandidates uncompetitive or obsolete.

 

***The Company may faceinterruption of production and services due to increased security measures inresponse to terrorism***

 

The Company’s business depends on the free flow ofproducts and services through the channels of commerce. Recently, in responseto terrorist activities and threats aimed at the U.S., transportation, mail,financial and other services have been slowed or stopped altogether. Furtherdelays or stoppages in transportation, mail, financial or other services couldhave a material adverse effect on the Company’s business, results of operationsand financial condition. Furthermore, the Company may experience an increase inoperating costs, such as costs for transportation, insurance and security, as aresult of the terrorist activities and potential activities. The Company mayalso experience delays in receiving payments from payers that have beenaffected by terrorist activities and potential activities. The U.S. economy ingeneral is being adversely affected by the terrorist activities and potentialactivities and any economic downturn could adversely impact the Company’sresults of operations, impair its ability to raise capital or otherwiseadversely effect its ability to grow its business.

 

***Variability ofquarterly results***

 

The Companyhas experienced, and expects to continue to experience, variations in its netsales and operating results from quarter to quarter. The Company believes thatthe factors which influence this variability of quarterly results include thetiming of the Company’s introduction of new product lines, the level ofconsumer acceptance of each product line, general economic and industryconditions that affect consumer spending and retailer purchasing, theavailability of manufacturing capacity, the timing of trade shows, the productmix of customer orders, the timing of placement or cancellation of customerorders, the weather, transportation delays, the occurrence of chargebacks inexcess of reserves and the timing of expenditures in anticipation of increasedsales and actions of competitors. Accordingly, a comparison of the Company’s resultsof operations from period to period is not necessarily meaningful, and theCompany’s results of operations for any period are not necessarily indicativeof future performance.

 

14

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***Product liabilityexposure***

 

Productliability risk is inherent in the testing, manufacture, marketing and sale ofthe Company’s products and product candidates, and there can be no assurancethat the Company will be able to avoid significant product liability exposure.The Company may be subject to various product liability claims, including,among others, that its products include inadequate instructions for use orinadequate warnings concerning possible side effects and interactions withother substances. The Company currently maintains a general liability insurancepolicy and a product liability insurance policy. There can be no assurance thatthe Company will be able to maintain insurance in sufficient amounts to protectthe Company against such liabilities at a reasonable cost. Any future productliability claim against the Company could result in the Company payingsubstantial damages, which may not be covered by insurance and may have amaterial adverse effect on the business and financial condition of the Company.

 

***The dietarysupplement industry as a whole is experiencing a decline in sales.***

 

The Company’s business consists primarily of selling natural productsand functional foods, including soy protein-based products. The soy foodscategory as a whole has recently experienced increased sales. Other categoriesof dietary supplements have experienced reduced sales in recent periods afterseveral years of dramatic growth. In particular, revenues in both the herbaland health food store categories have had periods of significant decline. Therecan be no assurance that this general consumer trend will not be experienced bythe Company’s product categories as well. Even if the Company is successful inincreasing sales within its market category, a decline in the overall market fornatural products or functional foods could have a material adverse affect onthe Company’s business.

 

***Effectof adverse publicity***

 

The Company’sproducts are formulated with vitamins, minerals, herbs and other ingredientsthat the Company regards as safe when taken as suggested by the Company andthat scientific studies have suggested may involve health benefits. While theCompany conducts extensive quality control testing on its products, the Companygenerally does not conduct or sponsor clinical studies relating to the benefitsof its products. The Company is highly dependent upon consumers’ perception ofthe overall integrity of its business, as well as the safety and quality of itsproducts and similar products distributed by other companies which may notadhere to the same quality standards as the Company. The Company could beadversely affected if any of the Company’s products, or any similar productsdistributed by other companies, should prove or be asserted to be harmful toconsumers or should scientific studies provide unfavorable findings regardingthe effectiveness of such products. The Company’s ability to attract and retaindistributors could be adversely affected by negative publicity relating to itor to other direct sales organizations or by the announcement by anygovernmental agency of investigatory proceedings regarding the businesspractices of the Company or other direct sales organizations.

 

***Intellectualproperty protection***

 

The Company’ssuccess depends in part on the Company’s ability to preserve the Company’strade secrets and know-how, and operate without infringing on the propertyrights of third parties. The Company does not have any patents, and as a resultanother company could replicate one or more of the Company’s products. TheCompany’s policy is to pursue registrations for all of the trademarksassociated with its key products. The Company relies on common law trademarkrights to protect its unregistered trademarks as well as its trade dressrights. Common law trademark rights generally are limited to the geographicarea in which the trademark is actually used, while a U.S. federal registrationof a trademark enables the registrant to stop the unauthorized use of thetrademark by any third party anywhere in the U. S. The Company intends toregister its trademarks in certain foreign jurisdictions where the Company’sproducts are sold. However, the protection available, if any, in suchjurisdictions may not be as extensive as the protection available to theCompany in the U.S.

 

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Currently, theCompany has U.S. trademarks as well as a California registration on fourtrademarks. The Company also maintains trademark registrations in approximatelyeleven foreign countries. Because of its limited financial resources, theCompany cannot in all cases exhaustively monitor the marketplace for trademarkviolations. It will evaluate and pursue potential infringement on acase-by-case basis in accordance with its business needs and financial resources.If the Company is not aware of some infringing uses or elects not to pursuethem, the value of its trademarks could be substantially weakened. If theCompany takes action to enforce its intellectual property rights, litigationmay be necessary. Any such litigation could be very costly and could distractthe Company’s personnel. Due to limited financial resources, The Company may beunable to pursue some litigation matters. In matters it does pursue, TheCompany can provide no assurance of a favorable outcome. An unfavorable outcomein any proceeding could have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

 

***Introduction of newproducts***

 

Each year, theCompany introduces new products to meet consumer demands and countercompetitive threats. These new products include product line extensions, suchas new flavors to currently existing products, as well as new formulations orconfigurations, such as ready-to-drink products and bars. The Company experiencessignificant costs in formulating new products, designing packaging andmerchandising. While the Company conducts extensive market research todetermine consumer trends in both the mass market and health food market, therecan be no assurance that consumers and retailers will accept the Company’s newproducts. In addition, there can be no assurance that once new products areinitially distributed to mass market and health food retailers, there will berepeat orders for these new products. Furthermore, expensive introductoryretailer charges for additional shelf space may negate any initial increase insales.

 

***Stock price***

 

The marketprice of the Company’s Common Stock is likely to be volatile and could besubject to significant fluctuations in response to the factors such asquarterly variations in operating results, operating results which vary fromthe expectations of securities analysts and investors, changes in financialestimates, changes in market valuations of competitors, announcements by the Companyor its competitors of a material nature, loss of one or more customers,additions or departures of key personnel, future sales of Common Stock andstock market price and volume fluctuations. Also, general political andeconomic conditions such as recession, or interest rate or currency ratefluctuations may adversely affect the market price of the Company’s CommonStock.

 

**Item 2. Properties**

 

InDecember 1998, the Company signed a 7 1/2 year leasefor a facility including new executive offices, sales and marketing offices andwarehouse located in Irvine, California. This 50,000 square foot facilityincludes a 40,000 square foot finished goods warehouse area configured with ahigh-density steel rack and frame storage floor plan. This maximum cubic spaceutilization provides the Company with reasonably sufficient warehousingcapacity for the term of the lease, specifically in light of the Company’sdecision to outsource production, thereby eliminating the need for anymanufacturing space. The rent expense related to this lease for fiscal yearended December 31, 2003 was $388,704. The lease agreement includes anapproximate 9% rent increase after the second, fourth and sixth year of thelease period, with a 60-month extension after the initial lease term at theprevailing market rental rate. Detailed information relating to this lease ispresented in Note 8 of Notes to the financial statements. The Company believesthis facility is sufficient for its needs for the foreseeable future.

 

**Item 3.  LegalProceedings**

 

From time totime, the Company is party to various claims and litigation that arise in theordinary course of business. While any litigation contains an element ofuncertainty, management believes that the ultimate outcome of any pendingclaims and litigation will not have a material effect on the Company’s resultsof operations or financial condition.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

None

 

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**PART II**

 

**Item 5.  Market for the Registrant’s Common Equity,Related Stockholder Matters and Issuers Purchases of Equity Securities**

 

**Market Information**

 

The Company’sCommon Stock began trading on the over-the-counter securities market in thethird quarter of 1991 under the symbol NRDC. The over-the-counter marketquotations reflect interdealer bid prices, without retail markup, markdown orcommission, and may not necessarily represent actual transactions. The pricesappearing below were obtained from the National Quotation Bureau.

 
| **Fiscal 2003** |   | **High** |   | **Low** |   |
|-----------------|--------|----------|--------|---------|--------|
|            |   |     |   |    |   |
| 1st Quarter     |   | $        | .07    |    | $      | .06 |   |
| 2nd Quarter     |   | .03      |   | .03     |   |
| 3rd Quarter     |   | .03      |   | .01     |   |
| 4th Quarter     |   | .04      |   | .01     |   |
|                 |        |          |        |         |        |  |  |

 
| **Fiscal  2002** |   | **High** |   | **Low** |   |
|------------------|--------|----------|--------|---------|--------|
|             |   |     |   |    |   |
| 1st Quarter      |   | $        | .40    |    | $      | .12 |   |
| 2nd Quarter      |   | .12      |   | .07     |   |
| 3rd Quarter      |   | .10      |   | .07     |   |
| 4th Quarter      |   | .10      |   | .06     |   |
|                  |        |          |        |         |        |  |  |

 

On March 22,2004, the last reported price for the Company’s Common Stock was $0.35.  Stockholders are urged to obtain currentmarket quotations for the Company’s Common Stock.

 

**Holders**

 

To the best knowledge of theCompany, the number of record holders of Common Stock as of December 31, 2003was 545. According to information obtained by the Company, approximately 446additional shareholders hold the Company’s Common Stock in “street name.”

 

**Dividends**

 

The Companydid not pay a cash dividend on its Common Stock during 2002 and 2003, and theCompany does not anticipate paying any cash dividends in the foreseeablefuture. As of the date of this Annual Report on Form 10-K, the Companyintends to follow a policy of retaining any future earnings to provide fundsfor the expansion of its business. The declaration and payment of cashdividends in the future will depend upon the Company’s earnings, financialcondition, capital needs and other factors deemed relevant by the Board ofDirectors. The Company’s ability to pay dividends is limited by the provisionsof Delaware law, by its Credit and Security Agreement with Wells Fargo BusinessCredit and under the Certificate of Designation of the Series BConvertible Preferred Stock.

 

**RecentSales of Unregistered Securities**

** **

None

 

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**Item 6. SelectedFinancial Data**

 

The followingtables summarize certain selected financial data for the periods presented andshould be read in conjunction with the more detailed information and financialstatements, including notes thereto, presented elsewhere herein.

 

**STATEMENT OFOPERATIONS DATA**

 
|                                                                                           |   | **Years  Ended December 31,** |       |
|------------------------------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                                           |   | **2003**                      |       |   |   | **2002** |   |   |   | **2001** |   |   |   | **2000** |   |   |   | **1999** |   |   |   |
| Net Sales                                                                                      |   | $                             | 16,326,296 |   | 100.0 | % | $ | 14,416,351 |   | 100.0 | % | $ | 16,641,109 |   | 100.0 | % | $ | 15,503,182 |   | 100.0 | % | $ | 11,946,702 |   | 100.0 | % |
|                                                                                           |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross profit                                                                                   |   | 7,663,997                     |       | 46.9 | % | 6,258,744 |   | 43.4 | % | 7,350,882 |   | 44.2 | % | 7,157,279 |   | 46.2 | % | 4,569,798 |   | 38.3 | % |
| Selling, general and administrative expenses                                                   |   | 7,883,398                     |       | 48.3 | % | 8,069,382 |   | 56.0 | % | 9,522,932 |   | 57.2 | % | 8,626,072 |   | 55.6 | % | 8,923,832 |   | 74.7 | % |
| Other operating expenses                                                                       |   | —                        |       | 0.0 | % | — |   | 0.0 | % | — |   | 0.0 | % | — |   | 0.0 | % | 2,844,344 |   | 23.8 | % |
| Operating loss                                                                                 |   | (219,401                      | )          | (1.3 | )% | (1,810,638 | ) | (12.6 | )% | (2,172,050 | ) | (13.1 | )% | (1,468,793 | ) | (9.5 | )% | (7,198,378 | ) | (60.3 | )% |
| Other loss                                                                                     |   | (181,514                      | )          | (1.1 | )% | (85,180 | ) | (0.6 | )% | (549,172 | ) | (3.3 | )% | (661,499 | ) | (4.3 | )% | (2,497,635 | ) | (20.9 | )% |
|                                                                                           |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss before provision for income taxes                                                         |   | (400,915                      | )          | (2.5 | )% | (1,895,818 | ) | (13.2% | ) | (2,721,222 | ) | (16.4 | )% | (2,130,292 | ) | (13.7 | )% | (9,696,013 | ) | (81.2 | )% |
| Provision for income taxes                                                                     |   | 800                           |       | 0.0 | % | 800 |   | 0.0 | % | 5,931 |   | 0.0 | % | 800 |   | 0.0 | % | 800 |   | 0.0 | % |
|                                                                                           |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                       |   | (401,715                      | )          | (2.5 | )% | (1,896,618 | ) | (13.2 | )% | (2,727,153 | ) | (16.4 | )% | (2,131,092 | ) | (13.7 | )% | (9,696,813 | ) | (81.2 | )% |
| Less:                                                                                          |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Preferred Stock Dividends                                                                      |   | (228,908                      | )          |   |   | (205,000 | ) |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   |
| Deemed Dividends                                                                               |   | (285,714                      | )          |   |   | (285,714 | ) |   |   | 0 |   |   |   | 0 |   |   |   | 0 |   |   |   |
|                                                                                           |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Loss Attributable to Common Shareholders                                                   |   | $                             | (916,337   | ) |   |   | $ | (2,387,332 | ) |   |   | $ | (2,727,153 | ) |   |   | $ | (2,131,092 | ) |   |   | $ | (9,696,013 | ) |   |   |
|                                                                                           |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic and diluted net loss per share                                                           |   | $                             | (0.02      | ) |   |   | $ | (0.05 | ) |   |   | $ | (0.36 | ) |   |   | $ | (0.30 | ) |   |   | $ | (1.81 | ) |   |   |
|                                                                                           |   |                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average number of shares used in computation of basic and  diluted net loss per share |   | 44,533,386                    |       |   |   | 44,000,000 |   |   |   | 7,600,000 |   |   |   | 7,000,000 |   |   |   | 5,346,000 |   |   |   |

 

18

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**BALANCE SHEET DATA**

 
|                             |   | **As of  December 31,** |       |
|----------------------------------|--------|-------------------------|------------|
|                             |   | **2003**                |       | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                             |   |                    |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents        |   | $                       | 144,102    |   | $ | 722,583 |   | $ | 55,388 |   | $ | 202,648 |   | $ | 1,056,240 |   |
| Working capital (deficiency)     |   | (1,789,482              | )          | (1,429,771 | ) | (1,864,116 | ) | 226,869 |   | (649,929 | ) |
| Total assets                     |   | 4,076,557               |       | 4,222,224 |   | 3,993,495 |   | 5,389,819 |   | 5,102,950 |   |
| Longterm debt                    |   | 5,609                   |       | 37,735 |   | 5,507,382 |   | 5,049,770 |   | 3,778,528 |   |
| Total stockholder’s deficit |   | $                       | (2,861,638 | ) | $ | (1,945,301 | ) | $ | (7,009,373 | ) | $ | (4,472,397 | ) | $ | (4,002,962 | ) |

 

**Item7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

The followingdiscussion and analysis of the Company’s financial condition and results ofoperations should be read in conjunction with “Item 6. Selected Financial Data”and the financial statements and related notes attached to this report. Thisdiscussion and analysis contains forward-looking statements that involve risks,uncertainties and assumptions. The Company’s actual results may differmaterially from those anticipated in these forward-looking statements as aresult of certain factors, including, but not limited, to those set forth under“Item 1. Business—Risk Factors Affecting the Company” and elsewhere in thisreport.

 

**General**

 

The Company isa branded natural products marketing company focused on growth throughinnovative, scientifically supported products designed to nourish the healthand well being of consumers.  TheCompany primarily competes in the $14.3 billion dollar segment defined by *NutritionBusiness Journal*(“NBJ”) as Sports Nutrition and Weight Loss(“SNWL”). In addition to weight control, the Company competes in the soy foodsmarket.  In 2002, that category grew by12.8% to an estimated $3.65 billion according to Spins/Soyatech. According tothe report entitled “Soyfoods: The U.S. Market 2003,” soy foods have beengrowing at a rate of more than 14 % per year for the past 10 years. The reportpoints out that sales of soy-based products were growing more quickly in massmarket channels than in natural product stores.

 

Within thebroad soy foods market, segments such as meal replacement drinks, soy milk andbars have outperformed other categories. With many brands entering the market and reduced spending by Slim Fast®,the soy protein powder category flattened in 2003.  The Company’s products include Naturade Total Soy®, a full lineof nutritionally complete meal replacements for weight loss and cholesterolreduction available in several flavors of powders, ready-to-drink products andbars, Naturade® protein powders, Aloe Vera 80® health and beauty care productsand other niche dietary supplements. The Company’s products are sold insupermarkets (e.g., Kroger, Fred Meyer, Safeway, Albertson’s and Ahold), massmerchandisers (e.g., Wal*Mart, Kmart and Shopko), club stores (e.g., Sam’sClubs, Costco and BJ’s Wholesale), drug stores (e.g., American Drug and SnyderDrug), natural food supermarkets (e.g., Whole Foods and Wild Oats) and over 5,000independent health food stores.

 

19

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**Resultsof Operations**

 

The following table sets forth, for the periods indicated, thepercentage which certain items in the statement of operations data bear to netsales and the percentage dollar increase (decrease) of such items from periodto period.

 
|                                          |   | **Percent of  Net Sales**    |   | **Percentage  Dollar Increase (Decrease)** |   |
|-----------------------------------------------|--------|------------------------------|--------|--------------------------------------------|--------|
|                                          |   | **Year Ended  December 31,** |   | **Year Ended  December 31,**               |   |
|                                          |   | **2003**                     |   | **2002**                                   |   | **2001** |   | **2003** |   | **2002** |   | **2001** |   |
|                                          |   |                         |   |                                       |   |   |   |   |   |   |   |   |   |
| Net Sales                                     |   | 100.0                        | %      | 100.0                                      | %      | 100.0 | % | 13.2 | % | (13.4 | )% | 7.3 | % |
| Gross profit                                  |   | 46.9                         | %      | 43.4                                       | %      | 44.2 | % | 22.5 | % | (14.9 | )% | 2.7 | % |
| Selling, general and administrative  expenses |   | 48.3                         | %      | 56.0                                       | %      | 57.2 | % | (2.3 | )% | (15.3 | )% | 10.4 | % |
| Operating loss                                |   | (1.3                         | )%     | (12.6                                      | )%     | (13.1 | )% | (87.9 | )% | (16.6 | )% | 47.9 | % |
| Other loss                                    |   | (1.1                         | )%     | (0.6                                       | )%     | (3.3 | )% | 113.1 | % | (84.5 | )% | (17.0 | )% |
| Loss before provision for income taxes        |   | (2.5                         | )%     | (13.2                                      | )%     | (16.4 | )% | (78.9 | )% | (30.3 | )% | 27.7 | % |
| Provision for income taxes                    |   | 0.0                          | %      | 0.0                                        | %      | 0.0 | % | 0.0 | % | 0.3 | % | (2.0 | )% |
| Net loss                                      |   | (2.5                         | )%     | (13.2                                      | )%     | (16.4 | )% | (78.8 | )% | (30.5 | )% | 28.0 | % |

 

EffectiveJanuary 1, 2002, the Company adopted Emerging Issues Task Force (“EITF”) issueNo. 01-9, Accounting for Consideration Given by a Vendor to a Customer or aReseller of the Vendor’s Products (“EITF 01-9”).  Upon adoption of EITF 01-9, the Company was required to classifycertain payments to its customers as a reduction of sales.  The Company previously classified certain ofthese payments as brand expenses, a component of selling, general and administrativeexpenses in the statement of operations. Upon the adoption of EITF 01-9, prior period amounts were reclassifiedand resulted in a reduction of sales (and an offsetting reduction of sellingexpenses) of $454,552 in 2001.  Inaddition, the Company reclassified coupon and rebate redemptions from selling,general and administrative expenses to net sales of $55,265 in 2001. New storeopenings were reclassified to cost of goods sold of $125,198 in 2001.

 

**Major trends that affected the Company’sresults of operations in 2003**

 

•                  The Companysuccessfully turned around declining revenues in the health food segmentthrough the introduction of new products coupled with successful promotion ofexisting product lines.

•                  Productreformulation coupled with increased manufacturing and distribution efficiencygrew gross margins by 3.5% as a percent of net sales

•                  Brand supportand promotional spending was focused on areas that provide a direct return tothe company resulting in reduced promotional costs per dollar of revenuegenerated.

 

***2003 Compared to2002***

 

***Net Sales***—Netsales for 2003 increased $1,909,945, or 13.2%, to $16,326,296 from $14,416,351for 2002 reflecting a turnaround in the health food channel coupled withconsistent growth in the mass market channel.  Domestic sales for 2003 increased $1,897,937, or 13.4%, to$16,091,995 from $14,194,058 for 2002. International sales for 2002 increased $12,008, or 5.4%, to $234,301from $222,293 for 2002

 

Mass Marketnet sales for 2003 increased $1,699,351, or 24.1%, to $8,749,569 from$7,050,218 for 2002. This increase was primarily a result of an increasein turn distribution sales in 2003 as compared to 2002 coupled with an increasein club business in 2003.  For 2003, thepercentage of mass market net sales to the Company’s total net sales basisincreased to 53.6% of total net sales as compared to 48.9% in 2002.

 

20

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For 2003,health food net sales increased $210,591, or 2.9%, to $7,576,727 from$7,366,133 for 2002 primarily as a result of the Company’s strong relationshipswith key health food distributors and retailers.  These relationships have provided the Company with the ability tointroduce new product Sku’s into distribution and ultimately into retail.  For 2003, the percentage of health food netsales to the Company’s total net sales basis decreased to 46.4% of total netsales as compared to 51.1% in 2002**.**

 

For 2003, thetop 40 customers accounted for $15,478,500, or 94.8%, of net sales, with 21health food customers contributing $7,123,000, or 43.6%, of net sales, 17 massmarket customers contributing $8,163,300, or 50.0%, of net sales, and twointernational customer contributing $192,200, or 1.2%, of net sales. Thiscompares to the top 40 customers accounting for $13,857,300, or 96.1%, of netsales, with 22 health food customers contributing $7,155,200, or 49.6%, of netsales, 17 mass market customers contributing $6,603,600, or 45.8%, of netsales, and one international customer contributing $98,500, or 0.7%, of netsales for 2002.

 

For all threeperiods, the Company considers the eight divisions of one major health fooddistributor and the seven divisions of a second major health food distributoras separate customers for purposes of this top 40 list, because of theirability to make independent purchasing decisions regarding the Company’sproducts once The Company products have been approved at the corporate level.In addition, two divisions of a mass market customer are one corporate legalentity, however they operate independently with separate buying departmentsand, thus, the Company considers them separate customers for purposes of thistop 40 list. This analysis differs from that shown in “Item 1.Business—General” in which the divisions of these three entities are combinedunder their corporate parent to reflect three major customers.

 

For 2003, the top40 products represented $12,965,100, or 79.4%, of net sales, with 19 NaturadeTotal Soy® products contributing $8,522,400, or 52.2%, of net sales, 11 proteinpowders contributing $2,910,800, or 17.8%, of net sales and 10 aloe vera andother products representing $1,513,900, or 9.4%, of net sales.  This compares to the top 40 productsrepresenting $12,129,900, or 84.1%, of net sales, with 17 Naturade Total Soy®products contributing $7,555,700, or 52.4%, of net sales, 13 protein powderscontributing $3,015,600, or 20.9%, of net sales and ten aloe vera and otherproducts representing $1,558,600, or 10.8%, of net sales for 2002.

 

***Gross Margin***—Grossprofit as a percentage of sales for 2003 increased to 46.9% from 43.4% in 2002.This increase in gross profit percentage is primarily due to the reformulationof Naturade Total Soy® and several other products which resulted in a productcosts decrease which more than offset small price increases implemented by akey vendor.  In addition, increasedefficiencies in distribution related to increased consistency of order flowresulting in lower product distribution costs.

 

***Selling, General andAdministrative Expenses****—*Selling, general andadministrative expenses for the fiscal year ended December 31, 2003decreased $185,984, or 2.3%, to $7,886,398, or 48.3% of net sales, from$8,069,382, or 56.0%, of net sales, for 2002. For 2003, brand expenses decreased $52,100, or 2.4%, compared to 2002,to $2,161,500 or 13.2% of net sales for 2003 from $2,213,600, or 15.4% of netsales for 2002.  The Company’s focus onthe support of retail programs that provide direct consumer consumption benefitshas resulted in this decrease as a percent of sales.  This decrease is coupled with a decrease of  $256,100 in overhead expenses, principallyfrom manpower and consulting fee reductions partially offset by increasesrelated to freight and commission expense of $95,200 and $37,700, respectively, resulting from increased sales volume

 

***Other Income(Expense)—***Other income (expense) consists of twocomponents, interest expense and other expense.

 

Interest expense consists of bank and other interest related to notesshown in Note 4 to the Financial Statements. For 2003, interest expenseincreased $75,982 to $189,462, or 1.2% of net sales, as compared to 2002 of$113,480, or .8% of net sales.  Thisincrease is principally related to an increase in the borrowing rate on theCompany’s Line of Credit and interest on the Loan Agreement as more fullyexplained in Note 4 to the Financial Statements.

 

The otherexpense category consists of unusual or non-recurring charges net of otherincome. For 2003 this other income was $7,948 compared to other income for 2002of $28,300 for a net decrease of $20,352.

 

21

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***2002 Compared to 2001***

*** ***

***Net Sales***—Netsales for 2002 decreased $2,224,758, or 13.4%, to $14,416,351 from $16,641,109for 2001 reflecting the softness in the overall economies of the U.S. andCanada.  Domestic sales for 2002decreased $2,096,502, or 12.9%, to $14,194,058 from $16,290,560 for 2001.  International sales for 2002 decreased$128,255, or 36.6%, to $222,293 from $350,548 for 2001

 

Mass Marketnet sales for 2002 decreased $1,306,828 or 15.6%, to $7,050,218 from $8,357,046for 2001. This decrease was primarily a result of (i) the decrease in newdistribution sales in 2002 as compared to 2001,  (ii) Kmart’s financial difficulties and the corresponding 45%reduction in sales to that account, and (iii) management’s decision toexit unprofitable accounts, all offset by a modest increase in turn business.

 

For 2002, the percentage of mass market net sales (excludinginternational) to the Company’s total net sales basis remained similar to theresults seen in 2001. For 2002, mass market net sales represented 48.9% oftotal net sales, compared to 50.1% of net sales for 2001.

 

For 2002,health food net sales decreased $917,930, or 11.1%, to $7,366,133 from $8,284,063for 2001. For 2002, the top 40 customers accounted for $13,857,300, or 96.1%,of net sales, with 22 health food customers contributing $7,155,200, or 49.6%,of net sales, 17 mass market customers contributing $6,603,600, or 45.8%, ofnet sales, and one international customer contributing $98,500, or 0.7%, of netsales. This compares to the top 40 customers accounting for $15,916,400, or95.7%, of net sales, with 23 health food customers contributing $7,921,800, or47.6%, of net sales, 16 mass market customers contributing $7,814,100, or47.0%, of net sales, and one international customer contributing $180,500, or1.1%, of net sales in 2001.

 

For 2002, thetop 40 products represented $12,129,900, or 84.1%, of net sales, with 17Naturade Total Soy® products contributing $7,555,700, or 52.4%, of net sales,13 protein powders contributing $3,015,600, or 20.9%, of net sales and ten aloevera and other products representing $1,558,600, or 10.8%, of net sales.  This compares to, the top 40 productsrepresented $13,507,000, or 81.2%, of net sales, with 18 Naturade Total Soy®products contributing $8,790,100, or 52.8%, of net sales, 13 protein powderscontributing $3,238,900, or 19.5%, of net sales and nine aloe vera and otherproducts representing $1,478,000, or 8.9%, of net sales for 2001.

 

***Gross Margin***—Grossprofit as a percentage of sales for 2002 decreased slightly to 43.4% from 44.2%in 2001. This decline in gross profit percentage is primarily due to priceincreases from several key vendors offset slightly by gains made in thereformulation of several products.

 

***Selling, General andAdministrative Expenses****—*Selling, general andadministrative expenses for the fiscal year ended December 31, 2002decreased $1,453,550, or 15.3%, to $8,069,382, or 56.0% of net sales, from$9,522,932, or 57.2%, of net sales, for 2001. Approximately 53.3% of thisdecrease or $775,252 is attributable to decreases in brand expenses and 10.8%is due to Health Food Sales (HFS) other costs. For 2002, brand expenses decreased $775,252, or 25.9%, compared to 2001,to $2,213,650, or 15.4% of net sales for 2002 from $2,988,902, or 18.0%, of netsales for 2001. The reduced spending in mass trade promotions and printadvertising represented the bulk of this decrease.  Mass trade promotions costs equaling $1,099,166, or 15.6%, ofmass market net sales, a $219,837, or 16.7%, decrease over the 2001 spending of$1,319,003 or 15.8% of mass market net sales. As part of the overall effort to reduce spending, advertising costsdecreased $314,822, or 99.0%, compared to 2001.  The balance of the decrease in brand expenses is attributable toHFS trade promotions, which decreased $142,680, or 16.9%, compared to2001.  Decreases in other costs in 2002;payroll (including related taxes and employee benefits) decreased 28,991, or5.6% compared to 2001; commissions decreased $50,145, or 14.0%; compared to2001; recruiting decreased $24,650, or 100.0%, compared to 2001 and all othercosts decreased $11,500, or 6.6% compared to 2001.

 

***Other Income(Expense)—***Other income (expense) consists of twocomponents, interest expense and other expense.

 

Interest expense consists of bank and other interest related to notesshown in Note 4 to the Financial Statements. For 2002, interest expensedecreased $442,599 compared to 2001 to $113,480, or .8% of net sales, for 2001,from $556,079 or 3.3% of net sales as a result of the Private EquityTransaction.

 

The otherexpense category consists of unusual or non-recurring charges net of otherincome. For 2002 this other income was $28,300 compared to other income for2001 of $6,907 for a net increase of $21,393.

 

22

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***Liquidityand Capital Resources***

 

The Company’ssources of cash in 2003 came principally from operations supported by drawingson its line of credit from Wells Fargo and a Loan Agreement with a principalshareholder and other shareholders.   Based on the current operating plan, the Company believes that itsexisting cash balances and financing arrangements will provide it withsufficient funds to finance its operations for at least the next twelve months.In the past, the Company has utilized both operating and capital leasefinancing for certain equipment used in our operations and expects to continueto selectively do so in the future. The Company may in the future requireadditional funds to support its working capital requirements or for otherpurposes, and may seek to raise such additional funds through the sale ofpublic or private equity and/or debt financings or from other sources. Noassurance can be given that additional financing will be available in thefuture or that if available, such financing will be obtainable on termsfavorable to the Company’s stockholders or us when we may require it.

 

The Company’scredit facility consists of a three year Credit and Security Agreement (the“Credit Agreement”) with Wells Fargo Business Credit, Inc. (“Wells Fargo”),which allows for maximum borrowings of up to $4,500,000, based on certainpercentages of eligible accounts receivable and inventories and pays interestat prime plus 4.5% per annum.  Availableborrowings under the Credit Agreement were $720,312 at December 31, 2003 andaveraged $510,296 during 2003.

 

The financialstatements accompanying this Annual Report on Form 10-K have been prepared on agoing-concern basis, which contemplates the realization of assets and thesatisfaction of liabilities in the normal course of business.  At December 31, 2003, the Company hadan accumulated deficit of $21,853,561 net working capital deficit of $1,789,482a stockholders’ capital deficiency of $2,861,638, and has incurred recurringnet losses.  These factors, amongothers, raise substantial doubt about the Company’s ability to continue as agoing concern.  In addition, the Company’sindependent certified public accountants have issued an opinion thatsubstantial doubt exists as to the Company’s ability to continue as a goingconcern.  The financial statements donot include any adjustments that might result from a negative outcome of thisuncertainty.

 

The Companyused cash of $1,393,881 from operating activities in the year ended December31, 2003, compared to a use of cash of $1,467,531in operating activities forthe year ended December 31, 2002. This decrease in cash used from operatingactivities is primarily due to the reduction in the Company’s net loss of$1,494,903 combined with a reduction in inventories of $949,266 partiallyoffset by a volume related increase in receivables of $1,458,634, a reductionin trade payables related to the inventory reduction of $514,334 and a increasein prepaid expenses of $296,079 compared to the same period in 2002.

 

Net cashprovided by inventories was $421,592 for the year ended December 31, 2003compared to net cash used in inventories of $527,674 for the year endedDecember 31, 2002 primarily due to lower December sales in 2002 and higherinventories at the end of the period resulting in an increase in cash providedwhen inventories were reduced to normal levels.

 

Net cash usedin accounts receivable was $906,336 for the year ended December 31, 2003compared to net cash provided from accounts receivable of $552,298 for the sameperiod of 2002, principally due to increased sales volume in 2003 coupled witha significant increase in sales volume in December 2003 related to seasonalclub store purchases compared to the same period in 2002.  Customer terms have remained constanthowever; there is a slight increase in day’s sales outstanding due to increasedvolume in the mass market channel that generally pays more slowly than thehealth food channel.

 

Net cash usedin accounts payable and accrued expenses was $569,068 year ended December 31,2003 compared to net cash used of $54,734 the same period of 2002, principallydue a higher level of accrued insurance related to premium increases fordirectors and officers insurance and workers compensation insurance.

 

The provisionfor excess and obsolete inventory provided $21,168 for the year ended December31, 2003 compared to $17,062 the same period of 2002.

 

Net cash usedby prepaid expenses was $43,368 for the year ended December 31, 2003 comparedto net cash provided in the same period of 2002 of $252,711.  The reduction in prepaid expenses in 2002was principally due to slotting fees paid to enter the mass market channel in2001 and 2002 and were amortized prior to December 31, 2002.  The Company incurred minimal slotting feesin 2003 and they were expensed as incurred.

 

The Company’sworking capital decreased $359,711 from ($1,429,771) at December 31, 2002to ($1,789,482) at December 31, 2003. This decrease was largely due to increasein receivables coupled with a reduction in accounts payable and accruedexpenses offset by a decrease in inventory and an increase borrowings on theCompany’s credit facility.

 

Cash used ininvestment activities during the year ended December 31, 2003 was $9,716compared to $7,579 for the year ended December 31, 2002.

 

23

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The Company’scash provided by financing activities was $825,116 for the year ended December31, 2003, compared to cash provided by financing activities of $2,142,304 forthe same period of 2002. The December 31, 2003 amount was the result of theLoan Agreement (described in Note 5) combined with borrowings on the Company’sline of credit.  The December 31, 2002amount was the result of the $2.5 million from the Private EquityTransaction, conversion into equity of the Health Holdings debt, and a decreasein borrowings under the Credit Agreement.

 

**Critical AccountingPolicies and Use of Estimates**

 

The Company’s significantaccounting policies are described in Note 1 of the Company’s FinancialStatements for the year ended December 31, 2003, which have been preparedin accordance with accounting principles generally accepted in the UnitedStates. In preparing the financial statements, the Company is required to makeestimates and judgments which affect the results of its operations and thereported value of assets and liabilities. Actual results may differ from theseestimates. The Company believes that the following summarizes criticalaccounting policies which require significant judgments and estimates in thepreparation of its financial statements.

 

***Revenue Recognition***. We recognizerevenue in accordance with SEC Staff Accounting Bulletin (SAB) No. 101, “Revenue Recognition in FinancialStatements,” as amended by SAB No. 101A and No. 101B.  SAB No. 101 requires that four basiccriteria must be met before revenue can be recognized: (1) persuasive evidenceof an arrangement exists; (2) delivery has occurred or services rendered; (3)the fee is fixed and determinable; and (4) collectibility is reasonablyassured.  Determination of criteria (3)and (4) require management’s judgments regarding the fixed nature of the feecharged for services rendered and products delivered and the collectibility ofthose fees. To satisfy the criteria, we: (1) input orders based upon receipt ofa customer purchase order; (2) record revenue upon shipment of goods when riskof loss and title transfer under the Company’s arrangements with customers orotherwise complying with the terms of the purchase order; (3) confirm pricingthrough the customer purchase order and; (4) validate creditworthiness throughpast payment history, credit agency reports and other financial data. Otherthan through warranty rights, the Company’s customers do not have explicit orimplicit rights of return.  Shouldchanges in conditions cause management to determine the revenue recognitioncriteria are not met for certain future transactions, such as a determinationthat an outstanding account receivable has become uncollectible, revenuerecognized for any reporting period could be adversely affected.

 

***InventoryValuation***. Merchandise inventories are stated at thelower of cost (first-in, first-out basis) or market. The Company considers costto include the direct cost of finished goods provided by co-packers as well asthe cost of those components supplied to the co-packers. At each balance sheetdate, we evaluate the Company’s ending inventories for excess quantities andobsolescence.  This evaluation includesanalyses of forecast sales levels by product and historical demand.  We write off inventories that are consideredobsolete.  Remaining inventory balances areadjusted to approximate the lower of the Company’s cost or market value andresult in a new cost basis in such inventory until sold.  If future demand or market conditions areless favorable than the Company’s projections, additional inventory write-downmay be required, and would be reflected in cost of sales in the period therevision is made.

 

***Accounts Receivable and Allowances forUncollectible Accounts***.  Accounts receivable are unsecured, and we are at risk to theextent such amounts become uncollectible. Accounts receivable is stated net of applicable reserves for returns andallowances, billbacks and doubtful accounts. The Company regularly reviews andmonitor individual account receivable balances to determine if the reserveamounts are appropriate and provides for an allowance for uncollectibleaccounts by considering historical customer buying patterns, invoice aging,specific promotions and seasonal factors.

 

24

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***Impactof Contractual Obligations and Commercial Commitments***

 

The followingsummarizes the Company’s contractual obligations at December 31, 2003 andthe effects such obligations are expected to have on liquidity and cash flow infuture periods.

 
|                                             |   | **Payments  Due by Period** |      |
|--------------------------------------------------|--------|-----------------------------|-----------|
| **Contractual Obligations**                      |   | **Total**                   |      | **Less than  1 Year** |   | **1-3 Years** |   | **4-5 Years** |   | **After 5  Years** |   |
|                                             |   |                        |      |   |   |   |   |   |   |   |   |
| Long-Term Debt                                   |   | $                           | 2,881,858 |   | $ | 2,876,249 |   | $ | 5,609 |   | $ | 0 |   | $ | 0 |   |
| Operating Leases                                 |   | $                           | 1,115,966 |   | $ | 405,286 |   | $ | 710,680 |   | $ | 0 |   | $ | 0 |   |
| Employment Contracts                             |   | $                           | 1,025,000 |   | $ | 385,000 |   | $ | 320,000 |   | $ | 320,000 |   |   | (a) |
| Consulting Agreements                            |   | $                           | 1,200,000 |   | $ | 400,000 |   | $ | 800,000 |   |   |   |   |   |
| Total Contractual Cash Obligations               |   | $                           | 6,222,824 |   | $ | 4,066,535 |   | $ | 1,836,289 |   | $ | 320,000 |   | $ | 0 |   |
| Series B Convertible Redeemable Preferred  Stock |   | $                           | 2,000,000 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 2,000,000 |   |
| Total                                            |   | $                           | 8,222,824 |   | $ | 4,066,535 |   | $ | 1,836,289 |   | $ | 320,000 |   | $ | 2,000,000 |   |

 

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(a) The employment agreementfor the Chief Financial Officer has an indefinite term.

 

In response tothese conditions, the Company entered into a Private Equity Transaction inJanuary 2002, raising $2.5 million and the Loan Agreement in April2003 pursuant to which the Company can borrow $450,000 and up to an additional$300,000 at the discretion of the lenders. See “Item 1. Business—Private EquityTransaction” and Note 4 to the Financial Statements. The net proceeds ofthese transactions will be used for working capital and general corporatepurposes, including continued penetration of the mass market. In addition, theCompany has made certain financial and organizational changes in light of thesoftening economy, including focusing its sales force on the growth-orientedmass market retail segment and stabilizing the health food segment, reducingoverhead costs and expanding the sales of previously-developed product lineextensions in the rapidly growing soy protein category, specifically in theready-to-drink market segment.

 

**Impact of Inflation**

 

From time to time, the Company experiences price increases fromthird-party manufacturers and these increases cannot always be passed on to theCompany’s customers. While, these price increases have not had a materialimpact on the Company’s historical operations or profitability in the past,they could affect sales in the future.

 

**New AccountingPronouncements**

 

In December2003, the Securities and Exchange Commission issued Staff Accounting BulletinNo. 104 (SAB No. 104), “*Revenue Recognition,”* which codifies,revises and rescinds certain sections of SAB No. 101, “*Revenue Recognition,”* inorder to make this interpretive guidance consistent with current authoritativeaccounting and auditing guidance and SEC rules and regulations. The changesnoted in SAB No. 104 did not have a material effect on the Company’sconsolidated results of operations, consolidated financial position orconsolidated cash flows.

 

In May 2003,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 150,*Accounting for Certain Instruments withCharacteristics of Both Liabilities and Equity (*“FAS 150”*),*which establishes standards for classifying and measuring certain financialinstruments with characteristics of both liabilities and equity.  FAS 150requires an issuer to classify a financial instrument that is within its scope,which may have previously been reported as equity, as a liability (or an assetin some circumstances).  This statement is effective at the beginning ofthe first interim period beginning after June 15, 2003 for publiccompanies.  The Company adopted this Statement as of July 1, 2003 and ithad no material impact on its financial statements.

 

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InApril 2003, the FASB issued SFAS No. 149, “*Amendment of Statement 133 onDerivative Instruments and Hedging Activities*” (“FAS No. 149”).FAS No. 149 amends and clarifies the accounting guidance on derivativeinstruments (including certain derivative instruments embedded in othercontracts) and hedging activities that fall within the scope of FASNo. 133, “Accounting for Derivative Instruments and Hedging Activities.”FAS No. 149 also amends certain other existing pronouncements, which willresult in more consistent reporting of contracts that are derivatives in theirentirety or that contain embedded derivatives that warrant separate accounting.This Statement is effective for contracts entered into or modified afterJune 30, 2003, with certain exceptions, and for hedging relationshipsdesignated after June 30, 2003. We do not have any contracts that are derivativesor that contain embedded derivatives.

 

In January2003, the FASB issued FASB Interpretation No. 46,*Consolidation of Variable InterestEntities,* an interpretation of Accounting Research Bulletins (“ARB”)No. 51,*Consolidated Financial Statements* (“FIN 46”).  FIN 46 clarifiesthe application of ARB No. 51 to certain entities in which equity investors donot have the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties.  The Companydoes not believe the adoption of FIN 46 will have a material impact on itsfinancial position and results of operations.

 

In December2002, the FASB issued Statement of Financial Accounting Standards No. 148,*Accountingfor Stock-Based Compensation — Transition and Disclosure* (“FAS148”), which amends Statement of Financial Accounting Standards No. 123,*Accountingfor Stock-Based Compensation* (“FAS 123”). FAS 148 provides alternativemethods of transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation. In addition, FAS 148 amendsthe disclosure requirements of FAS 123 to require more prominent and morefrequent disclosures in financial statements of the effects of stock-basedcompensation. The transition guidance and annual disclosure provisions of FAS148 are effective for fiscal years ending after December 15, 2002. The interimdisclosure provisions are effective for financial reports containing condensedfinancial statements for interim periods beginning after December 15, 2002. Theadoption of FAS 148 did not have a material impact on the Company’sconsolidated balance sheet or results of operations as the Company intends tocontinue to account for its equity based compensation plans using the intrinsicvalue method.  The Company provided the interim disclosures required byFAS 148 beginning in the first quarter of 2003.

 

In November2002, the FASB issued Interpretation No. 45,*Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness to Others*,an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASBInterpretation No. 34. This interpretation elaborates on the disclosures to bemade by a guarantor in its interim and annual financial statements about itsobligations under guarantees issued. The interpretation also clarifies that aguarantor is required to recognize, at inception of a guarantee, a liabilityfor the fair value of the obligation undertaken. The initial recognition andmeasurement provisions of the interpretation are applicable to guaranteesissued or modified after December 31, 2002 and are not expected to have amaterial effect on the Company’s financial statements. The disclosurerequirements are effective for financial statements of interim and annualperiods ending after December 31, 2002. The Company adopted this Statement asof January 1, 2003 and it had no material impact on its financial statements.

 

In June 2002,the FASB issued FAS No. 146,*Accounting for Costs Associated with Exit orDisposal Activities*, which addresses accounting for restructuringand similar costs. FAS No. 146 supersedes previous accounting guidance, principallyEmerging Issues Task Force (“EITF”) Issue No. 94-3. The Company will adopt theprovisions of SFAS No. 146 for restructuring activities initiated afterDecember 31, 2002. FAS No. 146 requires that the liability for costs associatedwith an exit or disposal activity be recognized when the liability is incurred.Under EITF No. 94-3, a liability for an exit cost was recognized at the date ofa company’s commitment to an exit plan. FAS No. 146 also establishes that theliability should initially be measured and recorded at fair value. Accordingly,FAS No. 146 may affect the timing of recognizing future restructuring costs aswell as the amount recognized.

 

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**Item 7A.  Quantitative and Qualitative DisclosureAbout Market Risk**

 

In the normalcourse of business, the Company is exposed to a variety of risks includingmarket risk associated with interest rate movements. The Company’s exposure tomarket risk for changes in interest rates relates primarily to the Company’slong-term debt.

 

The Company’slong-term debt primarily consists of a (i) $4.5 million line of creditwith Wells Fargo originally entered into on January 27, 2000 and amendedon December 20, 2001, September 19, 2002, March 24, 2003 and November 6,2003, (ii) $162,345 outstanding under Investor Notes with investors enteredinto on August 31, 2000 and (ii) $450,000 borrowed under a Loan Agreement withinvestors entered into on April 14, 2003. After giving effect to the Health Holdings debt-to-equity conversion onJanuary 2, 2002 as part of the Private Equity Transaction, a$4 million Credit Agreement with Health Holdings was converted into equityon January 2, 2002 as part of the Private Equity Transaction. The line ofcredit bears interest at prime rate plus 4.5%. The Investor Notes bear interestat 15% per annum with principal payments of $10,000 per month and a balloonpayment of $92,345 due on August 31, 2004, and the 2003 Loan Agreementbears interest at 15% per annum with a due date of December 31, 2004. Given thefixed interest rate on the Loan Agreements, interest rate changes generallywill have no effect on the interest rates under the Loan Agreements or on theCompany’s results of operations. However, given the variable interest rate on theline of credit, the impact of interest rate changes on the line of credit couldhave a material impact on the Company’s results of operations. For the fiscalyear ended December 31, 2003, the interest expense on the line of creditwas $117,243. If the interest rate on the line of credit were to increase byone percent, this would result in an interest expense of $139,382 for thefiscal year ended December 31, 2003.

 

**Item 8.  Financial Statements and Supplementary Data**

 

The Company’sfinancial statements and the notes thereto, and the Report of IndependentCertified Public Accountants, filed with this Annual Report on Form 10-K in aseparate section,  Part IV, as shown inthe index under Item 15(a).

 

**Item 9.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

None

 

**Item 9A.  Controls and Procedures**

 

The Company’s Chief Executive Officer, Bill D. Stewart, and ChiefFinancial Officer, Stephen M. Kasprisin, with the participation of theCompany’s management, carried out an evaluation of the effectiveness of theCompany’s disclosure controls and procedures pursuant to Exchange ActRule 15d-14(c).  Based upon thatevaluation, the Chief Executive Officer and the Chief Financial Officer believethat, as of the end of the period covered by this report, the Company’sdisclosure controls and procedures are effective in making known to themmaterial information relating to the Company (including its consolidatedsubsidiaries) required to be included in this report.

 

Disclosure controls andprocedures, no matter how well designed and implemented, can provide onlyreasonable assurance of achieving an entity’s disclosure objectives.  The likelihood of achieving such objectivesis affected by limitations inherent in disclosure controls and procedures.  These include the fact that human judgmentin decision-making can be faulty and that breakdowns in internal control canoccur because of human failures such a simple errors or mistakes or intentionalcircumvention of the established process.

 

There was no change in theCompany’s internal control over financial reporting, known to the ChiefExecutive Officer or the Chief Financial Officer that occurred during theperiod covered by the report that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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**PART III**

 

**Item 10. Directorsand Executive Officers**

 

The names andages of the directors and executive officers of the Company as of March 7,2004, are as follows:

 
| **Name**                 |   | **Age** |   | **Position**                                                 |   | **Since**      |   |
|--------------------------|--------|---------|--------|--------------------------------------------------------------|--------|----------------|--------|
|                     |   |    |   |                                                         |   |           |   |
| Bill D. Stewart          |   | 61      |   | Director,  Chairman of the Board and Chief Executive Officer |   | 1998           |   |
| Lionel P. Boissiere, Jr. |   | 45      |   | Director                                                     |   | 1997           |   |
| William B. Doyle, Jr.    |   | 44      |   | Director                                                     |   | 1997           |   |
| David A. Weil            |   | 65      |   | Director                                                     |   | 1999           |   |
| Jay W. Brown             |   | 58      |   | Director                                                     |   | 2002           |   |
| Robert V. Vitale         |   | 38      |   | Director                                                     |   | 2002           |   |
| Stephen M. Kasprisin     |   | 50      |   | Chief  Financial Officer                                     |   | March 2003     |   |
| Marwan Zreik             |   | 30      |   | Chief  Operating Officer                                     |   | February  2003 |   |

 

The directors serve untilthe next annual meeting of stockholders, or until their successors are elected.

 

* Bill D. Stewart.*  Mr. Stewart served from 1989 to 1997 asPresident of The Thompson’s Minwax Company. Mr. Stewart served as VicePresident of Sales with Thompson’s from 1986 to 1989. Prior to joiningThompson’s, Mr. Stewart served for 16 years with pharmaceuticalcompany Richardson Vicks in various capacities.

 

 *Lionel P. Boissiere, Jr.*  During the past eight years,Mr. Boissiere has been an investor and advisor to middle market companies.From 1993 through 1995, he worked with Govett Ltd., and since 1995,Mr. Boissiere has been a Managing Member at Doyle & BoissiereLLC.

 

 *William B. Doyle, Jr.*  Since 1995, Mr. Doyle has served as aManaging Member of Doyle & Boissiere LLC. Prior to such time,Mr. Doyle was with Govett Ltd. Mr. Doyle is an investor and anadvisor to middle market companies.

 

 *David A. Weil.*  Mr. Weil has been an investor andadvisor to early stage companies during the past five years. Mr. Weilcurrently serves as co-Chief Executive Officer of two private companies. UntilJune 1998, Mr. Weil also served as co-Chief Executive Officer ofFrontline Capital, Inc., a broker-dealer which specialized in working withearly stage companies. Mr. Weil holds engineering and law degrees fromWashington University and an LLM degree from New York University.

 

 *Jay W. Brown.*  For the last five years, Mr. Brown hasbeen a principal with Westgate Group, LLC, a related entity to Westgate EquityPartners, LLC. Prior to forming Westgate, Mr. Brown was a senior executivewith the Ralston Purina Company, running several divisions of thatmulti-dimensional food and agribusiness company. From 1995 to 1998,Mr. Brown was President and Chief Executive Officer of ProteinTechnologies International, Inc., the world’s largest supplier ofsoy-based protein to the food and paper processing industries. Prior to that,Mr. Brown was Chairman and Chief Executive Officer of Continental BakingCompany from 1984 to 1995 and President of Van Camp Seafood Company from 1983to 1984.

 

 *Robert V. Vitale.*  Mr. Vitale is a principal with WestgateGroup, LLC with primary responsibility for acquisitions and divestitures. From1994 to 1996, Mr. Vitale was a Vice President of the Boatmen’s CapitalMarkets and of NationsBank (after NationsBank’s 1997 acquisition of Boatmen’s).At Boatmen’s, Mr. Vitale was responsible for corporate finance activitiesincluding private placements of senior and subordinated debt as well as multi-tieredbank debt financing. Previously, Mr. Vitale was a Senior Associate withKPMG Peat Marwick from 1988 to 1993 where he was responsible for merger andacquisition engagements. Mr. Vitale is a certified public accountant.

 

*Stephen M. Kasprisin.*  Mr. Kasprisin served as Chief FinancialOfficer of Outsource Merchandising Corporation, a distributor of consumerproducts to grocery and drug stores, from 1999 to 2001.  From 1989 to 1999, he served as ChiefFinancial Officer of Acorn Products, Inc., a public consumer productsmanufacturer.  Mr. Kasprisin is aCertified Public Accountant and was on the audit staff of Coopers &Lybrand, now PriceWaterhouseCoopers, from 1976 to 1980.  He has a Bachelor of Arts fromBaldwin-Wallace College, with a major in Business Administration.

 

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*Marwan Zreik.* ACertified Clinical Nutritionist, Mr. Zreik joined Naturade in 1997 and isresponsible for all aspects of the Company’s distribution, purchasing, customerservice, research & development and quality control.  He was previously Research Coordinator forGero Vita International, Inc. and was a Research Assistant at the University ofCalifornia, San Diego while attending school there.  He received his BS degree in animal physiology and neurosciencefrom UC San Diego and an MS degree in physiology and biophysics from GeorgetownUniversity.  He is currently an MBAcandidate at the University of Southern California

 

**Code of Ethics**

 

The Companyhas adopted a Code of Ethics applicable to the principal executive officer andsenior financial executives, including the chief financial officer and thecontroller, of the Company, as well as all employees of the Company.  The Code of Ethics is available on requestby writing to the Secretary of the Company.

 

**Audit Committee**

 

The currentmembers of the Audit Committee are composed of Lionel P. Boissiere, Jr., RobertV. Vitale and David Weil.  The Companyhas determined that Robert V. Vitale qualifies as an “audit committee financialexpert” as defined in Item 401(h) of Regulation S-K.

 

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**Item 11. ExecutiveCompensation**

 

The followingtable sets forth, as to the Chief Executive Officer and as to the two othermost highly compensated officers whose compensation exceeded  $100,000 during the last fiscal year (the“Named Executive Officers”), information concerning all cash and non-cashcompensation awarded, earned or paid for services to the Company in all capacitiesfor each of the three years ended December 31, 2003, 2002 and 2001.

 

**Summary Compensation Table**

 
|                                                    |   |     |   |                     |   |      |   |                            |   | **Long Term  Compensation**     |   |                                    |   |
|---------------------------------------------------------|--------|----------|--------|--------------------------|--------|-----------|--------|---------------------------------|--------|---------------------------------|--------|-----------------------------------------|--------|
|                                                    |   |     |   | **Annual  Compensation** |   |      |   | **Awards**                      |   | **Payouts**                     |   |                                    |   |
| **Name and  Principal  Position**                       |   | **Year** |   | **Salary**               |   | **Bonus** |   | **Other  Annual  Compensation** |   | **Restricted  Stock  Award(s)** |   | **Securities  Underlying  Options/SAR** |   | **LTIP  Payouts** |   | **All Other  Compensation** |   |
|                                                    |   |     |   | **($)**                  |   | **($)**   |   | **($)**                         |   | **($)**                         |   | **($)**                                 |   | **($)** |   |   |   |
| Bill Stewart, Chief Executive Officer (1),  (5)         |   | 12/31/01 |   | 218,667                  |   |      |   | 30,000                          |   |                            |   | 50,000                                  | (4)    |   |   | 16,124 | (6) |
|                                                    |   | 12/31/02 |   | 225,000                  |   |      |   | -0-                             |   |                            |   | -0-                                     |   |   |   | 15,114 | (6) |
|                                                    |   | 12/31/03 |   | 236,755                  |   |      |   | -0-                             |   |                            |   | -0-                                     |   |   |   | 15,096 | (6) |
|                                                    |   |     |   |                     |   |      |   |                            |   |                            |   |                                    |   |   |   |   |   |
| Stephen M. Kasprisin, Chief Financial  Officer (2), (5) |   | 12/31/03 |   | 114,586                  |   |      |   |                            |   |                            |   |                                    |   |   |   | 186 | (7) |
|                                                    |   |     |   |                     |   |      |   |                            |   |                            |   |                                    |   |   |   |   |   |
| Marwan Zreik, Chief Operating Officer (3), (5)          |   | 12/31/01 |   | 99,184                   |   |      |   |                            |   |                            |   |                                    |   |   |   | 1,748 | (8) |
|                                                    |   | 12/31/02 |   | 98,241                   |   |      |   |                            |   |                            |   |                                    |   |   |   | 30,943 | (8) |
|                                                    |   | 12/31/03 |   | 119,247                  |   |      |   |                            |   |                            |   |                                    |   |   |   | 21,338 | (8) |

 

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(1)                                  For a description ofthe employment agreements between certain Named Executive Officers and theCompany, see “Employment Contracts, Termination of Employment and Change inControl Arrangements.”

 

(2)                                  Mr. Kasprisin wasappointed Chief Financial Officer on March 25, 2003.

 

(3)                                  Mr. Zreik wasappointed Chief Operating Officer on February 1, 2003.

 

(4)                                  Such amountsrepresent stock options that were granted by the Company to Mr. Stewartduring 2000 with an exercise price of $0.875 per share and 2001 with anexercise price of $0.44 per share. On January 2, 2002, these options wererepriced to $0.1477 per share, the purchase price in the Private EquityTransaction, and fully vested.  Theyexpire seven years from the initial grant date.

 

(5)                                  Mr. Stewart, Mr.Kasprisin and Mr. Zreik participated with other full-time employees in theCompany’s group health and life insurance program.

 

(6)                                  Such amountrepresents automobile lease payments and life insurance premiums, respectively,paid on behalf of Mr. Stewart.

 

(7)                                  Such amountrepresents life insurance premiums, paid on behalf of Mr. Kasprisin.

 

(8)                                  Such amountrepresents Company contributions to the Company’s 401(k) Plan, tuitionreimbursement and life insurance premiums, paid on behalf of Mr. Zreik.

 

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**Options/SARGrants In Last Fiscal Year**

 

The following table sets forth common stock options issued to namedexecutives during 2003:

 
|                 |   | **Individual  Grants**                                                 |   | **Potential  realizable  value at assumed  annual rates of stock  price appreciation for  option term** |   |
|----------------------|--------|------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|--------|
| **Name**             |   | **Number of  securities  underlying  options/SAR’s  granted (#)** |   | **Percent of  total  options/SAR’s  granted to  employees in  fiscal year**                        |   | **Exercise  price** |   | **Expiration  Date** |   | **5%** |   | **10%** |   |
|                 |   |                                                                   |   |                                                                                                    |   | **($/Sh)** |   |   |   | **($)** |   | **($)** |   |
|                 |   |                                                                   |   |                                                                                                    |   |   |   |   |   |   |   |   |   |
| Bill Stewart         |   | 300,000                                                                |   | 29                                                                                                      | %      | $ | 0.03 |   | 7/30/10 |   | $ | 12,664 |   | $ | 17,538 |   |
|                 |   |                                                                   |   |                                                                                                    |   |   |   |   |   |   |   |   |   |
| Stephen M. Kasprisin |   | 150,000                                                                |   | 15                                                                                                      | %      | $ | 0.03 |   | 6/30/10 |   | $ | 6,331 |   | $ | 8,769 |   |
|                 |   |                                                                   |   |                                                                                                    |   |   |   |   |   |   |   |   |   |
| Marwan Zreik         |   | 200,000                                                                |   | 20                                                                                                      | %      | $ | 0.03 |   | 6/30/10 |   | $ | 8,443 |   | $ | 11,692 |   |

 

**Report on Repricingof Options (and SARs)**

 

None

 

**Aggregated Option/SARExercises in Last Fiscal Year and Fiscal Year End Option/SAR Values**

 
|                 |   |                                  |   | **Number of  Securities Underlying Unexercised  Options/SARs at FY-End (#)** |   | **Value of  Unexercised In-  the-Money  Options/SARs at FY-End  ($)(1)** |   |
|----------------------|--------|---------------------------------------|--------|------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------|--------|
| **Name**             |   | **Shares  Acquired on  Exercise (#)** |   | **Value  Realized ($)**                                                      |   | **Exercisable/Unexercisable**                                            |   | **Exercisable/Unexercisable** |   |
|                 |   |                                  |   |                                                                         |   |                                                                     |   |   |   |
| Bill Stewart         |   | -0-                                   |   | -0-                                                                          |   | 325,000/340,000                                                          |   | $0/$0 |   |
| Stephen M. Kasprisin |   | -0-                                   |   | -0-                                                                          |   | 37,500/112,500                                                           |   | $0/$0 |   |
| Marwan Zreik         |   | -0-                                   |   | -0-                                                                          |   | 81,250/158,750                                                           |   | $0/$0 |   |
|                 |   |                                  |   |                                                                         |   |                                                                     |   |   |   |

 

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(1)          The value of unexercised “in-the-money”options is the difference between the closing sale price of Common Stock onDecember 31, 2003 ($0.01 per share) and the exercise price of the option,multiplied by the number of shares subject to the option.

 

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The following table sets forth certain information as of December 31,2003 with respect to all compensation plans under which equity securities ofthe Company maybe issued.

 

**EquityCompensation Plan Information**

 
| **Plan  category**                                          |   | **Number of  securities to be  issued upon exercise of  outstanding options,  warrants and rights** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights** |   | **Number of  securities  remaining available for future  issuance under equity  compensation plans (excluding  securities reflected in column (a)).** |    |
|-------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|---------|
|                                                        |   | **(a)**                                                                                             |   | **(b)**                                                                            |   | **(c)**                                                                                                                                               |    |
| Equity compensation plans approved by  security holders     |   | 1,619,500                                                                                           |   | $                                                                                  | 0.14   |                                                                                                                                                  | 380,500 |   |
| Equity compensation plans not approved by  security holders |   | 87,500                                                                                              |   | 1.03                                                                               |   | 0                                                                                                                                                     |    |
| **Total**                                                   |   | 1,707,000                                                                                           |   | $                                                                                  | 0.19   |                                                                                                                                                  | 380,500 |   |

 

**Compensation ofDirectors**

 

Effective June2002, all non-management directors except Messrs. Boissiere, Doyle, Brownand Vitale received directors’ fees of $3,000 for each meeting attended.

 

**Employment Contracts,Termination of Employment and Change-In-Control Arrangements**

 

OnFebruary 18, 1998, the Company and Bill D. Stewart entered into anemployment agreement under which the Company retained Mr. Stewart as ChiefExecutive Officer and a member of the Company’s Board of Directors for aninitial term of 48 months. Under the employment agreement, as amended,Mr. Stewart receives an annual salary of $225,000, automobile leasepayments and life insurance payable as directed by Mr. Stewart.

 

OnMarch 2, 1998, the Company granted to Mr. Stewart, pursuant to theCompany’s 1998 Incentive Stock Option Plan, options to acquire up to 255,000shares of Common Stock at $4.00 per share (the average closing bid price of theshares of Common Stock on the NASDAQ OTC Bulletin Board as quoted by Bloomberg,LP for the five (5) day trading period ending on March 2, 1998).These options were repriced to 110% of the market price of the Common Stock onOctober 14, 1999 ($1.13). On February 1, 2000, the Company granted toMr. Stewart, pursuant to the Company’s 1998 Incentive Stock Option Plan,options to acquire up to 60,000 shares of Common Stock at $0.875 per share (theclosing bid price of the shares of Common Stock on the NASD OTC Bulletin Board,as quoted by Bloomberg, LP). Furthermore, on January 26, 2001, the Companygranted to Mr. Stewart, pursuant to the Company’s 1998 Incentive StockOption Plan, options to acquire up to 50,000 shares of Common Stock at $0.44per share (the closing bid price of the shares of Common Stock on the NASD OTCBulletin Board, as quoted by Bloomberg, LP). All options will vest in fourequal portions on each of the first four anniversaries of the grant date,subject to any limitations on exercise contained in the 1998 Incentive StockOption Plan and provided that the term of Mr. Stewart’s employment withthe Company shall not have ended prior to such anniversary. In the event of anysale (including, pursuant to either a tender offer or a merger of the Companywhich results in the shareholders of the Company holding less than fiftypercent (50%) of the stock of the surviving corporation) of the Company duringsuch term, subject to certain limitations, all of Mr. Stewart’s optionsnot then vested shall immediately vest.

 

As part of thePrivate Equity Transaction on January 2, 2002, as described more fully inNote 5 to the Financial Statements and “Item 1. Business—Private EquityTransaction,” the employment agreement with Mr. Stewart was amended andrestated to extend the term until December 31, 2003 and allow for the immediatevesting of options to purchase 365,000 shares of Common Stock, 297,500 of whichwould have vested by March 2, 2002, the four-year anniversary of theoriginal employment agreement, at an exercise price reduced to $0.1477 pershare, the purchase price in the Private Equity Transaction. The amended andrestated employment agreement also reconfirmed the understanding that alloptions become fully vested in the event of any sale of the Company andextended the term of employment to December 31, 2003 which in turn, hasbeen extended to December 31, 2005.

 

In July 2003,Mr. Kasprisin, Chief Financial Officer, entered into an employmentagreement with the Company that can be terminated without cause by either partyupon 30 days’ notice. Mr. Kasprisin is entitled to severance equal to 6months base pay should he be terminated without cause by the Company.  Pursuant to the employment agreement,Mr. Kasprisin is entitled to a base salary of $160,000 per year and abonus based upon his base salary. In addition, Mr. Kasprisin has beengranted options to purchase up to 150,000 shares of Common Stock, which optionsvest in equal quarterly amounts on each of the first eight quarters of hisemployment.

 

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**Incentive StockOption Plan**

 

In 1998, theCompany adopted the 1998 Incentive Stock Option Plan (the “Incentive Plan”).The Incentive Plan provides for the issuance of incentive stock options withinthe meaning of Section 422 of the Internal Revenue Code of 1986, asamended (the “Code”). The purpose of the Incentive Plan is to enable theCompany to attract, retain and motivate its employees by providing forperformance-based benefits. At the 2000 annual stockholders’ meeting, thenumber of shares of the Company’s Common Stock, which may be subject to awardsgranted under the Incentive Plan, was increased to 850,000. At the 2001 annualstockholders’ meeting, the number was further increased to 2,000,000. As ofDecember 31, 2003 options to purchase under the Incentive Plan there were1,619,500 shares of the Company’s Common Stock subject to outstanding options,of which options to purchase 683,500 shares (subject to adjustment to preventdilution) had vested and 380,500 shares were available for future awards underthe Incentive Plan.

 

The IncentivePlan is administered by a committee of the Board of Directors, consisting ofthree members, or administered by the full Board of Directors. The Committeehas the power to construe and interpret the Incentive Plan and, subject toprovisions of the Incentive Plan, to determine the persons to whom and thedates on which awards will be granted, the number of shares to be subject toeach award, the times during the term of each award within which all or aportion of such award may be exercised, the exercise price, the type ofconsideration and other terms and conditions of such award. The exercise ofstock options under the Incentive Plan may not be less than the fair marketvalue of the Common Stock subject to the option on the date of the option grantand in some cases may not be less that 110% of fair market value. The maximumterm of the Incentive Plan is ten years, except that the Board may terminatethe Incentive Plan earlier. The term of each individual award will depend uponthe written agreement between the Company and the grantee setting forth theterms of the awards.

 

In addition tooptions issued under the Incentive Stock Option Plan, options to purchase87,500 shares of Common Stock have been issued to directors and a consultant ofthe Company under individual agreements.

 

**401(k) Plan**

 

The Companymaintains a 401(k) profit sharing plan (“401(k) Plan”) for the benefit of allemployees who meet certain age and length of service requirements. The 401(k)Plan provides for Company matching contributions equal to 25% of each employeeparticipant’s contribution not to exceed 6% of the employee participant’scompensation.

 

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**Item 12. Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters**

 

The followingtable sets forth information regarding beneficial ownership, as of December 31,2003, of the Company’s outstanding Common Stock by (i) any person who isknown to the Company to be the beneficial owner of more than 5% of theCompany’s voting securities, (ii) each director and each of the NamedExecutive Officers, and (iii) by the directors and executive officers ofthe Company as a group. Beneficial ownership is determined in accordance withthe rules of the Securities and Exchange Commission. In computing the number ofshares beneficially owned by a person and the percentage of ownership of thatperson, shares of Common Stock subject to options or warrants held by thatperson that are currently exercisable or will become exercisable within60 days are deemed outstanding but are not deemed to be outstanding as toany other person.

 

The Company’sSeries B Convertible Preferred Stock votes with the Common Stock on allmatters presented to the stockholders, on as as-converted-to-Common Stockbasis. Each share of Series B Convertible Preferred Stock is convertibleinto one share of Common Stock (subject to adjustment for antidilution), at anytime at the option of the holder.

 
| **Name and Address of  Beneficial Owner(1)**                                                             |   | **Class of  Stock**      |   | **Amount and  Nature  of Beneficial Owner** |   | **Percent  of Class (2)** |       |
|----------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|---------------------------------------------|--------|---------------------------|------------|
|                                                                                                     |   |                     |   |                                        |   |                      |       |
| Lionel P. Boissiere, Jr.                                                                                 |   | Common                   |   | 41,054,267                                  | (3)    | **92.2**                  | **%**      |
| Jay W. Brown                                                                                             |   | Series B  Preferred |   | 47,182,271                                  | (4)    | **100.0**                 | **%**      |
|                                                                                                     |   | Common                   |   | 55,822,996                                  | (5)    | **51.0**                  | **%**      |
| William B. Doyle, Jr.                                                                                    |   | Common                   |   | 41,054,267                                  | (3)    | **92.2**                  | **%**      |
| Health Holdings and Botanicals, LLC. Suite  500 330 Primrose Rd. Burlingame, CA 94010                    |   | Common                   |   | 41,054,267                                  | (3)    | **92.2**                  | **%**      |
| Bill D. Stewart                                                                                          |   | Common                   |   | 427,000                                     | (7)    | *****                     | ** ** |
| Stephen M. Kasprisin                                                                                     |   | Common                   |   | 37,500                                      | (8)    | *****                     | ** ** |
| Robert V. Vitale                                                                                         |   | Series B  Preferred |   | 47,182,271                                  | (4)    | **100.0**                 | **%**      |
|                                                                                                     |   | Common                   |   | 55,822,996                                  | (5)    | **51.0**                  | **%**      |
| David Weil                                                                                               |   | Common                   |   | 1,093,517                                   | (6)    | *****                     |       |
| Westgate Equity Partners, L.P. One Magna  Place Suite 650 1401 South Brentwood Blvd. St. Louis, MO 63144 |   | Series B  Preferred |   | 47,182,271                                  | (4)    | **100.0**                 | **%**      |
|                                                                                                     |   | Common                   |   | 55,822,996                                  | (5)    | **51.0**                  | **%**      |
| Executive officers and directors as a group  (7 persons)                                                 |   | Common                   |   | 98,523,280                                  | (9)    | **97.6**                  | **%**      |
| Marwan Zreik                                                                                             |   | Common                   |   | 87,500                                      | (10)   | *****                     |       |

 

----

*              Lessthan 1%

 

(1)                                  Exceptas otherwise indicated, the address of each person named in the above table isin care of Naturade, Inc., 14370 Myford Road, Irvine, CA. 92606.

 

(2)                                  CommonStock, including Series B Convertible Preferred Stock on asas-converted-to-Common Stock basis.

 

(3)                                  Totalincludes 5,064,412 shares of Common Stock owned by Health Holdings and35,989,855 shares of Common Stock received in exchange for $5,315,702 owedunder the Company’s Credit Agreement and Loan Agreement as discussed under Item13 and as more fully explained under Note 4 to the Financial Statements.Under the terms of the Private Equity Transaction, the 600,000 shares of CommonStock exercisable under warrants related to the Company’s Finance Agreementwere modified to make the warrants exercisable for Non-Voting Common Stockrather than Common Stock as discussed under Item 13. Common shares of HealthHoldings are held by (i) Doyle & Boissiere Fund I, LLC, aDelaware limited liability company (of which Messrs. William B. Doyle, Jr.and Lionel P. Boissiere, directors of the Company, are principals and managingmembers), (ii) Mr. Anders Brag and (iii) TaishanHoldings, Inc., a British Virgin Islands corporation (of whichMessrs. William S. Doyle (no relation to William B. Doyle, Jr.) and AndersBrag hold equity interests). Messrs. William B. Doyle, Jr. and Lionel P.Boissiere each disclaim beneficial ownership of the Company’s Common Stock andPreferred Stock held by Health Holdings. The list of shares in their name inthe table shall not be construed as an admission of beneficial ownership interest.

 

34

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(4)                                  Totalincludes 13,540,723 shares of Series B Convertible Preferred Stock andwarrants to purchase an additional 33,641,548 shares of Series BConvertible Preferred Stock. Each share of Series B Convertible PreferredStock is convertible into one share of Common Stock at the option of the holder(subject to adjustment to prevent dilution). The Series B ConvertiblePreferred Stock is held by Westgate Equity Partners, L.P. of which Messrs. Brownand Vitale are principals, a related company to Westgate Group, LLC.Messrs. Brown and Vitale each disclaim beneficial ownership of theCompany’s Common Stock and Preferred Stock held by Westgate Equity Partners,L.P. The list of shares in their name in the table shall not be construed as anadmission of beneficial ownership interest.

 

(5)                                  Totalincludes 16,020,499 shares of Common Stock issuable on conversion of the13,540,723 shares of Series B Preferred Stock owned by Westgate and 39,802,497shares issuable on the exercise and conversion of the 33,641,548 shares ofSeries B Preferred Stock subject to warrants owned by Westgate, which expire onDecember 31, 2004,, as adjusted for antidilution as of December 31,2003.   The 13,540,723 shares of  Series B Preferred Stock may currently bevoted on an as-converted-to-Common Stock basis.  

 

(6)                                  Totalincludes 85,000 shares of Common Stock solely owned by Mr. Weil, 238,125shares of Common Stock owned by a company of which Mr. Weil is a 50%owner, 50,000 shares of Common Stock which can be purchased under presentlyexercisable options and 720,392 shares of Common Stock issued upon conversionof a $50,000 note which is part of the Loan Agreement as discussed under Item13.

 

(7)                                  Totalincludes 365,000 shares of Common Stock which can be purchased under presentlyexercisable options.

 

(8)                                  Totalincludes 37,500 shares of Common Stock which can be purchased under presentlyexercisable options. 

 

(9)                                  Totalincludes shares of Common Stock beneficially owned by Health Holdings andCommon Stock beneficially owned by Westgate Equity Partners; see note 3and note 4 above, respectively. See also notes 5, 6, 7 and 9 above withrespect to additional shares of Common Stock included in this total.

 

(10)                            Totalincludes 240,000 shares of Common Stock which can be purchased under presentlyexercisable options. 

 

35

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**Item 13. CertainRelationships and Related Transactions**

 

As of December12, 1997 the Company entered into a Consulting Agreement with Doyle &Boissiere LLC (“D&B”), an affiliate of Health Holdings.  Under the Consulting Agreement, as long asaffiliates of D & B own at least 25% of the outstanding equity interests ofthe Company, D&B will provide consulting services to the Company andreceive a total annual fee of  $300,000,payable quarterly. D&B waived the payment of this fee for all of 2003.

 

InAugust 1999, the Company entered into a Credit Agreement (the “CreditAgreement”) with Health Holdings, a majority stockholder of the Company. TheCredit Agreement allows for advances (the “Advances”) of $4 million at aninterest rate of 8% per annum with a due date of July 31, 2004. During2001, Health Holdings agreed to convert interest earned from October 1,2000 to September 30, 2001 of $342,406 to the outstanding principal amountas a payment-in-kind resulting in a balance at December 31, 2001 of$4,496,194. As part of the Private Equity Transaction on January 2, 2002as described more fully in Note 5, Health Holdings agreed to convert allof the Company’s Credit Agreement debt due to Health Holdings, plus accruedinterest of $67,012, for a total debt conversion of $4,563,206.

 

InAugust 2000, the Company entered into a Loan Agreement (the “LoanAgreement”) with Health Holdings and other investors (the “Lender Group”). TheLoan Agreement allows for advances (the “Loan Advances”) of up to$1.2 million at an interest rate of 8% per annum. During 2001, the LoanAgreement was amended to allow for a one year term for $50,000 advanced from DavidWeil, a member of the Board of Directors. This amendment did not change theterms of the remaining Loan Agreement amounts. Thus, as of December 31,2001, amounts due under the Loan Agreement included $50,000 due onSeptember 12,2002 to David Weil and with the remaining balance outstandingdue August 31, 2003. Interest only payments are required on a quarterlybasis. On June 13, 2001, two investors converted their total debt of$150,000 plus accrued interest of $2,400 into Common Stock, receiving a totalof 476,250 shares of the Company’s Common Stock based on the then fair marketvalue of $0.32. As of December 31, 2001, the Company had borrowed $993,790under this facility. Of this amount, $741,445 is debt owed to Health Holdings.As part of the Private Equity Transaction on January 2, 2002 as describedmore fully in “Item 1.  Business-PrivateEquity Transaction” and Note 5, Health Holdings agreed to convert all ofthe Company’s Loan Agreement debt due to Health Holdings, plus accrued interestof $11,051, for a total debt conversion of $752,496. The Loan Agreement furtherprovides that the Lender Group may elect to convert all or any part of the LoanAdvances into shares of the Company’s Common Stock at a conversion price equalto the lower of (a) the average closing bid of the Company’s Common Stockfor the ten trading days prior to the making of a Loan Advance or (b) theaverage closing bid of the Company’s Common Stock for the ten trading daysprior to the date of receipt of notice of conversion.

 

On January 2,2002, as part of the Private Equity Transaction, the Company entered into aManagement Services Agreement with Westgate Group, LLC, an affiliate ofWestgate (“Westgate Group”).  Under theManagement Services Agreement, as long as Westgate owns 10% or more of theoutstanding voting securities of the Company, four principals of Westgate Groupprovide management and consulting services to the Company and receive a totalannual fee of $100,000, payable quarterly. The agreement extends until December 31, 2006, and is automaticallyrenewed for one-year terms unless terminated by either party.  The Westgate Group waived the payment ofthis fee for 2003.

 

OnApril 14, 2003, the Company entered into a loan agreement (the “LoanAgreement”) with Health Holdings and Botanicals, LLC, a principal stockholderof the Company, and David A. Weil, a director and stockholder of the Company(the “Lender Group”), pursuant to which the Lender Group has agreed to lend theCompany $450,000 and, subject to the discretion of the Lender Group, up to anadditional $300,000.  All advances underthe Loan Agreement bear interest at the rate of 15% per annum, are due onDecember 31, 2004, are secured by substantially all of the assets of the Company,and are subordinated to the Company’s indebtedness to Wells Fargo.  The advances under the Loan Agreement willbe used for the Company for working capital and general corporatepurposes.  For a more complete descriptionof this transaction, see “Item 1. Business – Loan Agreement.”  Inconsideration of the extension of credit under the Loan Agreement, Wells Fargowaived all defaults of the Company as of December 31, 2002 under the Credit andSecurity Agreement dated as of February 27, 2000 and amended the agreement to,among other things, reduce the covenants regarding minimum net income andminimum book net worth and increased the interest rate.  For a description of the amended bank creditfacility, see “Item 7.  Management’sDiscussion and analysis of Financial Condition and Results of Operations —Liquidity.”

 

36

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**Item 14.  Principal Accountant Fees and Services**

 

The Company paid the following fees to BDO Seidman,LLP during fiscal years 2003 and 2002: 

 
|               |   | **Year ended  December 31,** |   |
|--------------------|--------|------------------------------|--------|
|               |   | **2003**                     |   | **2002** |   |
| Audit Fees         |   | $                            | 82,000 |   | $ | 94,805 |   |
| All other Fees     |   |                         |   |   |   |
| Audit-related Fees |   | $                            | 1,500  |   | — |   |
| Tax-related Fees   |   | $                            | 10,960 |   | $ | 10,000 |   |
| All other fees     |   | $                            | 12,460 |   | $ | 10,000 |   |

 

The Audit Committee administers the Company’sengagement of BDO Seidman, LLP and pre-approves all audit and permissiblenon-audit services on a case-by-case basis. In approving non-audit services, the Audit Committee considers whetherthe engagement could compromise the independence of BDO Seidman, LLP, andwhether for reasons of efficiency or convenience it is in the best interest ofthe Company to engage its independent auditor to perform the services.  The audit committee has determined thatperformance by BDO Seidman, LLP of the non-audit services related to the feeson the table above did not affect their independence.

 

The AuditCommittee has not approved any non-audit services pursuant toParagraph (c)(7)(i)(C) of Rule 2-01 of Regulation S-X.

 

37

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**PART IV**

 

**Item 15. Exhibits**, FinancialStatement Schedules and Reports on Form 8-K

 

(a)                                  Seethe Index to Financial Statements on page F-1 for a list of financialstatements filed as part of this report.

 

Financial statement schedules have beenomitted because they either are not applicable or the required information isshown in the Company’s financial statements or the related notes thereto.

 

(b)                                 Reportson Form 8-K: On December 3, 2003, the Company filed a Current Report onForm 8-K reporting on Item 5 the amendment of its Credit and Security Agreementwith Wells Fargo Business Credit.

 

(c)                                  Exhibits:The following is a list of exhibits filed as a part of this report:

 
| **Exhibit No.** |   | **Document**                                                                                                                                                                                                                                                                                                                                                                                           |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                                                                                                                                                                                                                                                                   |
| 2               |   | Stock Purchase Agreement, dated as of December 15, 1997 (the “Stock  Purchase Agreement”), by and among the Company, Allan Schulman, L.S. Smith,  Dallas Gold & Silver Exchange, Inc. (“DGSE”), Barry M. Zwick and Health  Holdings and Botanicals, Inc., incorporated by reference to Exhibit 2 to the  Company’s Current Report on Form 8-K filed on December 23, 1997. |
| 3.1             |   | Certificate of Incorporation of Naturade, Inc., together with  Amendments and Certificate of Designations relating thereto, incorporated by  reference to the Company’s Annual Report on Form 10-K filed for fiscal 1997  and the exhibits and attachments thereto.                                                                                                                               |
| 3.2             |   | Amended and Restated Bylaws of Naturade, Inc., as amended December 7,  2001, incorporated by reference to Exhibit 3.6 to the Company’s Current  Report on Form 8-K filed on January 3, 2002.                                                                                                                                                                                                      |
| 3.3             |   | Certificate of Amendment to Certificate of Incorporation of Naturade,  Inc. dated December 20, 2001, incorporated by reference to Exhibit 3.3 to the  Company’s Current Report on Form 8-K filed on January 3, 2002.                                                                                                                                                                              |
| 3.4             |   | Certificate of Amendment to Certificate of Incorporation of Naturade,  Inc., dated December 28, 2001, incorporated by reference to Exhibit 3.4 to  the Company’s Current Report on Form 8-K filed on January 3, 2002.                                                                                                                                                                             |
| 3.5             |   | Certificate of Designation of Series B Convertible Preferred Stock,  dated December 20, 2001, incorporated by reference to Exhibit 3.5 to the  Company’s Current Report on Form 8-K filed on January 3, 2002.                                                                                                                                                                                     |
| 4.1             |   | Registration Rights Agreement, dated as of December 15, 1997, by and  between the Company and Health Holdings & Botanicals, Inc., incorporated  by reference to Exhibit 4 to the Company’s Current Report on Form 8-K as  filed on December 23, 1997.                                                                                                                                         |
| 4.2             |   | Form of Class B Warrant Certificate, incorporated by reference to the  Company’s Annual Report on Form 10-K filed for fiscal 1991 and the exhibits  and attachments thereto.                                                                                                                                                                                                                      |
| 4.3             |   | Form of Series B Convertible Preferred Stock Warrant Certificate,  incorporated by reference to Exhibit 4.3 to the Company’s Current Report on  Form 8-K filed on January 3, 2002.                                                                                                                                                                                                                |
| 10.1*           |   | Consulting Agreement dated as of December 12, 1997, by and between  the Company and Doyle & Boissiere LLC, incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K filed December 23,  1997.                                                                                                                                                                   |
| 10.2*           |   | Mutual Option Agreement, dated as of December 15, 1997, by and  between the Company and Allan Schulman, incorporated by reference to Exhibit  10.3 to the Company’s Current Report on Form 8-K as filed December 23, 1997.                                                                                                                                                                        |
| 10.3*           |   | Employment, Consulting and Non-Competition Agreement, dated as of  December 12, 1997, by and between the Company and Allan Schulman,  incorporated by reference to Exhibit 10.4 to the Company’s Current Report on  Form 8-K as filed December 23, 1997.                                                                                                                                          |

 

38

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| 10.4   |   | Form of Option Agreement for Purchase of Naturade, Inc. Common Stock  for Directors, incorporated by reference to the Company’s Annual Report on  Form 10— K filed for fiscal 1995 and the exhibits and attachments thereto.                                                                                                                                                                                                                                                       |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5   |   | Form of Broker Agreement between NPI and Domestic Brokers,  incorporated by reference to the Company’s Annual Report on Form 10-K filed  for fiscal 1991 and the exhibits and attachments thereto.                                                                                                                                                                                                                                                                                      |
| 10.8   |   | Amendment dated May 2, 1995 to Agreement For Purchase of Stock and  Real Property dated January 1, 1995, incorporated by Reference to the  Company’s Quarterly Report on Form 10-Q filed for period ended December 31,  1994 and Exhibits and Attachments thereto.                                                                                                                                                                                                                      |
| 10.13  |   | Lease Agreement between NPI and Messrs. Schulman and Becker,  incorporated by reference to the Company’s Annual Report on Form 10-K filed  for Fiscal 1991 and the Exhibits and Attachments thereto, and the First  Amendment to Lease, dated as of December 15, 1997, by and among Allan  Schulman and the Registrant (collectively as landlord) and the Company (as  tenant), incorporated by reference to the Company’s Current Report on Form  8-K as filed December 23, 1997. |
| 10.15* |   | Naturade, Inc. 1998 Incentive Stock Option Plan, as amended,  incorporated by reference to Exhibit 10.17 to the Company’s Quarterly Report  on Form 10-Q for the period ended March 31, 1998.                                                                                                                                                                                                                                                                                           |
| 10.16* |   | Incentive Stock Option Plan with Bill D. Stewart dated March 2, 1998,  incorporated by reference to Exhibit 10.18 to the Company’s Quarterly Report  on Form 10-Q filed for the period ended March 31, 1998.                                                                                                                                                                                                                                                                            |
| 10.17* |   | Incentive Stock Option Plan with Ronald Ahrens dated April 20, 1998,  incorporated by reference to Exhibit 10.19 to the Company’s Quarterly Report  on Form 10-Q filed for the period ended March 31, 1998.                                                                                                                                                                                                                                                                             |
| 10.19  |   | Finance Agreement by and Between Naturade, Inc. and Health Holdings  and Botanicals, Inc. dated as of March 17, 1999, incorporated by reference to  Exhibit 10. 2 to the Company’s Quarterly Report on Form 10-Q filed for the  period ended March 31, 1999.                                                                                                                                                                                                                            |
| 10.20  |   | Amendment No. 1 to Finance Agreement by and between Naturade, Inc.  and Health Holdings and Botanicals, Inc. dated June 1, 1999, incorporated by  reference to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  filed for the period ended June 30, 1999.                                                                                                                                                                                                                   |
| 10.21  |   | Credit Agreement by and Between Naturade, Inc. and Health Holdings  and Botanicals, Inc. dated as of August 9, 1999, incorporated by reference to  Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q filed for the  period ended June 30, 1999                                                                                                                                                                                                                                |
| 10.22  |   | Settlement Agreement between Naturade, Inc. and the PNI Trustee,  August 1999, incorporated by reference to Exhibit 10.3 to the Company’s  Quarterly Report on Form 10-Q filed for the period ended June 30, 1999.                                                                                                                                                                                                                                                                      |
| 10.23* |   | Employment Contract with Lawrence J. Batina, COO/CFO dated as of  February 1, 1999, incorporated by reference to Exhibit 10.1 to the Company’s  Quarterly Report on Form 10-Q filed for the period ended March 31, 1999.                                                                                                                                                                                                                                                                |
| 10.24  |   | Credit and Security Agreement by and Between Naturade, Inc. and Wells  Fargo Business Credit, Inc. dated as of January 27, 2000, incorporated by  reference to Exhibit 10.24 to the Company’s Annual Report on Form 10-K filed  for fiscal 1999.                                                                                                                                                                                                                                        |
| 10.25  |   | Amendment No. 2 to Finance Agreement by and between Naturade, Inc.  and Health Holdings and Botanicals, LLC dated as of March 17, 2000,  incorporated by reference to Exhibit 10.1 to the Company’s Quarterly Report  on Form 10-Q filed for the period ended March 31, 2000.                                                                                                                                                                                                           |
| 10.26  |   | Industrial Lease dated as of December 23, 1998 between the Company  and The Irvine Company, incorporated by reference to Exhibit 10.25 to the  Company’s Quarterly Report on Form 10-Q filed for the period ended June 30,  2000.                                                                                                                                                                                                                                                       |
| 10.27  |   | Loan Agreement by and Between Naturade, Inc. and Health Holdings and  Botanicals, LLC. and Wald Holdings, LLC. dated as of August 31, 2000,  incorporated by reference to Exhibit 99.1 to the Company’s Current Report on  Form 8-K filed on September 20, 2000.                                                                                                                                                                                                                        |
| 10.28  |   | Securities Purchase Agreement among Naturade, Inc., Westgate Equity  Partners, L.P., and Health Holdings & Botanicals, LLC, dated as of  December 20, 2001, incorporated by reference to Exhibit 10.28 to the  Company’s Current Report on Form 8-K filed January 3, 2002.                                                                                                                                                                                                          |
| 10.29  |   | Registration Rights Agreement between Naturade and Westgate Equity  Partners, L.P., dated as of January 2, 2002, incorporated by reference to  Exhibit 10.29 to the Company’s Current Report on Form 8-K filed January 3,  2002.                                                                                                                                                                                                                                                        |
| 10.30* |   | Management Services Agreement between Westgate Group, LLC and  Naturade, Inc. dated as of January 2, 2002, incorporated by reference to  Exhibit 10.30 to the Company’s Current Report on Form 8-K filed January 3,  2002.                                                                                                                                                                                                                                                              |
| 10.31  |   | Voting Agreement between Westgate Equity Partners, L.P. and Health  Holdings & Botanicals, LLC, dated as of January 2, 2002, incorporated by  reference to Exhibit 10.31 to the Company’s Current Report on Form 8-K filed  January 3, 2002.                                                                                                                                                                                                                                        |

 

39

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| 10.32*   |   | Amended and Restated Employment Agreement between Naturade, Inc. and  Bill D. Stewart, dated as of January 2, 2002, incorporated by reference to  Exhibit 10.31 to the Company’s Current Report on Form 8-K filed January 3,  2002.                                                                                                       |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.33    |   | Fourth Amendment to Credit and Security Agreement and Waiver of  Defaults between Naturade, Inc. and Wells Fargo Business Credit, Inc., dated  as of December 20, 2001, incorporated by reference to Exhibit 10.33 to the  Company’s Current Report on Form 8-K filed January 3, 2002.                                                    |
| 10.34    |   | Amendment No. 3 to Finance Agreement between Naturade, Inc. and  Health Holdings & Botanicals, LLC, dated as of January 2, 2002,  incorporated by reference to Exhibit 10.34 to the Company’s Current Report on  Form 8-K filed January 3, 2002.                                                                                      |
| 10.35    |   | Letter agreement of Wells Fargo Business Credit, Inc. waiving rights  arising from the Company’s defaults of covenants under the Credit and  Security Agreement dated as of January 27, 2000, incorporated by reference to  Exhibit 10.35 to the Company’s quarterly Report on Form 10-Q filed for the  period ended March 31, 2000. |
| 10.36    |   | Sixth Amendment to Credit and Security Agreement between Naturade,  Inc. and Wells Fargo Business Credit Inc., dated as of March 24, 2003,  incorporated by reference to Exhibit 10.36 to the Company’s quarterly Report  on Form 10-Q filed for the period ended September 30, 2003.                                                     |
| 10.37    |   | Consent and Mutual Release dated as of April 14, 2003, among the  Company, Westgate Equity Partners, LLP and Health Holdings and Botanicals,  LLC, incorporated by reference to Exhibit 10.37 to the Company’s Annual  Report on Form 10-K for the fiscal year ended December 31, 2002.                                                   |
| 10.38    |   | Fifth Amendment to Credit and Security Agreement between Naturade,  Inc. and Wells Fargo Business Credit Inc., dated as of September 19, 2002  incorporated by reference to Exhibit 10.38 to the Company’s quarterly Report  on Form 10-Q filed for the period ended September 30, 2002.                                                  |
| 10.39    |   | Irrevocable Proxy between Health Holdings and Botanicals, LLC and  Westgate Equity Partners, LLP dated April 14, 2003, incorporated by reference  to Exhibit 10.39 to the Company’s Annual Report on Form 10-K for the fiscal  year ended December 31, 2002.                                                                              |
| 10.40    |   | Loan Agreement by and between Naturade, Inc., Health Holdings and  Botanicals, LLC and David A. Weil dated April 14, 2003, incorporated by  reference to Exhibit 10.40 to the Company’s Annual Report on Form 10-K for  the fiscal year ended December 31, 2002.                                                                          |
| 10.41    |   | Waiver of Preferential Dividends by Holders of Series B Convertible  Preferred Stock by Westgate Equity Partners, L.P dated April 14, 2003,  incorporated by reference to Exhibit 10.41 to the Company’s Annual Report on  Form 10-K for the fiscal year ended December 31, 2002.                                                         |
| 10.42    |   | Seventh Amendment to Credit and Security Agreement between Naturade,  Inc. and Wells Fargo Business Credit Inc., dated as of April 15, 2003,  incorporated by reference to Exhibit 10.42 to the Company’s Current Report on  Form 8-K filed on April 25, 2003.                                                                            |
| 10.43    |   | Eighth Amendment to Credit and Security Agreement between Naturade,  Inc. and Wells Fargo Business Credit Inc., dated as of November 6, 2003,  incorporated by reference to Exhibit 10.43 to the Company’s Current Report on  Form 8-K filed on November 6, 2003.                                                                         |
| **10.44  |   | Ninth Amendment to Credit and Security Agreement between Naturade,  Inc. and Wells Fargo Business Credit Inc., dated as of March 29, 2004.                                                                                                                                                                                                     |
| **10.45* |   | First Amendment to Amended and Restated Employment Agreement                                                                                                                                                                                                                                                                                   |
| **14     |   | Naturade, Inc. Code of Financial Ethics.                                                                                                                                                                                                                                                                                                       |
| **31.1   |   | Certification Pursuant to Rule 15d-14(a) of the Securities Exchange  Act of 1934, Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                           |
| **31.2   |   | Certification Pursuant to Rule 15d-14(a) of the Securities Exchange  Act of 1934, Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                           |
| **32     |   | Certification  Pursuant to 18 U.S.C. 1350, Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                  |

 

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*   Management contracts or compensatory plan or arrangement.

** Filed herewith.

 

40

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**SIGNATURES**

 

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 

 
|                 |   | NATURADE, INC.     |
|----------------------|--------|-------------------------|
| Date: March 30, 2004 |   |                    |
|                 |   | /s/ Bill D. Stewart     |   |
|                 |   | Bill D. Stewart,        |
|                 |   | Chief Executive Officer |

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beenduly signed below by the following persons on behalf of the registrant and inthe capacities and dates indicated.

 
| **Signature**            |   | **Title**                             |   | **Date**        |
|--------------------------|--------|---------------------------------------|--------|-----------------|
|                     |   |                                  |   |            |
| /s/ BILL D. STEWART      |   | Director and  Chief Executive Officer |   | March 30,  2004 |
| Bill D. Stewart          |   | (Principal  Executive Officer)        |   |            |
|                     |   |                                  |   |            |
| /s/ STEPHEN M. KASPRISIN |   | Chief Financial Officer               |   | March 30, 2004  |
| Stephen M. Kasprisin     |   | (Principal Accounting Officer)        |   |            |
|                     |   |                                  |   |            |
| /s/ LIONEL P. BOISSIERE  |   | Director                              |   | March 30,  2004 |
| Lionel P. Boissiere      |   |                                  |   |            |
|                     |   |                                  |   |            |
| /s/ WILLIAM B. DOYLE, JR |   | Director                              |   | March 30, 2004  |
| William B. Doyle, Jr.    |   |                                  |   |            |
|                     |   |                                  |   |            |
| /s/ DAVID A. WEIL        |   | Director                              |   | March 30, 2004  |
| David A. Weil            |   |                                  |   |            |
|                     |   |                                  |   |            |
| /s/ JAY BROWN            |   | Director                              |   | March 30, 2004  |
| Jay Brown                |   |                                  |   |            |
|                     |   |                                  |   |            |
| /s/ ROBERT V. VITALE     |   | Director                              |   | March 30, 2004  |
| Robert V. Vitale         |   |                                  |   |            |

 

41

----

 

**NATURADE, INC.**

 

**INDEX OF FINANCIAL STATEMENTS**

 
| REPORT OF INDEPENDENT CERTIFIED PUBLIC  ACCOUNTANTS                                                  |   |
|------------------------------------------------------------------------------------------------------|--------|
| FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2003, DECEMBER  31, 2002 AND DECEMBER 31, 2001 |   |
|                                                                                                 |   |
| Balance  Sheets                                                                                      |   |
| Statements of Operations                                                                             |   |
| Statements of Stockholders’ Deficit                                                             |   |
| Statements of Cash Flows                                                                             |   |
| Notes to Financial Statements                                                                        |   |

 

F-1

----

 

**Reportof Independent Certified Public Accountants**

 

To the Board of Directors and Stockholders of

 

Naturade, Inc.

 

We have audited the accompanying balance sheets of Naturade, Inc.as of December 31, 2003 and 2002 and the related statements of operations,stockholders’ equity (deficit), and cash flows for the three years then ended.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

 

We conducted our audits in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, such financial statementspresent fairly, in all material respects, the financial position of the Companyas of December 31, 2003 and 2002 and the results of its operations and itscash flows for the years then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

The accompanying financial statements havebeen prepared assuming that the Company will continue as a going concern. Asdiscussed in Note 1 to the financial statements, the Company’s recurringlosses from operations and stockholders’ capital deficiency raise substantialdoubt about its ability to continue as a going concern. Management’s plansconcerning these matters are also described in Note 1. The financialstatements do not include any adjustments that might result from the outcome ofthis uncertainty.

 

 
| /s/ BDO Seidman, LLP                           |   |
|------------------------------------------------|--------|
|                                           |
| Los Angeles, California                        |
| February 13, 2004 (except for Note 12 which is |
| dated March 29, 2004.)                         |

 

F-2

----

 

**NATURADE, INC.**

 

**BalanceSheets**

**As of December 31, 2003 and December 31, 2002**

 
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   | **2003**    |      | **2002**    |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-----------|-------------|--------|
| ASSETS                                                                                                                                                                                                                                                                                                                                                                                                                                   |   |        |      |        |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| Current assets:                                                                                                                                                                                                                                                                                                                                                                                                                          |   |        |      |        |   |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                                                                                |   | $           | 144,102   |        | $      | 722,583 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                                                                                                                                                                                 |   | 2,333,394   |      | 1,427,058   |   |
| Inventories, net                                                                                                                                                                                                                                                                                                                                                                                                                         |   | 1,246,371   |      | 1,689,131   |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                                                                                                                                                |   | 148,503     |      | 105,135     |   |
| Total current assets                                                                                                                                                                                                                                                                                                                                                                                                                     |   | 3,872,370   |      | 3,943,907   |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| Property and equipment, net                                                                                                                                                                                                                                                                                                                                                                                                              |   | 161,885     |      | 228,723     |   |
| Other assets                                                                                                                                                                                                                                                                                                                                                                                                                             |   | 42,302      |      | 49,594      |   |
| Total assets                                                                                                                                                                                                                                                                                                                                                                                                                             |   | $           | 4,076,557 |        | $      | 4,222,224 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| LIABILITIES,  REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ DEFICIT                                                                                                                                                                                                                                                                                                                                                      |   |        |      |        |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| Current   liabilities:                                                                                                                                                                                                                                                                                                                                                                                                              |   |        |      |        |   |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                                                                         |   | $           | 2,310,317 |        | $      | 2,750,477 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                                                                                                         |   | 475,286     |      | 604,194     |   |
| Current portion of Note Payable to Related  Party                                                                                                                                                                                                                                                                                                                                                                                        |   | 644,471     |      | 202,345     |   |
| Current portion of long-term debt                                                                                                                                                                                                                                                                                                                                                                                                        |   | 2,231,778   |      | 1,816,662   |   |
| Total current liabilities                                                                                                                                                                                                                                                                                                                                                                                                                |   | 5,661,852   |      | 5,373,678   |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| Long-term debt, less current maturities                                                                                                                                                                                                                                                                                                                                                                                                  |   | 5,609       |      | 37,735      |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| Total Liabilities                                                                                                                                                                                                                                                                                                                                                                                                                        |   | 5,667,461   |      | 5,411,413   |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                                                                                                                                                                                                                                            |   |        |      |        |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                                                                                                                                                                                                                                                                                                                                                                   |   |        |      |        |   |
| Redeemable convertible preferred stock,  Series B including accumulated preferred stock dividends of $433,908 at  December 31, 2003 and $205,000 at December 31, 2002, less discount of  $1,428,572 at December 31, 2003, and $1,714,286 at December 31, 2002, par  value $0.0001 per share: authorized 50,000,000 shares; issued and  outstanding, 13,540,723 at December 31, 2003 and December 31, 2002  ($2,000,000 redemption value) |   | 770,734     |      | 256,112     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| WARRANT                                                                                                                                                                                                                                                                                                                                                                                                                                  |   | 500,000     |      | 500,000     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| STOCKHOLDERS’ DEFICIT:                                                                                                                                                                                                                                                                                                                                                                                                              |   |        |      |        |   |
| Common stock, par value $0.0001 per share;  authorized, 150,000,000 shares; issued and outstanding, 44,533,886 at  December 31, 2003 and  December 31,  2002                                                                                                                                                                                                                                                                        |   | 4,453       |      | 4,453       |   |
| Preferred stock, Series A, par value  $0.0001 per share; authorized 2,000,000 shares; issued and outstanding, -0-  at December 31, 2003 and 2002                                                                                                                                                                                                                                                                                         |   | 0           |      | 0           |   |
| Non-Voting Common stock, par value $0.0001  per share; authorized, 2,000,000 shares; issued and outstanding, 117,284 at  December 31, 2003 and December 31, 2002                                                                                                                                                                                                                                                                         |   | 12          |      | 12          |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |        |      |        |   |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                                                                                                               |   | 18,987,458  |      | 18,987,458  |   |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                                                                                                                      |   | (21,853,561 | )         | (20,937,224 | )      |
| Total stockholders’ deficit                                                                                                                                                                                                                                                                                                                                                                                                         |   | (2,861,638  | )         | (1,945,301  | )      |
| Total liabilities and stockholders’ deficit                                                                                                                                                                                                                                                                                                                                                                                         |   | $           | 4,076,557 |        | $      | 4,222,224 |   |

 

See accompanying notes to financial statements.

 

F-3

----

 

**NATURADE, INC**

 

**Statements of Operations for the Years EndedDecember 31, 2003, 2002 and 2001**

 
|                                                      |   | **Year Ended  December 31, 2003** |       | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   |
|-----------------------------------------------------------|--------|-----------------------------------|------------|-----------------------------------|--------|-----------------------------------|--------|
|                                                      |   |                              |       |                              |   |                              |   |
| Net sales                                                 |   | $                                 | 16,326,296 |                              | $      | 14,416,351                        |   | $ | 16,641,109 |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Cost of sales                                             |   | 8,662,299                         |       | 8,157,607                         |   | 9,290,227                         |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Gross profit                                              |   | 7,663,997                         |       | 6,258,744                         |   | 7,350,882                         |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Costs and expenses:                                       |   |                              |       |                              |   |                              |   |
| Selling, general and  administrative expenses        |   | 7,883,398                         |       | 8,069,382                         |   | 9,522,932                         |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Total operating costs and expenses                        |   | 7,883,398                         |       | 8,069,382                         |   | 9,522,932                         |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Operating loss                                            |   | (219,401                          | )          | (1,810,638                        | )      | (2,172,050                        | )      |
|                                                      |   |                              |       |                              |   |                              |   |
| Other expense:                                            |   |                              |       |                              |   |                              |   |
| Interest expense                                          |   | 189,462                           |       | 113,480                           |   | 556,079                           |   |
| Other expense (Income)                                    |   | (7,948                            | )          | (28,300                           | )      | (6,907                            | )      |
|                                                      |   |                              |       |                              |   |                              |   |
| Loss before provision for income taxes                    |   | (400,915                          | )          | (1,895,818                        | )      | (2,721,222                        | )      |
|                                                      |   |                              |       |                              |   |                              |   |
| Provision for income taxes                                |   | 800                               |       | 800                               |   | 5,931                             |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Net loss                                                  |   | $                                 | (401,715   | )                                 | $      | (1,896,618                        | )      | $ | (2,727,153 | ) |
|                                                      |   |                              |       |                              |   |                              |   |
| Less:                                                     |   |                              |       |                              |   |                              |   |
| Preferred Stock Dividends                                 |   | $                                 | (228,908   | )                                 | $      | (205,000                          | )      | $ | — |   |
| Deemed Dividend                                           |   | (285,714                          | )          | (285,714                          | )      | —                            |   |
|                                                      |   |                              |       |                              |   |                              |   |
| Net Loss Attributable to Common  Shareholders             |   | $                                 | (916,337   | )                                 | $      | (2,387,332                        | )      | $ | (2,727,153 | ) |
|                                                      |   |                              |       |                              |   |                              |   |
| Basic and Diluted Net Loss per share                      |   | $                                 | (0.02      | )                                 | $      | (0.05                             | )      | $ | (0.36 | ) |
|                                                      |   |                              |       |                              |   |                              |   |
| Weighted Average Number of Shares used in  Computation of |   | 44,533,386                        |       | 44,000,000                        |   | 7,600,000                         |   |
| Basic and Diluted Net Loss per share                      |   |                              |       |                              |   |                              |   |

 

See accompanying notes to financial statements

 

F-4

----

 

**NATURADE, INC.**

 

**Statements of Stockholders’ Deficit for theYears Ended December 31, 2003, 2002 and 2001**

 
|                                                          |   | **Common** |   | **Common(Non-Voting)** |   | **Preferred** |    | **Additional  Paid-In** |   | **(Accumulated** |   |       |   |
|---------------------------------------------------------------|--------|------------|--------|------------------------|--------|---------------|---------|-------------------------|--------|------------------|--------|------------|--------|
|                                                          |   | **Shares** |   | **Amount**             |   | **Shares**    |    | **Amount**              |   | **Shares**       |   | **Amount** |   | **Capital** |   | **Deficit)** |   | **Total** |   |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| BALANCE, DECEMBER 31, 2000                                    |   | 7,347,389  |   | 735                    |   |          |    |                    |   | 1,250,024        |   | 125        |   | 11,349,482 |   | (15,822,739 | ) | (4,472,397 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Conversion of debt into common stock and exercise of warrants |   | 476,250    |   | 48                     |   |          |    |                    |   |             |   |       |   | 152,352 |   |   |   | 152,400 |   |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Issuance of common stock options                              |   |       |   |                   |   |          |    |                    |   |             |   |       |   | 37,777 |   |   |   | 37,777 |   |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Net loss for the year                                         |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (2,727,153 | ) | (2,727,153 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| BALANCE, DECEMBER 31, 2001                                    |   | 7,823,639  |   | 783                    |   |          |    |                    |   | 1,250,024        |   | 125        |   | 11,539,611 |   | (18,549,892 | ) | (7,009,373 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Conversion of debt into preferred stock into common stock     |   | 36,710,247 |   | 3,670                  |   | 117,284       |    | 12                      |   | (1,250,024       | )      | (125       | )      | 5,410,070 |   |   |   | 5,413,627 |   |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Issuance of common stock options                              |   |       |   |                   |   |          |    |                    |   |             |   |       |   | 37,777 |   |   |   | 37,777 |   |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Preferred stock dividends                                     |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (205,000 | ) | (205,000 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Preferred stock discount                                      |   |       |   |                   |   |          |    |                    |   |             |   |       |   | 2,000,000 |   |   |   | 2,000,000 |   |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Deemed dividend                                               |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (285,714 | ) | (285,714 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Net loss for the year                                         |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (1,896,618 | ) | (1,896,618 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| BALANCE, DECEMBER 31, 2002                                    |   | 44,533,886 |   | $                      | 4,453  |          | 117,284 |                    | $      | 12               |   | 0          |   | $ | 0 |   | $ | 18,987,458 |   | $ | (20,937,224 | ) | $ | (1,945,301 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Preferred stock dividends                                     |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (228,908 | ) | (228,908 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Deemed dividend                                               |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (285,714 | ) | (285,714 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| Net loss for the year                                         |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   | (401,715 | ) | (401,715 | ) |
|                                                          |   |       |   |                   |   |          |    |                    |   |             |   |       |   |   |   |   |   |   |   |
| BALANCE, DECEMBER 31, 2003                                    |   | 44,533,886 |   | $                      | 4,453  |          | 117,284 |                    | $      | 12               |   | 0          |   | $ | 0 |   | $ | 18,987,458 |   | $ | (21,853,561 | ) | $ | (2,861,638 | ) |

 

See accompanying notes to financial statements

 

F-5

----

 

**NATURADE, INC**

 

**Statements of Cash Flows for the Years EndedDecember 31, 2003, 2001 and 2000**

 
|                                                                                           |   | **Year Ended  December 31, 2003** |       | **Year Ended  December 31, 2002** |       | **Year Ended  December 31, 2001** |       |
|------------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| Cash flows from operating activities:                                                          |   |                              |       |                              |       |                              |       |
| Net   loss                                                                                |   | $                                 | (401,715   | )                                 | $          | (1,896,618                        | )          | $ | (2,727,153 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                   |   |                              |       |                              |       |                              |       |
| Depreciation and amortization                                                                  |   | 75,436                            |       | 86,218                            |       | 95,774                            |       |
| Provision for bad debt expense                                                                 |   | —                            |       | 60,260                            |       | 66,309                            |       |
| Provision for excess and obsolete  inventories                                                 |   | 21,168                            |       | 17,062                            |       | 188,264                           |       |
| Loss from retirement of property &  equipment                                              |   | 1,118                             |       | —                            |       | —                            |       |
| Expense for stock options, warrants and  convertible debt                                      |   | —                            |       | 37,777                            |       | 37,777                            |       |
| Changes in assets and liabilities:                                                             |   |                              |       |                              |       |                              |       |
| Accounts receivable                                                                            |   | (906,336                          | )          | 552,298                           |       | 375,882                           |       |
| Inventories                                                                                    |   | 421,592                           |       | (527,674                          | )          | 749,876                           |       |
| Prepaid expenses and other current assets                                                      |   | (43,368                           | )          | 252,711                           |       | (119,646                          | )          |
| Other assets                                                                                   |   | 7,292                             |       | 5,169                             |       | 29,323                            |       |
| Accounts payable and accrued expenses                                                          |   | (569,068                          | )          | (54,734                           | )          | 520,928                           |       |
| Net cash used in operating activities:                                                         |   | (1,393,881                        | )          | (1,467,531                        | )          | (782,666                          | )          |
|                                                                                           |   |                              |       |                              |       |                              |       |
| Cash flows from investing activities:                                                          |   |                              |       |                              |       |                              |       |
| Purchase of property and equipment                                                             |   | (9,716                            | )          | (7,579                            | )          | (136,718                          | )          |
| Proceeds from sale of property and  equipment                                                  |   | —                            |       | —                            |       | —                            |       |
| Net cash   used in  investing activities:                                            |   | (9,716                            | )          | (7,579                            | )          | (136,718                          | )          |
|                                                                                           |   |                              |       |                              |       |                              |       |
| Cash flows from financing activities:                                                          |   |                              |       |                              |       |                              |       |
| Net borrowings (repayment) under line of  credit                                               |   | 444,780                           |       | (142,011                          | )          | 118,475                           |       |
| Proceeds from issuance of debt to related  party                                               |   | 450,000                           |       | —                            |       | 686,195                           |       |
| Payments of long-term debt                                                                     |   | (69,664                           | )          | (28,583                           | )          | (32,546                           | )          |
| Proceeds from issuance of preferred stock                                                      |   | —                            |       | 1,850,318                         |       | —                            |       |
| Proceeds from issuance of warrant                                                              |   | —                            |       | 462,580                           |       | —                            |       |
| Net cash provided by financing activities:                                                     |   | 825,116                           |       | 2,142,304                         |       | 772,124                           |       |
|                                                                                           |   |                              |       |                              |       |                              |       |
| Net increase (decrease) in cash and cash  equivalents                                          |   | (578,481                          | )          | 667,194                           |       | (147,260                          | )          |
| Cash and cash equivalents, beginning of  period                                                |   | 722,582                           |       | 55,388                            |       | 202,648                           |       |
| Cash and cash equivalents, end of period                                                       |   | $                                 | 144,101    |                              | $          | 722,582                           |       | $ | 55,388 |   |
|                                                                                           |   |                              |       |                              |       |                              |       |
| **Supplemental Disclosures of Cash Flow  Information**                                         |   |                              |       |                              |       |                              |       |
| **Cash paid during the period for:**                                                           |   |                              | ** ** |                              | ** ** |                              | ** ** |
| Interest                                                                                       |   | $                                 | 148,728    |                              | $          | 116,433                           |       | $ | 180,539 |   |
| Income taxes                                                                                   |   | $                                 | 800        |                              | $          | 800                               |       | $ | 800 |   |
| Non-cash financing transactions:                                                               |   |                              |       |                              |       |                              |       |
| Conversion of notes payable and accrued  interest to related party into common stock           |   | $                                 | —     |                              | $          | 5,413,627                         |       | $ | 152,400 |   |
| Surrender of preferred stock for  cancellation without conversion in exchange for common stock |   | $                                 | —     |                              | $          | 125                               |       | $ | — |   |
| Discount related to redeemable convertible  preferred stock                                    |   | $                                 | —     |                              | $          | 2,000,000                         |       | $ | — |   |
| Preferred stock dividend accrued                                                               |   | $                                 | 228,908    |                              | $          | 205,000                           |       | $ | — |   |
| Deemed dividend                                                                                |   | $                                 | 285,714    |                              | $          | 285,714                           |       | $ | — |   |
| Issuance of non-voting common stock in  connection with private equity transaction             |   | $                                 | —     |                              | $          | 47,500                            |       | $ | — |   |

 

See accompanying notes to financial statements

 

F-6

----

 

**NATURADE, INC.**

 

**NOTES TO FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001**

 

**1.****              ORGANIZATIONAND SIGNIFICANT ACCOUNTING POLICIES**

 

***Organization–***Naturade, Inc., a Delaware corporation (the“Company” or “Naturade”), is a branded nutraceuticals marketing company focusedon high growth, innovative natural products that nourish the health and wellbeing of consumers. The Company’s products include low carbohydrate, highprotein powders, aloe vera based health and beauty aids, nutritionalsupplements, aloe drinks and soy protein based powders, bars and ready-to-drinkproducts. Its products are sold to the health food and mass market channelsthrough distributors and directly to retailers in the United States andoverseas.

 

***Basisof Presentation –***The accompanying financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America.

 

***GoingConcern –***The accompanying financial statementshave been prepared on a going-concern basis, which contemplates the realizationof assets and the satisfaction of liabilities in the normal course of business.At December 31, 2003, the Company has an accumulated deficit of $21,853,561, anet working capital deficit of $1,789,482, a stockholders’ capital deficiencyof $2,861,638 and has incurred recurring net losses. These factors, amongothers, raise substantial doubt about the Company’s ability to continue as agoing concern.

 

The financial statements do notinclude any adjustments relating to the recoverability and classification of recordedasset amounts or the amounts and classification of liabilities that might benecessary should the Company be unable to continue as a going concern. TheCompany’s continuation as a going concern depends on its ability to generatesufficient cash flow to meet its obligations on a timely basis, to comply withthe terms and covenants of its financing agreements, to obtain additionalfinancing or refinancing as may be required and ultimately to attain successfuloperations.

 

In response to these conditions,the Company entered into a loan agreement as of April 14, 2003 with themajority shareholder and other investors, under which the Company borrowed$450,000 and can borrow up to an additional $300,000 at the discretion of thelenders. During 2003, this additional financing helped the Company meet itsobligations and sustain operations. In addition management has made certainfinancial and organizational changes and updated the detailed analysis of theCompany’s core competencies, the nutraceutical market, competitors and specificproduct categories in light of the softening economy during the year. Based onthis analysis, the management team has focused its sales force on thegrowth-oriented mass market retail segment and stabilizing the health food segment,taken action to reduce overhead costs and expanded the sales ofpreviously-developed product line extensions in the rapidly growing soy proteincategory, sports nutrition and safe, ephedra free weight loss segments. Noassurance can be given that management’s plans will be successful.

 

***Cashand Cash Equivalents –*** The Company considers allhighly liquid investments with maturities of three months or less whenpurchased to be cash equivalents.

 

***Useof Estimates and Assumptions –***The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ materially from those estimates.

 

F-7

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***Concentrationof Credit Risk –*** Financial instruments thatsubject Naturade to concentration of credit risk consist primarily of cash,accounts receivables, and notes receivable. Credit risk with respect to tradeaccounts receivable is generally diversified due to the large number of entitiescomprising the Company’s customer base and their geographic dispersion.Naturade performs ongoing credit evaluations of its customers and maintains anallowance for estimated credit losses. The Company maintains cash balances withfinancial institutions that are in excess of federally insured limits.

 

***FairValue of Financial Instruments –*** The Company’sbalance sheets include the following financial instruments: cash and cashequivalents, trade accounts receivable, trade accounts payable and long-termdebt. The Company considers the carrying amounts in the financial statements toapproximate fair value of these financial instruments due to the relativelyshort period of time between the origination of the instruments and theirexpected realization or the interest rates which approximate current marketrates.

 

***AccountsReceivable –*** Accounts receivable are presented netof an allowance for doubtful accounts of $9,739 and $70,000 at December 31,2003 and December 31, 2002, respectively, and net of an allowance for returnsand allowances of $ 685,946 and $817,042 at December 31, 2003 and December 31,2002, respectively. The allowance for doubtful accounts and returns andallowances includes the following:

 

| Balance as of December 31, 2000                             |   | $        | 529,394 |   |
|-------------------------------------------------------------|--------|----------|---------|--------|
| Provision for doubtful accounts and returns  and allowances |   | 419,056  |    |
| Deductions                                                  |   | 0        |    |
| Balance as of December 31, 2001                             |   | 948,450  |    |
| Provision for doubtful accounts and returns  and allowances |   | 342,418  |    |
| Deductions                                                  |   | (403,826 | )       |
| Balance as of December 31, 2002                             |   | 887,042  |    |
| Provision for doubtful accounts and returns  and allowances |   | 239,744  |    |
| Deductions                                                  |   | (431,101 | )       |
| Balance as of December 31, 2003                             |   | $        | 695,685 |   |

 

***Inventories–***Inventories are valued at the lower of cost ormarket. The weighted average method is used to determine cost. The reserve forexcess and obsolete inventories includes the following:

 

| Balance as of December 31, 2000             |   | $        | 269,618 |   |
|---------------------------------------------|--------|----------|---------|--------|
| Provision for excess and obsolete inventory |   | 188,264  |    |
| Write-offs                                  |   | (99,964  | )       |
| Balance as of December 31, 2001             |   | 357,918  |    |
| Provision for excess and obsolete inventory |   | 17,062   |    |
| Write-offs                                  |   | (302,879 | )       |
| Balance as of December 31, 2002             |   | 72,101   |    |
| Provision for excess and obsolete inventory |   | 21,168   |    |
| Write-offs                                  |   | (16,018  | )       |
| Balance as of December 31, 2003             |   | $        | 77,251  |   |

 

F-8

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***Propertyand Equipment –***Property and equipment are statedat cost, less accumulated depreciation and amortization computed using thestraight-line method over the estimated useful lives of the related assetsranging from five to ten years. Leasehold improvements are amortized on astraight-line basis over the lesser of the lease term or estimated useful life.Expenditures for maintenance and repairs are charged to operations as incurred.

 

***Impairmentof Long-Lived Assets –*** In accordance SFAS No. 144,*Accountingfor the Impairment or Disposal of Long-Lived Assets*, the Companyreviews long-lived assets for impairment whenever events or changes incircumstances indicate that the carrying value of such assets may not be recoverable.If long-lived assets become impaired, the Company recognizes an impairment lossmeasured as the amount by which the carrying value of the assets exceeds theestimated fair value of the assets.

 

***IncomeTaxes –*** The Company accounts for income taxesunder the provisions of SFAS 109, *Accounting for Income Taxes*. Under thismethod, deferred income taxes are recognized for the tax consequences in futureyears of differences between the tax bases of assets and liabilities and theirfinancial reporting amounts at each year-end based on enacted tax laws andstatutory rates applicable to the periods in which the differences are expectedto affect taxable income. Valuation allowances are established, when necessary,to reduce deferred tax assets to the amount expected to be realized.

 

***RevenueRecognition –***Sales are recognized upon shipmentand passage of title. The Company accrues for estimated returns at the time ofsale. In December 1999, the Securities and Exchange Commission issued StaffAccounting Bulletin 101, Revenue Recognition (“SAB 101”). SAB 101 summarizescertain of the SEC staff’s views in applying generally accepted accountingprinciples to selected revenue recognition issues in financial statements.Implementation of SAB 101 was required by the fourth quarter of 2000. Theimplementation of SAB 101 did not have a material impact on the Company’sfinancial condition or results of operations. The Company establishes reservesfor sales returns and allowances which are recorded as a reduction to sales.

 

***NetIncome (Loss) Per Share –*** Basic earnings (loss)per share (EPS) excludes dilution and is computed by dividing net income orloss attributable to common stockholders by the weighted average of commonshares outstanding for the period. Diluted EPS reflects the potential dilutionthat could occur if securities or other contracts to issue common stock (i.e.convertible preferred stock, warrants to purchase common stock and common stockoptions using the treasury stock method) were exercised or converted intocommon stock. Potentially dilutive securities, representing warrants andoptions to purchase 35,348,548, 34,473,548and 1,515,000 shares of common stockfor the years ended December 31, 2003, 2002 and 2001 are excluded in EPS astheir effect would be anti-dilutive.

 

***Researchand Development –***Research and development costsare expensed when incurred and amounted to $216,185,  $210,985 and $196,456 for the years ended December 31, 2003, 2002and 2001.

 

***Advertisingand Promotion******–*** Effective January 1, 2002, the Company adoptedEmerging Issues Task Force (“EITF”) issue No. 01-9, *Accounting for Consideration Given by aVendor to a Customer or a Reseller of the Vendor’s Products* (EITF01-9).  Upon adoption of EITF 01-9, theCompany was required to classify certain payments to its customers as areduction of sales.  The Companypreviously classified certain of these payments as brand expenses, a componentof selling, general and administrative expenses in the statement ofoperations.  Upon the adoption of EITF01-9, prior periods amounts were reclassified and resulted in a reduction ofsales (and an offsetting reduction of selling expenses) of $454,552 in 2001. Inaddition, the Company reclassified coupon and rebate redemptions from selling,general and administrative expenses to net sales of $55,265 in 2001 and newstore opening cost, were reclassified to cost of goods sold of $125,198 in2001.

 

***Advertising–***The Company expenses the cost of advertising asincurred. Advertising expenses amounted to $490,325, $559,797, and $951,529 forthe years ended December 31, 2003, 2002 and 2001.

 

***DeferredRent –***Deferred rent totaling $98,471 and $110,243at December 31, 2003 and 2002, respectively, is included in accrued expenses.Deferred rent represents rental expense (recorded on a straight-line basis) inexcess of actual rental payments to date.

 

F-9

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***MajorCustomers –***During the fiscal years ended December31, 2003, 2002 and 2001, the Company had sales to four customers in excess of10% of the Company’s total net sales as shown in the following table.

 

**Major Customers Table**

 
|              |   | **Customer  One** |      | **Customer  Two**                           |   | **Customer  Three** |   | **Customer  Four**                          |      |
|-------------------|--------|-------------------|-----------|---------------------------------------------|--------|---------------------|--------|---------------------------------------------|-----------|
|              |   | **Sales**         |      | **Accounts  Receivable  Balance  Year-end** |   | **Sales**           |   | **Accounts  Receivable  Balance  Year-end** |      | **Sales** |   | **Accounts  Receivable  Balance  Year-end** |   | **Sales** |   | **Accounts  Receivable  Balance  Year-end** |   |
|              |   |              |      |                                        |   |                |   |                                        |      |   |   |   |   |   |   |   |   |
| December 31, 2003 |   | $                 | 3,722,900 |                                        | $      | 229,501             |   | $                                           | 2,393,000 |   | $ | 189,512 |   | $ | 2,185,900 |   | $ | 101,260 |   | $ | 1,749,500 |   | $ | 1,502,459 |   |
|              |   |              |      |                                        |   |                |   |                                        |      |   |   |   |   |   |   |   |   |
| December 31, 2002 |   | $                 | 2,547,000 |                                        | $      | 438,200             |   | $                                           | 2,342,400 |   | $ | 185,439 |   | $ | 2,352,500 |   | $ | 241,539 |   | $ | 882,100 |   | $ | 754,799 |   |
|              |   |              |      |                                        |   |                |   |                                        |      |   |   |   |   |   |   |   |   |
| December 31, 2001 |   | $                 | 2,574,416 |                                        | $      | 354,822             |   | $                                           | 2,236,700 |   | $ | 183,175 |   | $ | 2,545,400 |   | $ | 213,548 |   | $ | 1,096,873 |   | $ | 1,020,373 |   |
|                   |        |                   |           |                                             |        |                     |        |                                             |           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The loss of any one of thesecustomers could have a material adverse effect on the Company’s results ofoperations. The Company does not have long-term contracts with any of itscustomers and, accordingly, there can be no assurance that any customer willcontinue to place orders with the Company to the same extent it has in thepast, or at all.

 

***Accountingfor Stock-Based Compensation –***SFAS 123, *Accountingfor Stock-Based Compensation*, requires disclosure of the fair valuemethod of accounting for stock options and other equity instruments. Under thefair value method, compensation cost is measured at the grant date based on thefair value of the award and is recognized over the service period which isusually the vesting period. The Company has chosen, under the provisions ofSFAS 123, to continue to account for employee stock-based transactions usingthe intrinsic value method under Accounting Principles Board (APB) Opinion No.25, *Accountingfor Stock Issued to Employees.*

 

Pursuant to SFAS 123, theCompany has elected to continue using the intrinsic value method of accountingfor stock-based awards granted to employees and directors in accordance withAPB Opinion No. 25 and related interpretations in accounting for its stockoption plan. Had the compensation cost for the Company stock option plan beendetermined based on the fair value at the grant dates for awards under the planconsistent with the method of SFAS 123, the Company’s net loss and loss pershare would have been the pro forma amounts presented below:

 
|                                                                                                                    |   | **Year Ended  December 31, 2003** |     | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|----------|-----------------------------------|--------|-----------------------------------|--------|
|                                                                                                                    |   |                              |     |                              |   |                              |   |
| Net loss: As reported                                                                                                   |   | $                                 | (401,715 | )                                 | $      | (1,896,618                        | )      | $ | (2,727,153 | ) |
|                                                                                                                    |   |                              |     |                              |   |                              |   |
| Add:   Stock-based employee compensation expense included in reported net  loss                                    |   | 0                                 |     | 0                                 |   | 0                                 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards |   | (8,066                            | )        | (333,710                          | )      | (333,710                          | )      |
|                                                                                                                    |   |                              |     |                              |   |                              |   |
| Pro forma                                                                                                               |   | $                                 | (409,781 | )                                 | $      | (2,230,328                        | )      | $ | (3,060,863 | ) |
|                                                                                                                    |   |                              |     |                              |   |                              |   |
| Basic and Diluted net loss per share: As  reported                                                                      |   | $                                 | (0.02    | )                                 | $      | (0.05                             | )      | $ | (0.36 | ) |
| Pro forma                                                                                                               |   | $                                 | (0.02    | )                                 | $      | (0.06                             | )      | $ | (0.40 | ) |

 

F-10

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The fair value for each optiongrant was estimated on the date of grant using the Black-Scholes option pricingmodel with the following assumptions:

 
|                                     |   | **Year Ended  December 31, 2003** |   | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   |
|------------------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|                                     |   |                              |   |                              |   |                              |   |
| Weighted Average Risk-Free Interest Rate |   | 4.41 to 5.21                      | %      | not applicable                    |   | 4.41 to 5.21                      | %      |
|                                     |   |                              |   |                              |   |                              |   |
| Expected Life of an Option               |   | 7 years                           |   | not applicable                    |   | 7 years                           |   |
|                                     |   |                              |   |                              |   |                              |   |
| Expected Stock Volatility                |   | 76                                | %      | not applicable                    |   | 177                               | %      |

 

**New Accounting Pronouncements**

 

In December 2003, the Securitiesand Exchange Commission issued Staff Accounting Bulletin No. 104 (SAB No. 104),“*RevenueRecognition,”*  whichcodifies, revises and rescinds certain sections of SAB No. 101, “*RevenueRecognition,”*  in order tomake this interpretive guidance consistent with current authoritativeaccounting and auditing guidance and SEC rules and regulations. The changesnoted in SAB No. 104 did not have a material effect on the Company’sconsolidated results of operations, consolidated financial position or consolidatedcash flows.

 

In May 2003, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards No. 150,*Accounting for Certain Instruments with Characteristics of BothLiabilities and Equity (*“FAS 150”*),* which establishes standards forclassifying and measuring certain financial instruments with characteristics ofboth liabilities and equity.  FAS 150 requires an issuer to classify afinancial instrument that is within its scope, which may have previously beenreported as equity, as a liability (or an asset in some circumstances). This statement is effective at the beginning of the first interim periodbeginning after June 15, 2003 for public companies.  The Company adoptedthis Statement as of July 1, 2003 and it had no material impact on itsfinancial statements.

 

In April 2003, the FASBissued SFAS No. 149, “*Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities*” (“FAS No. 149”). FAS No. 149amends and clarifies the accounting guidance on derivative instruments(including certain derivative instruments embedded in other contracts) andhedging activities that fall within the scope of FAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities.” FAS No. 149 alsoamends certain other existing pronouncements, which will result in moreconsistent reporting of contracts that are derivatives in their entirety orthat contain embedded derivatives that warrant separate accounting. ThisStatement is effective for contracts entered into or modified afterJune 30, 2003, with certain exceptions, and for hedging relationshipsdesignated after June 30, 2003. We do not have any contracts that arederivatives or that contain embedded derivatives.

 

In January 2003, the FASBissued FASB Interpretation No. 46,*Consolidation of Variable Interest Entities,*an interpretation of Accounting Research Bulletins (“ARB”) No. 51,*Consolidated Financial Statements* (“FIN 46”).  FIN 46 clarifiesthe application of ARB No. 51 to certain entities in which equity investors donot have the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties.  The Companydoes not believe the adoption of FIN 46 will have a material impact on itsfinancial position and results of operations.

 

In December 2002, the FASBissued Statement of Financial Accounting Standards No. 148,*Accounting for Stock-BasedCompensation — Transition and Disclosure* (“FAS 148”), which amendsStatement of Financial Accounting Standards No. 123,*Accounting for Stock-BasedCompensation* (“FAS 123”). FAS 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, FAS 148 amends thedisclosure requirements of FAS 123 to require more prominent and more frequentdisclosures in financial statements of the effects of stock-based compensation.The transition guidance and annual disclosure provisions of FAS 148 areeffective for fiscal years ending after December 15, 2002. The interimdisclosure provisions are effective for financial reports containing condensedfinancial statements for interim periods beginning after December 15, 2002. Theadoption of FAS 148 did not have a material impact on the Company’sconsolidated balance sheet or results of operations as the Company intends tocontinue to account for its equity based compensation plans using the intrinsicvalue method.  The Company provided the interim disclosures required byFAS 148 beginning in the first quarter of 2003.

 

F-11

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In November 2002, the FASBissued Interpretation No. 45,*Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness to Others*,an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASBInterpretation No. 34. This interpretation elaborates on the disclosures to bemade by a guarantor in its interim and annual financial statements about itsobligations under guarantees issued. The interpretation also clarifies that aguarantor is required to recognize, at inception of a guarantee, a liabilityfor the fair value of the obligation undertaken. The initial recognition andmeasurement provisions of the interpretation are applicable to guaranteesissued or modified after December 31, 2002 and are not expected to have amaterial effect on the Company’s financial statements. The disclosurerequirements are effective for financial statements of interim and annualperiods ending after December 31, 2002. The Company adopted this Statement asof January 1, 2003 and it had no material impact on its financial statements.

 

In June 2002, the FASB issuedFAS No. 146,*Accounting for Costs Associated with Exit or Disposal Activities*,which addresses accounting for restructuring and similar costs. FAS No. 146supersedes previous accounting guidance, principally Emerging Issues Task Force(“EITF”) Issue No. 94-3. The Company will adopt the provisions of SFAS No. 146for restructuring activities initiated after December 31, 2002. FAS No. 146requires that the liability for costs associated with an exit or disposalactivity be recognized when the liability is incurred. Under EITF No. 94-3, aliability for an exit cost was recognized at the date of a company’s commitmentto an exit plan. FAS No. 146 also establishes that the liability shouldinitially be measured and recorded at fair value. Accordingly, FAS No. 146 mayaffect the timing of recognizing future restructuring costs as well as theamount recognized.

 

**2. INVENTORIES**

 

Inventories are stated at thelower of weighted average cost or market. Weighted average cost is determinedon a first-in, first-out basis. Inventories at December 31, 2003 and December31, 2002 consisted of the following:

 
|                                               |   | **December  31, 2003** |      | **December  31, 2002** |   |
|----------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
| Raw Materials                                      |   | $                      | 208,615   |                   | $      | 224,033 |   |
| Finished Goods                                     |   | 1,115,007              |      | 1,537,199              |   |
|                                               |   |                   |      |                   |   |
| Subtotal                                           |   | 1,323,622              |      | 1,761,232              |   |
| Less: Reserve for Excess and Obsolete  Inventories |   | (77,251                | )         | (72,101                | )      |
|                                               |   | $                      | 1,246,371 |                   | $      | 1,689,131 |   |

 

**3. PROPERTY AND EQUIPMENT**

 

Property and equipment atDecember 31, 2003 and December 31, 2002 consisted of the following:

 
|                                            |   | **December  31, 2003** |    | **December  31, 2002** |   |
|-------------------------------------------------|--------|------------------------|---------|------------------------|--------|
| Building and improvements                       |   | $                      | 160,196 |                   | $      | 160,196 |   |
| Machinery and equipment                         |   | 477,185                |    | 550,939                |   |
| Automobiles                                     |   | 83,980                 |    | 83,980                 |   |
|                                            |   |                   |    |                   |   |
| Total                                           |   | 721,361                |    | 795,115                |   |
| Less accumulated depreciation and  amortization |   | (559,476               | )       | (566,392               | )      |
|                                            |   |                   |    |                   |   |
| Property and equipment, net                     |   | $                      | 161,885 |                   | $      | 228,723 |   |

 

Depreciation expenses amountedto $75,436, $86,218and $95,774 for the fiscal years ended December 31, 2003,2002 and 2001.

 

F-12

----

 

**4. DEBT**

 

Long-term debt consists of thefollowing at December 31, 2003 and 2002.

 
|                                                                                                                                    |   | **December  31, 2003** |      | **December  31, 2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|------------------------|--------|
|                                                                                                                                    |   |                   |      |                   |   |
| Line of Credit                                                                                                                          |   | $                      | 2,231,778 |                   | $      | 1,786,998 |   |
| Credit Agreement with majority shareholder                                                                                              |   |                   |      |                   |   |
| Investor Notes with majority shareholder  and other investors                                                                           |   | 162,345                |      | 202,345                |   |
| Notes Payable due to a former stockholder’s  estate; borrowings bear interest at 8% and are due in monthly installments of  $2,832 |   | 37,735                 |      | 67,399                 |   |
| Loan Agreement with majority shareholder  and other investors                                                                           |   | 450,000                |      | 0                      |   |
| Total                                                                                                                                   |   | 2,881,858              |      | 2,056,742              |   |
| Less line of credit and current portion of  long-term debt                                                                              |   | (2,876,249             | )         | (2,019,007             | )      |
| Long-term debt                                                                                                                          |   | $                      | 5,609     |                   | $      | 37,735 |   |

 

A summary oflong-term debt maturities as of December 31, 2003 is as follows:

 

| **Year Ending December 31,** |   | **Amount** |      |
|------------------------------|--------|------------|-----------|
| 2004                         |   | $          | 2,876,249 |   |
| 2005                         |   | 5,609      |      |
| Total                        |   | $          | 2,881,858 |   |

 

***Lineof Credit –***On January 27, 2000, the Companyentered into a three year Credit and Security Agreement (the “CreditAgreement”) with Wells Fargo Business Credit, Inc. (“Wells Fargo”), whichinitially allowed for maximum borrowings of up to $3,000,000, based on certainpercentages of eligible accounts receivable and inventories as defined. As morefully described in Note 7, *Private Equity Transaction*, on December20, 2001, the terms of the Credit Agreement were modified to include waivingthe enforcement of existing defaults as of December 20, 2001, increasing thecredit available to the Company to a maximum of $4,500,000 with an inventorymaximum subline of $2,000,000, increasing the floating rate to the prime rateplus 2% and extending the maturity date to December 31, 2003. On September 19,2002, the terms of the Credit Agreement were modified to include waiving theenforcement of existing defaults, reducing the credit availability of theCompany to a maximum of $4,325,000, requiring that the Company maintain certainminimum levels of cash, and reducing the covenants regarding minimum net incomeand minimum book net worth.  Inconsideration of the extension of credit under the Loan Agreement on April 14,2003, Wells Fargo waived all defaults of the Company as of December 31, 2002under the Credit Agreement dated as of February 27, 2000 and amended theagreement to, among other things, reduce the covenants regarding minimum net incomeand minimum book net worth and increased the interest rate to the prime rateplus 4.5%. On November 6, 2003, the terms of the Credit Agreement were modifiedto extend the maturity date until March 31, 2004 and on March 29, 2004, theterms of the Credit Agreement were modified to extend the maturity date untilDecember 31, 2005 (See Note 12). Borrowings under the Credit Agreement, which totaled $2,231,778 atDecember 31, 2003, are collateralized by substantially all assets of theCompany. At December 31, 2003 the prime rate was 4.0% and the interest chargeunder the Credit and Security Agreement was 8.50%. The Credit Agreementcontains covenants, which, among other things, require that certain financialratios be met. As of December 21, 2003, the Company was in compliance with allcovenants.  Available borrowings underthe Credit and Security Agreement were $720,312 at December 31, 2003.

 

***CreditAgreement with Majority Shareholder***– InAugust 1999, the Company entered into a Credit Agreement (the “CreditAgreement”) with Health Holdings and Botanicals, LLC (“Health Holdings”), themajority stockholder of the Company. The Credit Agreement allows for advances(the “Advances”) of $4 million at an interest rate of 8% per annum with adue date of July 31, 2004. During the year ended December 31, 2001,Health Holdings agreed to convert interest earned from October 1, 2000 toSeptember 30, 2001 of $342,406 to the outstanding principal amount as apayment-in-kind resulting in a balance at December 31, 2001 of $4,496,193. Aspart of the Private Equity Transaction on January 2, 2002 as describedmore fully in Note 5, Health Holdings converted all of the Company’sCredit Agreement debt due to Health Holdings, plus accrued interest of $67,013for a total debt conversion of $4,563,206 into 35,989,855 shares of theCompany’s Common Stock.

 

F-13

----

 

***LoanAgreement with Majority Shareholder and Other Investors –***InAugust 2000, the Company entered into a Loan Agreement (the “InvestorNotes”) with Health Holdings and other investors (the “Lender Group”). TheInvestor Notes allowed for advances (the “Loan Advances”) of up to$1.2 million at an interest rate of 8% per annum with due dates ofSeptember 11, 2002 for $50,000 and August 31, 2003 for the remainingbalance outstanding. Interest only payments were to be required on a quarterlybasis.

 

The Loan Agreement further provided that the Lender Group could elect toconvert all or any part of the Loan Advances into shares of the Company’sCommon Stock at a conversion price equal to the lower of (a) the averageclosing bid of the Company’s Common Stock for the ten trading days prior to themaking of a Loan Advance or (b) the average closing bid of the Company’scommon stock for the ten trading days prior to the date of receipt of notice ofconversion.  On June 13, 2001, twoinvestors converted their total debt of $150,000 plus accrued interest of$2,400 into Common Stock, receiving a total of 476,250 shares of the Company’sCommon Stock based on the then fair market value of $0.32. As part of thePrivate Equity Transaction on January 2, 2002 as described more fully inNote 7, Health Holdings converted into Common Stock all of the Company’sInvestor Notes due to Health Holdings, plus accrued interest of $11,051 for atotal debt conversion of $752,496.  OnAugust 8, 2002, one investor (a member of the Board of Directors) converteddebt of $50,000 which was due September 11, 2002 plus accrued interest of $427into Common Stock, receiving a total of 720,392 shares of the Company’s CommonStock based on the then fair market value of $0.07.

 

On August 21, 2003, the terms of the remaining outstanding InvestorNotes totaling $202,345 were modified to include increasing the interest rateto 15% per annum paid in quarterly increments and setting a principal repaymentschedule of $20,000 each on September 15, 2003 and October 15, 2003,installments of $10,000 per month from January 15, 2004 through July 15, 2004and a final payment of $92,345 on August 15, 2004.  As of December 31, 2003, there is $162,345 outstanding on theInvestor Notes.

 

On April 14, 2003, the Companyentered into a loan agreement (the “Loan Agreement”) with Health Holdings andcertain other lenders (the “Lender Group”), pursuant to which the Lender Grouphas agreed to lend the Company $450,000 and, subject to the discretion of theLender Group, up to an additional $300,000. All advances under the Loan Agreement bear interest at the rate of 15%per annum, are due on December 31, 2004, are secured by substantially all ofthe assets of the Company, and are subordinated to the Company’s indebtednessto Wells Fargo Business Credit, Inc. (“Wells Fargo”).  The advances under the Loan Agreement will be used by the Companyfor working capital and general corporate purposes.  In consideration of the extension of credit under the LoanAgreement, Wells Fargo waived all defaults of the Company as of December 31,2002 under the Credit and Security Agreement dated as of February 27, 2000 andamended the agreement to, among other things, reduce the covenants regardingminimum net income and minimum book net worth and increased the interest rateto the prime rate plus 4.5%. As of December 31, 2003 there is $450,000outstanding under the Loan Agreement.

 

**5. PRIVATE EQUITY TRANSACTION**

 

On January 2,2002, the Company privately sold 13,540,723 shares of Series B ConvertiblePreferred Stock (the “Shares”) for $2 million, and warrants, which expire onDecember 31, 2004, to purchase an additional 33,641,548 shares of Series BConvertible Preferred Stock at an aggregate exercise price of $3.5 million (the“Warrants”), for $500,000. The Shares and Warrants were purchased by WestgateEquity Partners, L.P. (“Westgate”). The Series B Convertible Preferred Stock bearsdividends at a rate of 10% per annum, which will accumulate and compoundsemi-annually if not paid in cash. The Series B Convertible Preferred Stock maybe converted into Common Stock at any time at the option of the holder.  On the seventh anniversary of its issuance,any unconverted shares of Series B Convertible Preferred Stock will beautomatically redeemed by the Company at the original issuance price plusaccrued and unpaid dividends, provided the Company is legally able to do so.Two members of the Board of Directors of the Company are elected exclusively bythe holders of the Series B Convertible Preferred Stock voting as a separateclass.

 

The Companymay redeem the Series B Convertible Preferred Stock at any time prior toDecember 31, 2004 if the Company receives a bona fide offer from a third partyto invest equity capital in the Company and the holders of the Series BConvertible Preferred Stock do not make a Qualified Counter-Offer.  A “Qualified Counter-Offer” is a writtenoffer for an equity investment in the Company that will yield gross proceeds inexcess of the third party’s offer (but need not exceed $3,500,000), and whicheither (A) is accomplished through the exercise of some or all of the Warrants,or (B) will provide capital on the same or better terms as the third partyoffer.  The Series B ConvertiblePreferred Stock had a beneficial conversion feature of $2,000,000, which wasrecorded as a discount and is being amortized over seven years.

 

As part ofthis transaction, Health Holdings agreed to convert all of the Company’soutstanding debt to Health Holdings, including accrued interest (approximately$5,316,000), and to surrender all of Health Holdings’ Series A ConvertiblePreferred Stock (1,250,024 shares) for cancellation without conversion, inexchange for 35,989,855 shares of the Company’s Common Stock. Furthermore, thewarrants that Health Holdings holds to purchase up to 600,000 shares of CommonStock have been modified to be exercisable for Non-Voting Common Stock at an exerciseprice of $1 per share.

 

F-14

----

 

As part ofthis transaction, the Company entered into a Management Services Agreementunder which certain principals of Westgate or its affiliates will providemanagement and consulting services to the Company and amended and extended theemployment agreement with the Company’s CEO. Also, on December 20, 2001 as partof this transaction and effective on its completion, Wells Fargo agreed tomodify the terms of its Credit and Security Agreement with the Company, toinclude waiving the enforcement of existing defaults, increasing creditavailable to the Company to a maximum of $4,500,000, increasing the floatingrate to the prime rate plus 2% and extending the maturity date to December 31,2003, as more fully described under Note 4, *Line of Credit*.

 

Under theterms of the Private Equity Transaction, if Westgate exercises the warrants infull, Westgate would hold a total of 47,182,271 shares of Series B ConvertiblePreferred Stock which would be convertible into the same number of shares ofCommon Stock, subject to adjustment for anti-dilution, or 51% of the Company’sCommon Stock on a fully diluted basis as of December 31, 2003.

 

After thecompletion of the Private Equity Transaction, Westgate asserted that theCompany’s representations and warranties concerning the Company’scapitalization in the Purchase Agreement were inaccurate in that they omittedto disclose the fact that certain outstanding promissory notes of the Company inan amount of $252,345 (the “Convertible Notes”) were convertible into shares ofthe Common Stock of the Company at the market price of the Common Stock on thedate of conversion.  Convertible Notesin the amount of $50,000 have been converted into 720,392 shares of CommonStock to date, and $162,345 in Convertible Notes remain outstanding and wereconvertible into 8,117,250 shares as of December 31, 2003.

 

The Companyand Westgate agreed to resolve this dispute by adjusting the conversion formulafor the Series B Convertible Preferred Stock. In addition, Westgate and Health Holdings agreed that (i) the Companymay grant additional options to purchase up to 1,250,000 shares of Common Stockto employees in accordance with the Naturade, Inc. 1998 Incentive Stock OptionPlan, and (ii) Health Holdings would grant to Westgate a proxy to vote 1.041shares of Common Stock owned by Health Holdings for each share of Common Stockissued on exercise of the new options.

 

**6. STOCKHOLDERS’ EQUITY**

 

***ConvertiblePreferred Stock –***During fiscal year endedSeptember 30, 1998, the Company issued 1,250,024 shares of Series A ConvertiblePreferred Stock (the “shares”) to Health Holdings. The shares paid dividendsexcept in the event of a liquidation or reorganization of the Company. Whileconvertible, the preferred shares had voting rights equivalent to the commonstock on as “as converted’ basis. As described more fully in Note 5, *PrivateEquity Transaction*, Health Holdings surrendered the shares January3, 2002.

 

***EmployeeStock Option Plan –***In February 1998, the Companyadopted an Incentive Stock Option Plan (the “Plan”) to enable participatingemployees to acquire shares of the Company’s common stock. The Plan providedfor the granting of incentive stock options up to an aggregate of 850,000shares, as amended. In October 2001, the Company amended the Plan by increasingto 2,000,000 the number of shares of the Company’s common stock which may besubject to awards granted pursuant to the Plan. The actual amount of incentivestock options that may be granted to employees is determined by theCompensation Committee based on the parameters set forth in the Plan. Under theterms of the Plan, incentive stock options may be granted at not less than 100%of the fair market value at the date of the grant (110% in the case of 10%shareholders). Incentive options granted under the Plan vest over a four-yearperiod from the date of grant. The Company has granted 1,619,500 incentiveoptions under the Plan at the weighted average exercise price per share of$0.14 as of December 31, 2003. These options expire seven years from the dateof grant.

 

***DirectorStock Options –*** In October 1999, 87,500 optionswere issued to each of two then new board members at an exercise price of

$1.03.

 

***Warrants–***On January 2, 2002, the Company sold warrants topurchase 33,641,548 shares of Series B Convertible Common Stock. The aggregatepurchase price of the warrants was $500,000 and the aggregate exercise price is$3.5 million. These warrants expire on December 31, 2004.  This transaction is described more fully inNote 5, *PrivateEquity Transaction.*

 

In 1999, the Company granted600,000 warrants in conjunction with certain financing agreements. Thesewarrants expire ten years from the date of grant. As part of the *PrivateEquity Transaction* described in Note 5, the holders of the warrantsagreed they would be exercisable for Non-Voting Common Stock.

 

F-15

----

 

A summary of the Company’soutstanding stock options activity is as follows:

 
|                             |   | **Number of  Shares** |   | **Weighted  Average  Exercise Price  per Share** |   | **Number  Exercisable** |      | **Weighted  Average  Exercise  Price** |   |
|----------------------------------|--------|-----------------------|--------|--------------------------------------------------|--------|-------------------------|-----------|----------------------------------------|--------|
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Outstanding at January 1, 2001   |   | 1,365,000             |   | $                                                | 1.04   |                    | 962,750   |                                   | $      | 1.04 |   |
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Granted                          |   | 170,000               |   | $                                                | 0.39   |                    |      |                                   |   |   |
| Exercised                        |   | (0                    | )      | $                                                | — |                    |      |                                   |   |   |
| Expired                          |   | (20,000               | )      | $                                                | 1.18   |                    |      |                                   |   |   |
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Outstanding at December 31, 2001 |   | 1,515,000             |   | $                                                | 0.98   |                    | 1,052,750 |                                   | $      | 1.08 |   |
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Granted                          |   | 0                     |   | $                                                | .104   |                    |      |                                   |   |   |
| Exercised                        |   | (0                    | )      | $                                                | — |                    |      |                                   |   |   |
| Expired                          |   | (683,000              | )      | $                                                | 1.01   |                    |      |                                   |   |   |
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Outstanding at December 31, 2002 |   | 832,000               |   | $                                                | 0.58   |                    | 679,875   |                                   | $      | 0.56 |   |
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Granted                          |   | 1,025,000             |   | $                                                | 0.03   |                    |      |                                   |   |   |
| Exercised                        |   | (0                    | )      | $                                                |   |                    |      |                                   |   |
| Expired                          |   | (150,000              | )      | $                                                | 1.25   |                    |      |                                   |   |   |
|                             |   |                  |   |                                             |   |                    |      |                                   |   |
| Outstanding at December 31, 2003 |   | 1,707,000             |   | $                                                | 0.19   |                    | 771,000   |                                   | $      | 0.35 |   |

 

The following table summariesinformation about stock options outstanding at December 31, 2003

 
| **Range of  Exercise Prices** |        | **Options  Outstanding** |      | **Weighted  Average  Remaining  Contract Life  In Years** |   | **Weighted  Average  Exercise  Price** |   | **Options  Exercisable** |   | **Weighted  Average  Exercise Price  for Exercisable  Options** |   |
|-------------------------------|-------------|--------------------------|-----------|-----------------------------------------------------------|--------|----------------------------------------|--------|--------------------------|--------|-----------------------------------------------------------------|--------|
| $                             | 0.025-0.100 |                     | 1,025,000 |                                                      | 7      |                                   | $      | 0.03                     |   | 181,250                                                         |   | $ | 0.03 |   |
| $                             | 0.15-0.875  |                     | 559,500   |                                                      | 3      |                                   | $      | 0.30                     |   | 467,250                                                         |   | $ | 0.30 |   |
| $                             | 1.03 - 1.13 |                     | 122,500   |                                                      | 2      |                                   | $      | 1.04                     |   | 122,500                                                         |   | $ | 1.04 |   |
|                          |        | 1,707,000                |      |                                                      |   | $                                      | 0.19   |                     | $      | 771,000                                                         |   | $ | 0.35 |   |
|                               |             |                          |           |                                                           |        |                                        |        |                          |        |                                                                 |        |  |  |  |  |

 

F-16

----

 

A summary of the Company’soutstanding warrant activity is as follows:

 
|                             |   | **Number of  Shares** |   | **Weighted  Average  Exercise Price  per Share** |   | **Number  Exercisable** |       | **Weighted  Average  Exercise  Price** |   |
|----------------------------------|--------|-----------------------|--------|--------------------------------------------------|--------|-------------------------|------------|----------------------------------------|--------|
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at January 1, 2001   |   | 600,000               |   | $                                                | 1.00   |                    | 600,000    |                                   | $      | 1.00 |   |
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Granted                          |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
| Exercised                        |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
| Expired                          |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at December 31, 2001 |   | 600,000               |   | $                                                | 1.00   |                    | 600,000    |                                   | $      | 1.00 |   |
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Granted                          |   | 33,641,548            |   | $                                                | 0.10   |                    |       |                                   |   |   |
| Exercised                        |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
| Expired                          |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at December 31, 2002 |   | 34,241,548            |   | $                                                | 0.12   |                    | 34,241,548 |                                   | $      | 0.12 |   |
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Granted                          |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
| Exercised                        |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
| Expired                          |   | 0                     |   | $                                                | 0      |                    |       |                                   |   |   |
|                             |   |                  |   |                                             |   |                    |       |                                   |   |
| Outstanding at December 31, 2003 |   | 34,241,548            |   | $                                                | 0.12   |                    | 34,241,548 |                                   | $      | 0.12 |   |

 

The following table summariesinformation about warrants outstanding at December 31, 2003

 
| **Range of  Exercise Prices** |   | **Warrants  Outstanding** |   | **Weighted  Average  Remaining  Contract Life  In Years** |   | **Weighted  Average  Exercise  Price** |   | **Warrants  Exercisable** |       | **Weighted  Average  Exercise Price  for Exercisable  Warrants** |   |
|-------------------------------|--------|---------------------------|--------|-----------------------------------------------------------|--------|----------------------------------------|--------|---------------------------|------------|------------------------------------------------------------------|--------|
| $0.10                         |   | 33,641,548                |   | 1                                                         |   | $                                      | 0.10   |                      | 33,641,548 |                                                             | $      | 0.10 |   |
| $1.00                         |   | 600,000                   |   | 6                                                         |   | $                                      | 1.00   |                      | 600,000    |                                                             | $      | 1.00 |   |
|                          |   | 34,241,548                |   |                                                      |   | $                                      | 0.12   |                      | 34,241,548 |                                                             | $      | 0.12 |   |

 

F-17

----

 

**7. INCOME TAXES**

 

The provision for income taxesfor the years ended December 31, 2003, 2002 and 2001 consists of the following:

 
|            |   | **Year Ended  December 31, 2003** |   | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   |
|-----------------|--------|-----------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|            |   |                              |   |                              |   |                              |   |
| Current         |   |                              |   |                              |   |                              |   |
| Federal         |   | $                                 | 0      |                              | $      | 0                                 |   | $ | 5,131 |   |
| State           |   | 800                               |   | 800                               |   | 800                               |   |
|            |   |                              |   |                              |   |                              |   |
| Total current   |   | $                                 | 800    |                              | $      | 800                               |   | $ | 5,931 |   |
|            |   |                              |   |                              |   |                              |   |
| Deferred        |   |                              |   |                              |   |                              |   |
| Federal         |   | 0                                 |   | 0                                 |   | 0                                 |   |
| State           |   | 0                                 |   | 0                                 |   | 0                                 |   |
|            |   |                              |   |                              |   |                              |   |
| Total deferred  |   | 0                                 |   | 0                                 |   | 0                                 |   |
|            |   |                              |   |                              |   |                              |   |
| Total provision |   | $                                 | 800    |                              | $      | 800                               |   | $ | 5,931 |   |

 

The income tax provisiondiffers from the amount of income tax determined by applying the U.S. federalincome tax rate to income before income taxes due to the following:

 
|                                                 |   | **Year Ended  December 31, 2003** |     | **Year Ended  December 31, 2002** |   | **Year Ended  December 31, 2001** |   |
|------------------------------------------------------|--------|-----------------------------------|----------|-----------------------------------|--------|-----------------------------------|--------|
|                                                 |   |                              |     |                              |   |                              |   |
| Computed tax (benefit) expense                       |   | $                                 | (136,651 | )                                 | $      | (644,578                          | )      | $ | (925,215 | ) |
| Increase (decrease) in income taxes  resulting from: |   |                              |     |                              |   |                              |   |
| Nondeductible expenses                               |   | 6,674                             |     | 1,783                             |   | 3,438                             |   |
| State income taxes, net of federal tax  benefit      |   | 528                               |     | 528                               |   | 528                               |   |
| State NOL disallowance and others                    |   | (32,124                           | )        | (285,207                          | )      | (137,721                          | )      |
| Change in valuation allowance                        |   | 162,373                           |     | 928,274                           |   | 1,064,901                         |   |
|                                                 |   |                              |     |                              |   |                              |   |
|                                                 |   | $                                 | 800      |                              | $      | 800                               |   | $ | 5,931 |   |

 

F-18

----

 

Deferred income taxes reflectthe net tax effects of temporary differences between the carrying amounts ofassets and liabilities for financial reporting purposes and the amounts usedfor income tax purposes. The significant components of the net deferred taxassets and liabilities were as follows:

 
|                                           |   | **Year Ended  December 31, 2003** |   | **Year Ended  December 31, 2002** |   |
|------------------------------------------------|--------|-----------------------------------|--------|-----------------------------------|--------|
|                                           |   |                              |   |                              |   |
| Current deferred tax assets (liabilities)      |   |                              |   |                              |   |
| Uniform capitalization                         |   | $                                 | 46,872 |                              | $      | 55,124 |   |
| Accounts Receivable                            |   | 278,274                           |   | 354,817                           |   |
| Accrued vacation                               |   | 29,403                            |   | 33,528                            |   |
| Inventory reserve                              |   | 30,900                            |   | 30,040                            |   |
| State taxes                                    |   | 272                               |   | 272                               |   |
| Other                                          |   | 48,601                            |   | 64,695                            |   |
| Valuation allowance                            |   | (434,322                          | )      | (538,476                          | )      |
| Total current                                  |   | —                            |   | —                            |   |
|                                           |   |                              |   |                              |   |
| Noncurrent deferred tax assets  (liabilities): |   |                              |   |                              |   |
| Net operating losses and credit  carryforwards |   | 6,954,058                         |   | 7,656,335                         |   |
| Depreciation                                   |   | 17,790                            |   | (24,317                           | )      |
| Stock option                                   |   | 0                                 |   | 80,325                            |   |
| Other                                          |   | 0                                 |   | (4,003                            | )      |
| Valuation allowance                            |   | (6,971,848                        | )      | (7,708,340                        | )      |
| Total noncurrent                               |   | —                            |   | —                            |   |
|                                           |   |                              |   |                              |   |
| Total                                          |   | $                                 | — |                              | $      | — |   |

 

As of December 31, 2003, theCompany had federal net operating loss carryforwards of approximately$19,000,000 that begin expiring in December 2017 and state net operating losscarryforwards of $8,100,000, which begin expiring in December 2004.  A valuation allowance for the full amount ofnet deferred taxes has been provided because it is more likely than not thatthe deferred taxes will not be realized. Under Federal Tax Law IRC Section 382,certain significant changes in ownership that the Company is currentlyundertaking may restrict the future utilization of these tax losscarryforwards.

 

F-19

----

 

**8. COMMITMENTS, CONTINGENCIES, AND RELATEDPARTY TRANSACTIONS**

 

***EmploymentAgreements –***The Company has a four-yearemployment agreement with its chief executive officer (CEO) that began in March1998. As amended, the agreement provides for an annual salary of $225,000. Aspart of the Private Equity Transactionon January 2, 2002 as described more fully in Note 5, the employmentagreement with the Company’s CEO was amended to allow for the immediate vestingof options to purchase 365,000 shares of Common Stock, 297,500 of which wouldhave vested by March 2, 2002, at an exercise price reduced to $0.1477 pershare, which equals terms of the Private Equity Transaction. Furthermore, theemployment agreement was extended to December 31, 2003 and subsequently,extended to December 31, 2005.

 

In July 2003,Mr. Kasprisin, Chief Financial Officer, entered into an employmentagreement with the Company that can be terminated without cause by either partyupon 30 days’ notice. Mr. Kasprisin is entitled to severance equal to 6months base pay should he be terminated without cause by the Company.  Pursuant to the employment agreement,Mr. Kasprisin is entitled to a base salary of $160,000 per year and abonus based upon his base salary. In addition, Mr. Kasprisin has beengranted options to purchase up to 150,000 shares of Common Stock, which optionsvest in equal quarterly amounts on each of the first eight quarters of hisemployment.

 

***ConsultingAgreements –***The Company is a party to aconsulting agreement with an affiliate of its majority stockholder, HealthHoldings, for $300,000 per year payable quarterly. The agreement isautomatically renewable for successive one-year terms so long as HealthHoldings or any of its affiliates owns 25% or more of the Company. As part ofthe Private Equity Transaction**on January 2, 2002 as described morefully in Note 5, the Company entered into a management and consulting servicesagreement with Westgate, a principal stockholder, or its affiliates for$100,000 per year payable quarterly for an initial period of five years endingDecember 31, 2006. Both Health Holdings and Westgate elected to forego paymentson these consulting agreements in fiscal 2003.

 

***OperatingLeases –*** The Company rents property and equipmentunder certain noncancellable operating leases expiring in various years through2006. Future minimum commitments under operating leases as of December 31, 2003are as follows:

 

| **Year Ending December 31** |   | **Amount** |      |
|-----------------------------|--------|------------|-----------|
|                        |   |       |      |
| 2004                        |   | $          | 405,286   |   |
| 2005                        |   | 427,624    |      |
| 2006                        |   | 283,056    |      |
|                        |   |       |      |
| Total                       |   | $          | 1,115,966 |   |

 

Rent expense charged tooperations was $458,687, $457,230 and $431,091for the years ended December 31,2003, 2002 and 2001, respectively.

 

**Legal Proceedings**.

 

From time to time, the Companyis party to various other claims and litigation that arise in the normal courseof business.  While any litigationcontains an element of uncertainty, management believes that the ultimateoutcome of these claims and litigation will not have a material adverse effecton the Company’s results of operations or financial condition.

 

**9. 401(k) PLAN**

 

The Company has a 401(k) planthat is available to all employees of the Company who meet certain age andlength of service requirements. The plan provides for Company matchingcontributions equal to 25% of each employee participant’s contribution not toexceed 6% of the employee participant’s compensation. The Company’scontribution to the plan was $14,538, $13,763 and $12,728 for the years endedDecember 31, 2003, 2002 and 2001, respectively.

 

F-20

----

 

**10. SEGMENT REPORTING**

 

Operating segments are definedas components of an enterprise about which separate financial information isavailable that is evaluated regularly by the Company’s chief operatingdecision-maker, or decision-making group, in deciding how to allocate resourcesand in assessing performance. The Company’s chief operating decision maker isthe CEO.

 

The Company’s reportableoperating segments include health food specialty stores and mass marketcategories. The Company does not allocate operating expenses to these segments,nor does it allocate specific assets to these segments. Therefore, segmentinformation reported includes only sales, cost of sales and gross profit.Operating segment data for the years ended December 31, 2003, 2002 and 2001 areas follows:

 

Distribution Channels

 
|                         |   | **Health  Food** |      | **Mass**  |   | **Total** |   |
|------------------------------|--------|------------------|-----------|-----------|--------|-----------|--------|
| Year ended December 31, 2003 |   |             |      |      |   |      |   |
| Sales                        |   | $                | 7,576,727 |      | $      | 8,749,569 |   | $ | 16,326,296 |   |
| Cost of Sales                |   | 4,049,706        |      | 4,612,593 |   | 8,662,299 |   |
| Gross Profit                 |   | $                | 3,527,021 |      | $      | 4,136,976 |   | $ | 7,663,997 |   |

 
|                         |   | **Health  Food** |      | **Mass**  |   | **Total** |   |
|------------------------------|--------|------------------|-----------|-----------|--------|-----------|--------|
| Year ended December 31, 2002 |   |             |      |      |   |      |   |
| Sales                        |   | $                | 7,366,133 |      | $      | 7,050,218 |   | $ | 14,416,351 |   |
| Cost of Sales                |   | 4,067,120        |      | 4,090,487 |   | 8,157,607 |   |
| Gross Profit                 |   | $                | 3,299,013 |      | $      | 2,959,731 |   | $ | 6,258,744 |   |

 
|                         |   | **Health  Food** |      | **Mass**  |   | **Total** |   |
|------------------------------|--------|------------------|-----------|-----------|--------|-----------|--------|
| Year ended December 31, 2001 |   |             |      |      |   |      |   |
| Sales                        |   | $                | 8,284,063 |      | $      | 8,357,046 |   | $ | 16,641,109 |   |
| Cost of Sales                |   | 4,714,076        |      | 4,576,151 |   | 9,290,227 |   |
| Gross Profit                 |   | $                | 3,569,987 |      | $      | 3,780,895 |   | $ | 7,350,882 |   |

 

Sales are attributed togeographic areas based on the location of the entity to which the products weresold. Geographic segment data for the years ended December 31, 2003, 2002 and2001 are as follows:

 
|                         |   | **United  States** |       | **International** |   | **Total** |   |
|------------------------------|--------|--------------------|------------|-------------------|--------|-----------|--------|
|                         |   |               |       |              |   |      |   |
| Year ended December 31, 2003 |   |               |       |              |   |      |   |
| Sales                        |   | $                  | 16,091,995 |              | $      | 234,301   |   | $ | 16,326,296 |   |
| Cost of Sales                |   | 8,515,755          |       | 146,544           |   | 8,662,299 |   |
| Gross Profit                 |   | $                  | 7,576,240  |              | $      | 87,757    |   | $ | 7,663,997 |   |
|                         |   |               |       |              |   |      |   |
| Year ended December 31, 2002 |   |               |       |              |   |      |   |
| Sales                        |   | $                  | 14,194,058 |              | $      | 222,293   |   | $ | 14,416,351 |   |
| Cost of Sales                |   | 8,011,004          |       | 146,603           |   | 8,157,607 |   |
| Gross Profit                 |   | $                  | 6,183,054  |              | $      | 75,690    |   | $ | 6,258,744 |   |
|                         |   |               |       |              |   |      |   |
| Year ended December 31, 2001 |   |               |       |              |   |      |   |
| Sales                        |   | $                  | 16,290,561 |              | $      | 350,548   |   | $ | 16,641,109 |   |
| Cost of Sales                |   | 9,085,405          |       | 204,822           |   | 9,290,227 |   |
| Gross Profit                 |   | $                  | 7,205,156  |              | $      | 145,726   |   | $ | 7,350,882 |   |

 

F-21

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**11. QUARTERLY FINANCIAL DATA (UNAUDITED)**

 

Summary unaudited quarterlyfinancial data from continuing operations for 2003 and 2002

 

is as follows:

 

 
| **Fiscal year ended December 31, 2003**                 |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|---------------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
|                                                    |   |               |      |                |   |               |   |                |      |
| Net Sales                                               |   | $                  | 3,866,055 |                | $      | 4,082,684          |   | $                   | 3,767,767 |   | $ | 4,609,790 |   |
| Gross Margin                                            |   | 1,787,819          |      | 1,840,616           |   | 1,793,076          |   | 2,242,486           |      |
| Operating Income (Loss)                                 |   | (164,508           | )         | (187,589            | )      | (183,902           | )      | 316,598             |      |
| Net Income (Loss)                                       |   | (192,659           | )         | (234,437            | )      | (236,375           | )      | 261,756             |      |
| Net Income (Loss) per share, basic and  diluted         |   | $                  | (0.01     | )                   | $      | (0.01              | )      | $                   | (0.01     | ) | $ | 0.00 |   |
| Weighted average shares outstanding, basic  and diluted |   | 44,533,886         |      | 44,533,886          |   | 44,533,886         |   | 44,533,886          |      |

 
| **Fiscal year ended December 31, 2002**                 |   | **First  Quarter** |      | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |      |
|---------------------------------------------------------|--------|--------------------|-----------|---------------------|--------|--------------------|--------|---------------------|-----------|
|                                                    |   |               |      |                |   |               |   |                |      |
| Net Sales                                               |   | $                  | 3,373,016 |                | $      | 3,235,269          |   | $                   | 3,597,557 |   | $ | 4,210,509 |   |
| Gross Margin                                            |   | 1,487,903          |      | 1,261,076           |   | 1,579,849          |   | 1,929,916           |      |
| Operating Loss                                          |   | (645,415           | )         | (639,252            | )      | (459,414           | )      | (66,557             | )         |
| Net loss                                                |   | (665,811           | )         | (660,298            | )      | (480,558           | )      | (89,951             | )         |
| Net loss per share, basic and diluted                   |   | $                  | (0.02     | )                   | $      | (0.02              | )      | $                   | (0.01     | ) | $ | (0.00 | ) |
| Weighted average shares outstanding, basic  and diluted |   | 43,813,494         |      | 43,813,494          |   | 44,236,333         |   | 44,533,886          |      |

 

**12. SUBSEQUENT EVENT**

 

On March 29,2004, the Company completed the Ninth Amendment to Credit and SecurityAgreement between Naturade, Inc. and Wells Fargo Business Credit Inc. dated asof February 27, 2000.  This amendmentextended the term of the Credit and Security Agreement to December 31, 2005,reduced maximum borrowings to $3.5 million, and among other things, set thecovenants regarding minimum net income and minimum book net worth for 2004.

 

F-22

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