**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q**

 

| **(Mark One)**                                                                                                                                        |   |                                                                                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                            |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                  |
| **For the  quarterly period ended September 30, 2003**                                                                                                |
|                                                                                                                                                  |
| **or**                                                                                                                                                |
|                                                                                                                                                  |
| **o**                                                                                                                                                 |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**      |
|                                                                                                                                                  |
| **For the transition period from            to           ** |
|                                                                                                                                                  |
| **Commission File Number: 33-7106-A**                                                                                                                 |

 

**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 Rd., Irvine, California 92606**                  |
| (Address of principal executive offices) (Zip code)             |
|                                                            |
| **(714) 573-4800**                                         |
| (Registrant’s telephone number, including area code)       |

 

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Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes ý No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes o   No ý

 

Indicatethe number of shares outstanding of the registrant’s common stock, as of thelatest practicable date: 44,533,886 shares as of October 30, 2003.

 

 

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**FORM 10-QQUARTERLY REPORT**

**Quarter Ended September 30, 2003TABLE OF CONTENTS**

 
| PART  I:   | FINANCIAL  INFORMATION                                                                                                                  |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.    | Financial  Statements                                                                                                                   |
|       | Balance Sheets as  of September 30, 2003 (unaudited) and December 31, 2002 (audited)                                                    |
|       | Statements  of Operations for the three and nine month periods ended September 30, 2003  (unaudited) and September 30, 2002 (unaudited) |
|       | Statements  of Cash Flows for the nine months ended September 30, 2003 (unaudited) and  September 30, 2002 (unaudited)                  |
|       | Notes to Financial  Statements                                                                                                          |
| Item  2.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                             |
| Item  3.   | Quantitative  and Qualitative Disclosures About Market Risk                                                                             |
| Item 4     | Controls and Procedures                                                                                                                 |
| PART II:   | OTHER INFORMATION                                                                                                                       |
| Item 1.    | Legal  Proceedings                                                                                                                      |
| Item  2.   | Changes  in Securities and Use of Proceeds                                                                                              |
| Item 3.    | Defaults Upon  Senior Securities                                                                                                        |
| Item  4.   | Submission  of Matters to a Vote of Security Holders                                                                                    |
| Item 5.    | Other  Information                                                                                                                      |
| Item 6.    | Exhibits and  Reports on Form 8-K                                                                                                       |
| SIGNATURES |

 

2

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**NATURADE, INC.**

 

**BalanceSheets**

**As of September 30, 2003 and December 31, 2002**

 
|                                                                                                                                                                                                                                                                                                                  |   | **September  30, 2003** |      | **December  31, 2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                                                                                                                                                                                                                                                                                                  |   | **(Unaudited)**         |      | **(Audited)**          |   |
| ASSETS                                                                                                                                                                                                                                                                                                                |   |                    |      |                   |   |
| Current assets:                                                                                                                                                                                                                                                                                                       |   |                    |      |                   |   |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                             |   | $                       | 186,030   |                   | $      | 722,583 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                                                              |   | 1,331,542               |      | 1,427,058              |   |
| Inventories, net                                                                                                                                                                                                                                                                                                      |   | 1,081,558               |      | 1,689,131              |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                             |   | 306,040                 |      | 105,135                |   |
| Total current assets                                                                                                                                                                                                                                                                                                  |   | 2,905,170               |      | 3,943,907              |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Property and  equipment, net                                                                                                                                                                                                                                                                                          |   | 175,738                 |      | 228,723                |   |
| Other assets                                                                                                                                                                                                                                                                                                          |   | 48,549                  |      | 49,594                 |   |
| Total assets                                                                                                                                                                                                                                                                                                          |   | $                       | 3,129,457 |                   | $      | 4,222,224 |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                                                                                                                                                                                                            |   |                    |      |                   |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Current liabilities:                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Accounts payable                                                                                                                                                                                                                                                                                                      |   | $                       | 2,135,529 |                   | $      | 2,750,477 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                                      |   | 799,041                 |      | 604,194                |   |
| Current portion of Note Payable to Related  Party                                                                                                                                                                                                                                                                     |   | 213,837                 |      | 202,345                |   |
| Current portion of long-term debt                                                                                                                                                                                                                                                                                     |   | 1,368,227               |      | 1,816,662              |   |
| Total current liabilities                                                                                                                                                                                                                                                                                             |   | 4,516,634               |      | 5,373,678              |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Long-term portion of Notes Payable to  Related Parties, less current maturities                                                                                                                                                                                                                                       |   | 450,000                 |      | 0                      |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Long-term debt, less current maturities                                                                                                                                                                                                                                                                               |   | 13,882                  |      | 37,735                 |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Total Liabilities                                                                                                                                                                                                                                                                                                     |   | 4,980,516               |      | 5,411,413              |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                                                                                                                         |   |                    |      |                   |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                                                                                                                                                                                                                                                |   |                    |      |                   |   |
| Redeemable convertible preferred stock,  Series B, less discount of $1,330,456 at September 30, 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 September 30, 2003 and December  31, 2002 ($2,000,000 redemption value) |   | 639,942                 |      | 256,112                |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| WARRANT                                                                                                                                                                                                                                                                                                               |   | 500,000                 |      | 500,000                |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| STOCKHOLDERS’ DEFICIT:                                                                                                                                                                                                                                                                                           |   |                    |      |                   |   |
| Common stock, par value $0.0001 per share;  authorized, 100,000,000 shares; issued and outstanding, 44,533,886 at  September 30, 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  June 30, 2003 and December 31, 2002                                                                                                                                                              |   | 0                       |      | 0                      |   |
| Non-Voting Common stock, par value $0.0001  per share; authorized, 2,000,000 shares; issued and outstanding, 117,284 at  September 30, 2003 and December 31, 2002                                                                                                                                                     |   | 12                      |      | 12                     |   |
|                                                                                                                                                                                                                                                                                                                  |   |                    |      |                   |   |
| Additional paid-in capital                                                                                                                                                                                                                                                                                            |   | 18,987,458              |      | 18,987,458             |   |
| Accumulated deficit                                                                                                                                                                                                                                                                                                   |   | (21,982,924             | )         | (20,937,224            | )      |
| Total stockholders’ deficit                                                                                                                                                                                                                                                                                      |   | (2,991,001              | )         | (1,945,301             | )      |
| Total liabilities and stockholders’ deficit                                                                                                                                                                                                                                                                      |   | $                       | 3,129,457 |                   | $      | 4,222,224 |   |

 

See accompanying notes to financial statements.

 

3

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**NATURADE, INC**

 

**Statementsof Operations for the Three Months and Nine Months**

**Ended September 30, 2003 and September 30, 2002**

 
|                                                                                       |   | **Three  Months  Ended  September 30, 2003** |      | **Three  Months  Ended  September 30, 2002** |   | **Nine  Months  Ended  September 30, 2003** |   | **Nine  Months  Ended  September 30, 2002** |       |
|--------------------------------------------------------------------------------------------|--------|----------------------------------------------|-----------|----------------------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|------------|
|                                                                                       |   | **(Unaudited)**                              |      | **(Unaudited)**                              |   | **(Unaudited)**                             |   | **(Unaudited)**                             |       |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Net sales                                                                                  |   | $                                            | 3,767,767 |                                         | $      | 3,597,557                                   |   | $                                           | 11,716,506 |   | $ | 10,205,842 |   |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Cost of sales                                                                              |   | 1,974,691                                    |      | 2,017,708                                    |   | 6,294,995                                   |   | 5,877,014                                   |       |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Gross profit                                                                               |   | 1,793,076                                    |      | 1,579,849                                    |   | 5,421,511                                   |   | 4,328,828                                   |       |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Costs and expenses:                                                                        |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Selling, general and administrative  expenses                                              |   | 1,958,255                                    |      | 2,018,420                                    |   | 5,900,736                                   |   | 6,006,981                                   |       |
| Depreciation and amortization                                                              |   | 18,723                                       |      | 20,843                                       |   | 56,774                                      |   | 65,928                                      |       |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Total operating costs and expenses                                                         |   | 1,976,978                                    |      | 2,039,263                                    |   | 5,957,510                                   |   | 6,072,909                                   |       |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Operating loss                                                                             |   | (183,902                                     | )         | (459,414                                     | )      | (535,999                                    | )      | (1,744,081                                  | )          |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Other expense:                                                                             |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Interest expense                                                                           |   | 53,365                                       |      | 24,894                                       |   | 132,282                                     |   | 87,469                                      |       |
| Other expense (income)                                                                     |   | (1,692                                       | )         | (4,550                                       | )      | (7,210                                      | )      | (25,683                                     | )          |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Loss before provision for income taxes                                                     |   | (235,575                                     | )         | (479,758                                     | )      | (661,071                                    | )      | (1,805,867                                  | )          |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Provision for income taxes                                                                 |   | 800                                          |      | 800                                          |   | 800                                         |   | 800                                         |       |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Net loss                                                                                   |   | (236,375                                     | )         | (480,558                                     | )      | (661,871                                    | )      | (1,806,667                                  | )          |
| Less:                                                                                      |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Preferred Stock Dividend                                                                   |   | (57,916                                      | )         | (52,445                                      | )      | (169,544                                    | )      | (152,445                                    | )          |
| Deemed Dividend                                                                            |   | (71,429                                      | )         | (71,429                                      | )      | (214,286                                    | )      | (214,287                                    | )          |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Net loss applicable to common shares                                                       |   | $                                            | (365,720  | )                                            | $      | (604,432                                    | )      | $                                           | (1,045,701 | ) | $ | (2,173,399 | ) |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Basic and Diluted Loss per share                                                           |   | $                                            | (0.01     | )                                            | $      | (0.01                                       | )      | $                                           | (0.02      | ) | $ | (0.05 | ) |
|                                                                                       |   |                                         |      |                                         |   |                                        |   |                                        |       |
| Weighted Average Number of Shares used in  Computation of Basic and Diluted Loss per Share |   | 44,533,886                                   |      | 44,236,233                                   |   | 44,533,886                                  |   | 43,824,158                                  |       |

 

See accompanying notes to financial statements

 

4

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**NATURADE, INC**

 

**Statementsof Cash Flows for the Nine Months**

**Ended September 30, 2003 and September 30, 2002**

 
|                                                                                           |   | **Nine  Months Ended  September 30, 2003** |     | **Nine  Months Ended  September 30, 2002** |   |
|------------------------------------------------------------------------------------------------|--------|--------------------------------------------|----------|--------------------------------------------|--------|
|                                                                                           |   | **(Unaudited)**                            |     | **(Unaudited)**                            |   |
| Cash flows from operating activities:                                                          |   |                                       |     |                                       |   |
| Net loss                                                                                       |   | $                                          | (661,871 | )                                          | $      | (1,806,667 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                   |   |                                       |     |                                       |   |
| Depreciation and amortization                                                                  |   | 56,774                                     |     | 65,928                                     |   |
| Provision for excess and obsolete  inventories                                                 |   | —                                     |     | 30,000                                     |   |
| Expense for stock options, warrants and  convertible debt                                      |   | —                                     |     | 28,332                                     |   |
| Changes in assets and liabilities:                                                             |   |                                       |     |                                       |   |
| Accounts receivable                                                                            |   | 95,516                                     |     | 1,224,353                                  |   |
| Inventories                                                                                    |   | 607,574                                    |     | 117,595                                    |   |
| Prepaid expenses and other current assets                                                      |   | (200,905                                   | )        | 174,070                                    |   |
| Other assets                                                                                   |   | 1,053                                      |     | (23,831                                    | )      |
| Accounts payable and accrued expenses                                                          |   | (420,101                                   | )        | (799,924                                   | )      |
| Net cash used in operating activities:                                                         |   | (521,960                                   | )        | (990,144                                   | )      |
|                                                                                           |   |                                       |     |                                       |   |
| Cash flows from investing activities:                                                          |   |                                       |     |                                       |   |
| Purchase of property and equipment                                                             |   | (3,797                                     | )        | (7,289                                     | )      |
| Net cash used in investing activities:                                                         |   | (3,797                                     | )        | (7,289                                     | )      |
|                                                                                           |   |                                       |     |                                       |   |
| Cash flows from financing activities:                                                          |   |                                       |     |                                       |   |
| Net borrowings under line of credit                                                            |   | (418,771                                   | )        | (532,195                                   | )      |
| Proceeds from issuance of debt to related  parties                                             |   | 450,000                                    |     | —                                     |   |
| Payments of long-term debt                                                                     |   | (42,025                                    | )        | (21,529                                    | )      |
| Proceeds from issuance of equity                                                               |   | —                                     |     | 2,312,898                                  |   |
| Net cash provided by (used in) financing  activities:                                          |   | (10,796                                    | )        | 1,759,174                                  |   |
|                                                                                           |   |                                       |     |                                       |   |
| Net increase (decrease) in cash and cash  equivalents                                          |   | (536,553                                   | )        | 761,741                                    |   |
| Cash and cash equivalents, beginning of  period                                                |   | 722,583                                    |     | 55,388                                     |   |
| Cash and cash equivalents, end of period                                                       |   | $                                          | 186,030  |                                       | $      | 817,129 |   |
|                                                                                           |   |                                       |     |                                       |   |
| **Supplemental  Disclosures of Cash Flow Information**                                         |   |                                       |     |                                       |   |
| **Cash paid during  the period for:**                                                          |   |                                       |     |                                       |   |
| Interest                                                                                       |   | $                                          | 133,836  |                                       | $      | 88,806 |   |
| Taxes                                                                                          |   | $                                          | 800      |                                       | $      | 800 |   |
|                                                                                           |   |                                       |     |                                       |   |
| **Non-cash financing activities:**                                                             |   |                                       |     |                                       |   |
| Conversion of notes payable to related  party to common stock                                  |   | $                                          | 0        |                                       | $      | 5,366,131 |   |
| Surrender of preferred stock for  cancellation without conversion in exchange for common stock |   | $                                          | 0        |                                       | $      | 125 |   |
| Discount related to redeemable convertible preferred  stock                                    |   | $                                          | 0        |                                       | $      | 2,000,000 |   |
| Private Equity Transaction                                                                     |   | $                                          | 0        |                                       | $      | 47,500 |   |
| Preferred stock dividend accrued                                                               |   | $                                          | 169,544  |                                       | $      | 152,445 |   |
| Deemed dividend                                                                                |   | $                                          | 214,286  |                                       | $      | 214,287 |   |

 

See accompanying notes to financial statements

 

5

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**NATURADE, INC.**

**Notes to Financial Statements**

 

1.             *Basis of Presentation**—*The accompanying unaudited financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States for interim financial information andwith the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand footnotes required by accounting principles generally accepted in theUnited States for complete financial statements. The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe amounts reported in the financial statements and accompanying notes. Actualresults could differ from those estimates.

 

Theresults of operations for the interim periods shown in this report are notnecessarily indicative of results to be expected for the fiscal year. In theopinion of management, the information contained herein includes alladjustments necessary for the fair presentation of the financial statements.All such adjustments are of a normal recurring nature. These financialstatements do not include all disclosures associated with the Company’s annualaudited financial statements included in the Company’s Annual Report onForm 10-K and accordingly, should be read in conjunction with suchstatements.

 

2.             *Inventories**—*Inventories are stated at the lower ofweighted average cost or market. Weighted average cost is determined on a first-in,first-out basis. Inventories at September 30, 2003 and December 31, 2002consisted of the following:

 
|                                              |   | **September 30, 2003** |      | **December 31, 2002** |   |
|---------------------------------------------------|--------|------------------------|-----------|-----------------------|--------|
|                                              |   | **(Unaudited)**        |      | **(Audited)**         |   |
|                                              |   |                   |      |                  |   |
| Raw Materials                                     |   | $                      | 175,186   |                  | $      | 224,033 |   |
| Finished Goods                                    |   | 962,455                |      | 1,537,199             |   |
| Subtotal                                          |   | 1,137,641              |      | 1,761,232             |   |
| Less: Reserve for Excess and Obsolete Inventories |   | (56,083                | )         | (72,101               | )      |
|                                              |   | $                      | 1,081,558 |                  | $      | 1,689,131 |   |

 

3.             *Leases**—*The Company rents property and equipment undercertain noncancellable operating leases expiring in various years through 2006.Future minimum commitments under operating leases as of September 30, 2003 areas follows:

 
| **Year**                |   | **Amount** |      |
|-------------------------|--------|------------|-----------|
|                    |   |       |      |
| 2003 (October-December) |   | $          | 113,440   |   |
| 2004                    |   | 414,305    |      |
| 2005                    |   | 427,624    |      |
| 2006                    |   | 283,056    |      |
| Total                   |   | $          | 1,238,425 |   |

 

4.*            **Credit Agreement withMajority 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 7, 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.

 

6

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5.     *Loan Agreements withMajority Shareholder and Other Investors—*In August 2000, the Company entered into a Loan Agreement (the“Investor Notes”) with Health Holdings and other investors (the “LenderGroup”). The Investor 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.

 

TheLoan Agreement further provided that the Lender Group could elect to convertall or any part of the Loan Advances into shares of the Company’s Common Stockat a conversion price equal to the lower of (a) the average closing bid ofthe Company’s Common Stock for the ten trading days prior to the making of aLoan Advance or (b) the average closing bid of the Company’s common stockfor 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.

 

OnAugust 21, 2003, the terms of the remaining outstanding Investor Notes totaling$202,345 were modified to include increasing the interest rate to 15% per annumpaid in quarterly increments and setting a principal repayment schedule 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, 2004 and a finalpayment of $92,345 on August 15, 2004. As of September 30, 2003, there is $182,345 outstanding on the InvestorNotes.

 

OnApril 14, 2003, the Company entered into a loan agreement (the “LoanAgreement”) with Health Holdings and certain other lenders (the “LenderGroup”), pursuant to which the Lender Group has agreed to lend the Company$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 theCompany, and are subordinated to the Company’s indebtedness to Wells FargoBusiness Credit, Inc. (“Wells Fargo”). The advances under the Loan Agreement will be used by the Company forworking 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 September 30, 2003 there is $450,000outstanding under the Loan Agreement.

 

6.*            **Line of Credit—* On January 27, 2000, the Company entered intoa three year Credit and Security Agreement (the “Credit Agreement”) with WellsFargo Business Credit, Inc. (“Wells Fargo”), which initially allowed formaximum borrowings of up to $3,000,000, based on certain percentages ofeligible accounts receivable and inventories as defined. As more fullydescribed in Note 7, *Private EquityTransaction*, on December 20, 2001, the terms of the Credit Agreementwere modified to include waiving the enforcement of existing defaults as ofDecember 20, 2001, increasing the credit available to the Company to a maximumof $4,500,000 with an inventory maximum subline of $2,000,000, increasing thefloating rate to the prime rate plus 2% and extending the maturity date toDecember 31, 2003. On September 19, 2002, the terms of the Credit Agreementwere modified to include waiving the enforcement of existing defaults, reducingthe credit availability of the Company to a maximum of $4,325,000, requiringthat the Company maintain certain minimum levels of cash, and reducing thecovenants regarding minimum net income and minimum book net worth.  In consideration of the extension of creditunder the Loan Agreement on April 14, 2003, Wells Fargo waived all defaults ofthe Company as of December 31, 2002 under the Credit Agreement dated as ofFebruary 27, 2000 and amended the agreement to, among other things, reduce thecovenants regarding minimum net income and minimum book net worth and increasedthe interest rate to the prime rate plus 4.5%. Borrowings under the CreditAgreement, which totaled $1,368,227 at September 30, 2003, are collateralizedby substantially all assets of the Company. At September 30, 2003 the primerate was 4.0% and the interest charge under the Credit and Security Agreementwas 8.50%. The Credit Agreement contains covenants, which, among other things,require that certain financial ratios be met. As of September 30, 2003, theCompany was in compliance with all covenants.

 

7

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7.*            **Private Equity Transaction—* On January 2, 2002, the Company privatelysold 13,540,723 shares of Series B Convertible Preferred Stock (the “Shares”)for $2 million, and warrants to purchase an additional 33,641,548 shares ofSeries B Convertible Preferred Stock at an aggregate exercise price of $3.5million (the “Warrants”), for $500,000. The Shares and Warrants were purchasedby Westgate Equity Partners, L.P. (“Westgate”). The Series B ConvertiblePreferred Stock bears dividends at a rate of 10% per annum, which willaccumulate and compound semi-annually if not paid in cash. The Series BConvertible Preferred Stock may be converted into Common Stock at any time atthe option of the holder.  On theseventh anniversary of its issuance, any unconverted shares of Series BConvertible Preferred Stock will be automatically redeemed by the Company atthe original issuance price plus accrued and unpaid dividends, provided theCompany is legally able to do so. Two members of the Board of Directors of theCompany are elected exclusively by the holders of the Series B ConvertiblePreferred Stock voting as a separate class.

 

TheCompany may redeem the Series B Convertible Preferred Stock at any time priorto December 31, 2004 if the Company receives a bona fide offer from a thirdparty to invest equity capital in the Company and the holders of theSeries B Convertible Preferred Stock do not make a QualifiedCounter-Offer.  A “QualifiedCounter-Offer” is a written offer for an equity investment in the Company thatwill yield gross proceeds in excess of the third party’s offer (but need notexceed $3,500,000), and which either (A) is accomplished through the exerciseof some or all of the Warrants, or (B) will provide capital on the same orbetter terms as the third party offer. The Series B Convertible Preferred Stock had a beneficial conversionfeature of $2,000,000, which was recorded as a discount and is being amortizedover seven years.

 

Aspart of this transaction, Health Holdings agreed to convert all of theCompany’s outstanding debt to Health Holdings, including accrued interest(approximately $5,316,000), and to surrender all of Health Holdings’ Series AConvertible Preferred Stock (1,250,024 shares) for cancellation withoutconversion, in exchange for 35,989,855 shares of the Company’s Common Stock.Furthermore, the warrants that Health Holdings holds to purchase up to 600,000shares of Common Stock have been modified to be exercisable for Non-VotingCommon Stock at an exercise price of $1 per share.

 

Aspart of this transaction, the Company entered into a Management ServicesAgreement under which certain principals of Westgate or its affiliates willprovide management and consulting services to the Company and amended andextended the employment agreement with the Company’s CEO. Also, on December 20,2001 as part of this transaction and effective on its completion, Wells Fargoagreed to modify the terms of its Credit and Security Agreement with theCompany, to include waiving the enforcement of existing defaults, increasingcredit available to the Company to a maximum of $4,500,000, increasing thefloating rate to the prime rate plus 2% and extending the maturity date toDecember 31, 2003, as more fully described under Note 6, *Line of Credit*.

 

Underthe terms of the Private Equity Transaction, if Westgate exercises the warrantsin full, Westgate would hold a total of 47,182,271 shares of Series BConvertible Preferred Stock which would be convertible into the same number ofshares of Common Stock, subject to adjustment for anti-dilution, or 55% of theCompany’s Common Stock on a fully diluted basis as of September 30, 2003.

 

Afterthe completion 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 Companyin an amount of $252,345 (the “Convertible Notes”) were convertible into sharesof the Common Stock of the Company at the market price of the Common Stock onthe date of conversion.  ConvertibleNotes in the amount of $50,000 have been converted into 720,392 shares ofCommon Stock to date, and $182,345 in Convertible Notes remain outstanding andwere convertible into 6,078,167 shares as of September 30, 2003.

 

TheCompany and Westgate agreed to resolve this dispute by adjusting the conversionformula for the Series B Convertible Preferred Stock.  In addition, Westgate and Health Holdings agreed that (i) theCompany may grant additional options to purchase up to 1,250,000 shares ofCommon Stock to employees in accordance with the Naturade, Inc. 1998 IncentiveStock Option Plan, and (ii) Health Holdings would grant to Westgate a proxy tovote 1.041 shares of Common Stock owned by Health Holdings for each share ofCommon Stock issued on exercise of the new options.

 

8

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Thenet proceeds of the transactions have been used by the Company for workingcapital and general corporate purposes.

 

*8.**   **Stock-Based Compensation*

 

*Employee Stock Option Plan****–***In February 1998, the Company adopted anIncentive Stock Option Plan (the “Plan”) to enable participating employees toacquire shares of the Company’s Common Stock. The Plan provided for thegranting of incentive stock options up to an aggregate of 850,000 shares, asamended. In October 2001, the Company amended the Plan by increasing to2,000,000 the number of shares of the Company’s Common Stock that may besubject to awards granted pursuant to the Plan. The actual number 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-year period from thedate of grant. The Company has granted 1,619,500 incentive options under thePlan at the weighted average exercise price per share of $0.14 as of September30, 2003. These options expire seven years from the date of grant.

 

*Director Stock Options***–**In October 1999,87,500 options were issued to each of two then new board members at an exerciseprice of $1.03.

 

*Warrants***–**On January 2, 2002, the Company sold warrantsto purchase 33,641,548 shares of Series B Convertible Preferred Stock. Theaggregate purchase price of the warrants was $500,000 and the aggregateexercise price is $3.5 million. This transaction is described more fully inNote 7, *Private Equity Transaction.*

 

In1999, the Company granted 600,000 warrants in conjunction with certainfinancing agreements. These warrants expire ten years from the date of grant.As part of the Private Equity Transaction described in Note 7, the holders ofthe warrants agreed they would be exercisable for Non-Voting Common Stock.

 

Asummary of the Company’s outstanding stock options and warrants activity is asfollows:

 
|                              |   | **Number of  Shares** |   | **Weighted  Average  Exercise  Price per  Share** |   | **Number  Exercisable** |       | **Weighted  Average  Exercise  price** |   |
|-----------------------------------|--------|-----------------------|--------|---------------------------------------------------|--------|-------------------------|------------|----------------------------------------|--------|
| Outstanding at December 31, 2002  |   | 34,473,548            |   | $                                                 | 0.12   |                    | 34,321,423 |                                   | $      | 0.11 |   |
| Granted                           |   | 1,025,000             |   | $                                                 | .025   |                    |       |                                   |   |   |
| Exercised                         |   | 0                     |   |                                              |   |                    |       |                                   |   |
| Expired                           |   | (150,000              | )      | $                                                 | 1.32   |                    |       |                                   |   |   |
| Outstanding at September 30, 2003 |   | 35,348,548            |   | $                                                 | 0.11   |                    | 34,224,048 |                                   | $      | 0.11 |   |

 

9

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Thefollowing table summarizes information about stock options and warrantsoutstanding at September 30, 2003

 
| **Range of  Exercise Prices** |   | **Options and  Warrants  Outstanding** |   | **Weighted  Average  Remaining  Contract Life  In Years** |   | **Weighted  Average  Exercise  Price** |   | **Options and  Warrants  Exercisable** |       | **Average  Exercise Price  for Exercisable  Options and  Warrants** |   |
|-------------------------------|--------|----------------------------------------|--------|-----------------------------------------------------------|--------|----------------------------------------|--------|----------------------------------------|------------|---------------------------------------------------------------------|--------|
| $ 0.104                       |   | 33,641,548                             |   | 2                                                         |   | $                                      | 0.10   |                                   | 33,641,548 |                                                                | $      | 0.10 |   |
| $.025                         |   | 1,025,000                              |   | 7                                                         |   | $                                      | .025   |                                   | 0          |                                                                | $      | 0 |   |
| $ 0.15-.875                   |   | 559,500                                |   | 3                                                         |   | $                                      | 0.30   |                                   | 467,250    |                                                                | $      | 0.29 |   |
| $ 1.03 -1.13                  |   | 122,500                                |   | 2                                                         |   | $                                      | 1.04   |                                   | 115,250    |                                                                | $      | 1.04 |   |
|                          |   | 33,348,548                             |   | 2                                                         |   | $                                      | 0.11   |                                   | 34,224,048 |                                                                | $      | 0.11 |   |

 

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:

 
|                                                                                                                                                |   | **Three  Months Ended** |     | **Nine Months  Ended**  |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------|-------------------------|--------|
|                                                                                                                                                |   | **September  30, 2003** |     | **September  30, 2002** |   | **September  30, 2003** |   | **September  30, 2002** |   |
|                                                                                                                                                |   |                    |     |                    |   |   |   |   |   |
| Net loss: As reported                                                                                                                               |   | $                       | (365,720 | )                       | $      | (604,432 | ) | $ | (1,045,701 | ) | $ | (2,173,399 | ) |
|                                                                                                                                                |   |                    |     |                    |   |   |   |   |   |
| Add:   Stock-based employee compensation expense included in reported net  loss, net of related tax effects                                    |   | 0                       |     | 0                       |   | 0 |   | 0 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based method for all awards, net of related tax effects |   | (2,855                  | )        | (83,428                 | )      | (5,221 | ) | (250,284 | ) |
|                                                                                                                                                |   |                    |     |                    |   |   |   |   |   |
| Pro forma                                                                                                                                           |   | $                       | (368,575 | )                       | $      | (687,860 | ) | $ | (1,050,922 | ) | $ | (2,423,683 | ) |
|                                                                                                                                                |   |                    |     |                    |   |   |   |   |   |
| Basic and Diluted                                                                                                                                   |   |                    |     |                    |   |   |   |   |   |
| Net loss per share: As reported                                                                                                                     |   | $                       | (0.01    | )                       | $      | (0.01 | ) | $ | (0.02 | ) | $ | (0.05 | ) |
| Pro forma                                                                                                                                           |   | $                       | (0.01    | )                       | $      | (0.02 | ) | $ | (0.02 | ) | $ | (0.06 | ) |

 

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9.             *Segment Reporting -* Operating segments are defined as componentsof an enterprise about which separate financial information is available thatis evaluated regularly by the Company’s chief decision-maker, or decision-makinggroup, in deciding how to allocate resources and in assessing performance.

 

TheCompany’s reportable operating segments include health food specialty storesand mass market stores. The Company does not allocate operating expenses tothese segments, nor does it allocate specific assets to these segments.Therefore, segment information reported includes only sales, cost of sales andgross profit.

 

Operatingsegment data for the three and nine months ended September 30, 2003 andSeptember 30, 2002 was as follows:

 
|                                  |   | **Distribution Channels** |      |            |   |
|---------------------------------------|--------|---------------------------|-----------|-----------------|--------|
|                                  |   | **Health Food**           |      | **Mass Market** |   | **Total** |   |
|                                  |   |                      |      |            |   |   |   |
| Three months ended September 30, 2003 |   |                      |      |            |   |   |   |
| Sales                                 |   | $                         | 1,840,219 |            | $      | 1,927,548 |   | $ | 3,767,767 |   |
| Cost of Sales                         |   | 956,618                   |      | 1,018,073       |   | 1,974,691 |   |
| Gross Profit                          |   | $                         | 883,601   |            | $      | 909,475 |   | $ | 1,793,076 |   |
|                                  |   |                      |      |            |   |   |   |
| Three months ended September 30, 2002 |   |                      |      |            |   |   |   |
| Sales                                 |   | $                         | 1,755,143 |            | $      | 1,842,414 |   | $ | 3,597,557 |   |
| Cost of Sales                         |   | 949,885                   |      | 1,067,823       |   | 2,017,708 |   |
| Gross Profit                          |   | $                         | 805,258   |            | $      | 774,591 |   | $ | 1,579,849 |   |
|                                  |   |                      |      |            |   |   |   |
| Nine months ended September 30, 2003  |   |                      |      |            |   |   |   |
| Sales                                 |   | $                         | 5,791,730 |            | $      | 5,924,776 |   | $ | 11,716,506 |   |
| Cost of Sales                         |   | 3,089,174                 |      | 3,205,821       |   | 6,294,995 |   |
| Gross Profit                          |   | $                         | 2,702,556 |            | $      | 2,718,955 |   | $ | 5,421,511 |   |
|                                  |   |                      |      |            |   |   |   |
| Nine months ended September 30, 2002  |   |                      |      |            |   |   |   |
| Sales                                 |   | $                         | 5,475,292 |            | $      | 4,730,550 |   | $ | 10,205,842 |   |
| Cost of Sales                         |   | 3,009,195                 |      | 2,867,819       |   | 5,877,014 |   |
| Gross Profit                          |   | $                         | 2,466,097 |            | $      | 1,862,731 |   | $ | 4,328,828 |   |

 

Salesare attributed to geographic areas based on the location of the entity to whichthe products were sold. Geographic segment data for the three and nine monthsended September 30, 2003 and September 30, 2002 was as follows:

 
|                                  |   | **United States** |       | **International** |   | **Total** |   |
|---------------------------------------|--------|-------------------|------------|-------------------|--------|-----------|--------|
|                                  |   |              |       |              |   |      |   |
| Three months ended September 30, 2003 |   |              |       |              |   |      |   |
| Sales                                 |   | $                 | 3,747,834  |              | $      | 19,933    |   | $ | 3,767,767 |   |
| Cost of Sales                         |   | 1,964,030         |       | 10,661            |   | 1,974,691 |   |
| Gross Profit                          |   | $                 | 1,783,804  |              | $      | 9,272     |   | $ | 1,793,076 |   |
|                                  |   |              |       |              |   |      |   |
| Three months ended September 30, 2002 |   |              |       |              |   |      |   |
| Sales                                 |   | $                 | 3,513,700  |              | $      | 83,857    |   | $ | 3,597,557 |   |
| Cost of Sales                         |   | 1,962,645         |       | 55,063            |   | 2,017,708 |   |
| Gross Profit                          |   | $                 | 1,551,055  |              | $      | 28,794    |   | $ | 1,579,849 |   |
|                                  |   |              |       |              |   |      |   |
| Nine months ended September 30, 2003  |   |              |       |              |   |      |   |
| Sales                                 |   | $                 | 11,537,530 |              | $      | 178,976   |   | $ | 11,716,506 |   |
| Cost of Sales                         |   | 6,183,575         |       | 111,420           |   | 6,294,995 |   |
| Gross Profit                          |   | $                 | 5,353,955  |              | $      | 67,556    |   | $ | 5,421,511 |   |
|                                  |   |              |       |              |   |      |   |
| Nine months ended September 30, 2002  |   |              |       |              |   |      |   |
| Sales                                 |   | $                 | 10,016,031 |              | $      | 189,811   |   | $ | 10,205,842 |   |
| Cost of Sales                         |   | 5,753,767         |       | 123,247           |   | 5,877,014 |   |
| Gross Profit                          |   | $                 | 4,262,264  |              | $      | 66,564    |   | $ | 4,328,828 |   |

 

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Duringthe three and nine months ended September 30, 2003 and 2002, the Company hadsales to customers whose purchases exceed 10% of the Company’s total net salesas shown in the table below.

 

**Major Customer Table**

 
|                                  |   | **Customer One** |      | **Customer Two** |   | **Customer Three** |   |
|---------------------------------------|--------|------------------|-----------|------------------|--------|--------------------|--------|
|                                  |   | **Sales**        |      | **% of Sales**   |   | **Sales**          |   | **% of Sales** |   | **Sales** |   | **% of Sales** |   |
| Three Months ended September 30, 2003 |   | $                | 1,021,000 |             | 27.1   |               | $      | 637,100 |   | 16.9 |   | $ | 469,000 |   | 12.4 |   |
| Three Months ended September 30, 2002 |   | $                | 614,800   |             | 17.1   |               | $      | 554,800 |   | 15.4 |   | $ | 566,400 |   | 15.7 |   |
| Nine months ended September 30, 2003  |   | $                | 2,051,800 |             | 17.5   |               | $      | 2,036,100 |   | 17.4 |   | $ | 1,868,000 |   | 15.9 |   |
| Nine months ended September 30, 2002  |   | $                | 1,836,200 |             | 18.0   |               | $      | 1,713,500 |   | 16.8 |   | $ | 1,725,100 |   | 16.9 |   |

 

10.           *Guarantees-*In November 2002, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation Number (“FIN”) 45 *“Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, including Indirect Guarantees of Indebtedness of Others-aninterpretation of FASB Statements No. 5,57 and 107 and rescission of FIN34.” *The following is asummary of the Company’s agreements that the Company has determined are withinthe scope of FIN 45.

 

Underits bylaws, the Company has agreed to indemnify its officers and directors forcertain events or occurrences arising as a result of an officer’s or director’sserving in such capacity.  The term ofthe indemnification period is the officer’s or director’s lifetime.  The maximum potential amount of futurepayments the Company could be required to make under these indemnificationagreements is unlimited.  However, theCompany has a directors’ and officers’ liability insurance policy that limitsits exposure and enables it to recover a portion of any future amountspaid.  As a result of its insurancepolicy coverage, the Company believes the estimated fair value of theseindemnification agreements is minimal and has no liability recorded for theseagreements as of September 30, 2003.

 

TheCompany enters into indemnification provisions under (i) its agreements withother companies in its ordinary course of business, typically businesspartners, contractors, customers and landlords and (ii) its agreements withinvestors.  Under these provisions theCompany generally agrees to indemnify and hold harmless the indemnified partyfor losses suffered or incurred by the indemnified party as a result of theCompany’s activities or, in some cases, as a result of the indemnified party’sactivities under the agreement.  Theseindemnification provisions often include indemnifications relating torepresentations made by the Company with regard to intellectual propertyrights.  These indemnificationprovisions generally survive the termination of the underlying agreement.  In addition, in some cases, the Company hasagreed to reimburse employees for certain expenses and to provide salarycontinuation during short-term disability. The maximum potential amount of future payments the Company could berequired to make under these indemnification provisions is unlimited.  The Company has not incurred material coststo defend lawsuits or settle claims related to these indemnificationprovisions.  As a result, the Companybelieves the estimated fair value of these provisions is minimal.  Accordingly, the Company has no liabilitiesrecorded for these agreements as of September 30, 2003.

 

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**ITEM 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*This discussion contains “forward-looking statements”within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, asamended. Although the Company believes that the expectations reflected in suchforward-looking statements are reasonable, such statements are inherentlysubject to risk and the Company can give no assurances that such expectationswill prove to be correct. Such forward-looking statements involve risks and uncertainties,and actual results could differ from those described herein. Future results maybe subject to numerous factors, many of which are beyond the control of theCompany. Such risk factors include, without limitation, the risks set forthbelow under “Risk Factors.” The Company undertakes no obligation to publiclyrelease the result of any revisions to these forward-looking statements thatmay be made to reflect events or circumstances after the date hereof or toreflect the occurrence of unexpected events.*

 

Allcomparisons below are for the three and nine month periods ended September 30,2003 compared to the three and nine month periods ended September 30, 2002.

 

*General*

 

TheCompany is a branded natural products marketing company focused on high growth,innovative products designed to nourish the health and well being of consumers.The Company concentrates on the rapidly expanding soy food market, whichreached sales of almost $2.5 billion in 2002 and is expected to grow 15% to 20%per year reaching $5 to $6 billion by 2005, according to Soyatech marketresearch dated February 2001. The Company has purposely avoided thevitamin category, where growth has been flat, as well as the herbal category,which has experienced 15% to 25% declines per year since the late nineties. TheCompany’s products include Naturade Total Soy, a full line of nutritionallycomplete meal replacements available in several flavors of powders,ready-to-drink products and bars, Naturade Low Carb protein boosters, Aloe Vera80 health and beauty care products and other niche dietary supplements. TheCompany’s products are sold in over 10,000 supermarkets and drug stores (e.g.,Kroger, Fred Meyer, Safeway and Albertson’s, Longs Drug and Sav On Drug), massmerchants (e.g., Wal*Mart and Kmart), club stores (e.g., Sam’s Clubs andCostco), natural food supermarkets (e.g., Whole Foods and Wild Oats) and over5,000 independent health food stores.

 

*Critical Accounting Policies and Use of Estimates*

 

Inpreparing its financial statements, the Company is required to make estimatesand judgments that affect the results of its operations and the reported valueof assets and liabilities. Actual results may differ from these estimates. TheCompany believes that the following summarizes the critical accounting policiesthat require significant judgments and estimates in the preparation of itsfinancial statements.

 

***Revenue Recognition*****.** Sales are recognized upon shipment andpassage of title. The Company accrues for estimated returns at the time of sale.  The Company accounts for certain promotionalallowances such as consumer coupons and rebates and customer slotting fees as areduction of sales and new store opening costs are recorded as cost of goodssold in the period incurred in accordance with Emerging Issues Task Force(“EITF”) issue No. 01-09.  InDecember 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.

 

***Inventory Valuation*****.** 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. The Company regularlyreviews aged and excess inventories to determine if the carrying value of suchinventories exceeds market value, and records a reserve to reduce the carryingvalue to market value if necessary.

 

***Accounts Receivable Valuation*****.** Accounts receivable is stated net ofapplicable reserves for returns and allowances, bill backs and doubtfulaccounts. The Company regularly reviews accounts receivable to determine if thereserve amounts are appropriate by considering historical customer buyingpatterns, invoice aging, specific promotions and seasonal factors.

 

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*Results of Operations*

 

*Net Sales.*

 

Totalnet sales for three months ended September 30, 2003 increased $170,210, or4.7%, to $3,767,767 from $3,597,557 for the same period in 2002.  Total net sales for the nine month periodended September 30, 2003 increased $1,510,664, or 14.8%, to $11,716,506 from$10,205,842 for the same period in 2002. The increase in net sales wasprimarily due to new distribution and promotional support in the health foodchannel combined with improved economic conditions during both the quarter andnine months ended September 30, 2003. In addition, the Company’s initiative of penetrating the mass market hasproven successful through increasing turn sales.

 

*Mass Market Net Sales.*  Forthe three months ended September 30, 2003, mass market net sales increased$85,134, or 4.6%, to $1,927,548 from $1,842,414 for the three months endedSeptember 30, 2002.  Mass market netsales for the nine months ended September 30, 2003 increased $1,194,226, or25.2%, to $5,924,776 from $4,730,550 for the nine months ended September 30,2002. The growth in both the quarter and the nine months ended September 30,2003 is primarily due to increased turn business through key accountpenetration coupled with new distribution into a major domestic club storechain for distribution in Mexico and Canada.

 

*Health Food Net Sales.*  Forthe three months ended September 30, 2003, health food channel net salesincreased $85,076, or 4.8%, to $1,840,219 from $1,755,143 for the three monthsended September 30, 2002.  Health foodsales for the nine months ended September 30, 2003 increased $316,438, or 5.8%,to $5,791,730 from $5,475,292 for the nine months ended September 30,2002.  This increase in revenue for boththe quarter and nine months ended September 30, 2003 was a result of newdistribution within the key customer base, increased turn business resultingfrom improved promotional support and the overall strengthening of the healthchannel compared to 2002.

 

*Channels of Distribution** *On a percent ofnet sales basis, the breakdown of sales between the mass market and health foodchannels was 48.8% for the health food channel and 51.2% for the mass marketchannel for each of the three month periods ended September 30, 2003 and2002.  The breakdown for the nine-monthperiod ended September 30, 2003 was 49.4% for the health food channel and 50.6%for the mass market channel compared to 53.6% in the health food channel and46.4% in the mass market channel for the same periods in 2002.  Management believes its strategy to increasemass market penetration and overall promotional support has directly caused theshift in the nine month channel revenue distribution.

 

Forthe three months ended September 30, 2003, domestic net sales increased$234,134, or 6.7%, to $3,747,834 from $3,513,700 for the three months endedSeptember 30, 2002.  Domestic net salesfor the nine months ended September 30, 2003 increased $1,521,499, or 15.2%, to$11,537,530 from $10,016,031 for the same period in 2002.  Increases in domestic net sales areprimarily due to the previously mentioned increase in penetration and supportcombined with new distribution.  For thethree months ended September 30, 2003, international sales decreased $63,924,or 76.2%, to $19,933 from $83,857, and for the nine months ended September 30,2003, international net sales decreased $10,836, or 5.7%, to $178,975 from$189,811.  The decrease in internationalsales during the third quarter 2003 was due to pipeline fill during the thirdquarter of 2002 as the Company reentered the Canadian market.

 

*Gross Profit*

 

Grossprofit as a percentage of net sales for the three months ended September 30,2003 increased 3.7% to 47.6% of net sales, from 43.9% for the three monthsended September 30, 2002. Gross profit as a percentage of net sales for thenine months ended September 30, 2003 increased 3.9% to 46.3% from 42.4% for thenine months ended September 30, 2002. The increase for both the quarter andnine months ended September 30, 2003 was due to lower product cost related tothe increased sales mix of the reformulated Naturade Total Soy® product formulacoupled with continued efforts to reduce product and packaging costs.

 

*Selling, General and Administrative Expenses*

 

Selling,general and administrative expenses (“S, G &A”) for the three monthsended September 30, 2003 decreased $60,165 to $1,958,255 or 52.0% of net salesfrom $2,018,420 or 56.1% of net sales for the three months ended September 30,2002. This decrease is primarily due to increased management controls overspending with an emphasis on matching brand expenses with profitable salesopportunities.  As a percentage ofsales, S,G & A expenses decreased 4.1% primarily due to a $145,600 decreasein brand expenses related to management’s strategy to control promotionexpenses offset by volume related increases in freight and commissions of$25,100 and $35,400 respectively.   As apercent of sales, brand expenses were 13.0% and 17.5%, respectively, for thethree months ended September 30, 2003 and 2002. The decrease in brand expenses,as a percent of net sales, is primarily due to the Company’s strategy to controloverall costs and match brand expenses with profitable sales opportunities.

 

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S,G&A for the nine months ended September 30, 2003 decreased $106,245 to$5,900,736 or 50.4% of net sales from $6,006,981 or 58.9% of net sales for thenine months ended September 30, 2002. This decrease is primarily due to a$138,400 decrease in brand expenses and a decrease of  $105,900 in overhead expenses, principally from manpower andconsulting fee reductions partially offset by increases related to freight andcommission expense of  $65,800 and$72,200, respectively, resulting from increased sales volume.  Brand expenses for the period were 13.6% ofnet sales down 3.2% from 16.8% for the same period in 2002. The decrease inbrand expenses, as a percent of net sales, is primarily due to the Company’sstrategy to control overall costs and match brand expenses with proven salesopportunities.

 

*Interest Expense*

 

Interestexpense for the three months ended September 30, 2003 increased $28,471compared to the three months ended September 30, 2002 due to borrowings on theLoan Agreement with related parties, more fully explained in Note 5, partiallyoffset by lower borrowing levels combined with lower base cost of money on theCompany’s credit facility.  Interestexpense for the nine months ended September 30, 2003 increased $44,813 comparedto the nine months ended September 30, 2002 due to borrowings on the LoanAgreement with a majority shareholder, more fully explained in Note 5,partially offset by lower borrowing levels combined with lower base cost ofmoney on the Company’s credit facility.

 

*Liquidity and Capital Resources*

 

TheCompany used cash of $521,960 from operating activities in the nine monthsended September 30, 2003, compared to a use of cash of $990,144 in operatingactivities for the nine months ended September 30, 2002. This decrease in cashused from operating activities is primarily due to the reduction in theCompany’s operating loss of $1,144,796 combined with a reduction in inventoriesof $489,979 partially offset by a volume related increase in receivables of$1,128,873 compared to the same period in 2002.

 

Netcash provided by inventories was $607,574 for the nine months ended September30, 2003 compared to net cash provided by inventories of $117,595 for the ninemonths ended September 30, 2002 primarily due to lower December sales in 2002and higher inventories at the end of the period resulting in an increase incash provided when inventories were reduced to normal levels.

 

Netcash provided by accounts receivable was $95,516 for the nine month periodended September 30, 2003 compared to net cash provided from accounts receivableof $1,224,353 for the same period of 2002, principally due to increased salesvolume in 2003 compared to the same period in 2002.  Customer terms have remained constant however, there is a slightincrease in days sales outstanding due to increased volume in the mass marketchannel which generally pays more slowly than the Health channel.

 

Netcash used in accounts payable and accrued expenses was $420,101 for the ninemonth period ended September 30, 2003 compared to net cash used of $799,924 thesame period of 2002, principally due a higher level of accrued insurancerelated to premium increases for director’s and officer’s insurance and workerscompensation insurance.

 

Theprovision for excess and obsolete inventory used $0 in cash for the nine monthperiod ended September 30, 2003 compared to $30,000 the same period of 2002,principally due to the disposal of excess product lines in 2002 and theimplementation of an inventory management system in 2003 decreasing excessinventory levels.

 

Netcash used by prepaid expenses was $200,905 for the nine month period endedSeptember 30, 2003 compared to net cash provided in the same period of 2002 of$174,070, principally due to increased prepaid insurance costs related todirectors’ and officers’ insurance premiums.

 

TheCompany’s working capital decreased $181,693 from ($1,429,771) at December 31,2002 to ($1,611,464) at September 30, 2003. This decrease was largely due to adecrease in inventory as a result of a concentrated inventory reduction programpartially offset by a decrease in accounts payable and borrowings on the Company’scredit facility.

 

Cashused in investment activities during the nine months ended September 30, 2003was $3,797 compared to $7,289 for the nine months ended September 30, 2002.

 

TheCompany’s cash used in financing activities was $10,796 for the nine months endedSeptember 30, 2003, compared to cash provided by financing activities of$1,759,174 for the same period of 2002. The September 30, 2003 amount was theresult of the Loan Agreement (described in Note 5) partially offset by net paydowns on the Company’s line of credit. The September 30, 2002 amount was the result of the $2.5 millionfrom the Private Equity Transaction, conversion into equity of the HealthHoldings debt, and a decrease in borrowings under the Credit Agreement. SeeNotes 4, 5 and 7.

 

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Asof September 30, 2003, the Company was in compliance with all of the covenantsof the Credit and Security Agreement with Wells Fargo.

 

Theaccompanying financial statements have been prepared on a going-concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. At September 30, 2003, theCompany has an accumulated deficit of $21,982,924, a net working capitaldeficit of $1,611,465 and a stockholders’ capital deficiency of $2,991,001, andhas incurred recurring net losses. These factors, among others, raisesubstantial doubt about the Company’s ability to continue as a going concern.The financial statements do not include any adjustments that might result fromthe outcome of this uncertainty. The Company’s independent auditors qualifiedtheir opinion on the Company’s December 31, 2002 financial statements byincluding an explanatory paragraph in which they expressed substantial doubt aboutthe Company’s ability to continue as a going concern

 

TheCompany believes that its existing cash balances and financing arrangementswill provide it with sufficient funds to finance its operations during the nexttwelve months, provided that Wells Fargo does not exercise its right toterminate, or demand immediate payment of all amounts outstanding under theCredit Agreement. However, the Company may seek to raise additional fundsthrough the sale of public or private equity and/or debt financings or fromother sources. No assurance can be given that additional financing will beavailable in the future or that, if available, such financing will beobtainable on terms acceptable to the Company or its stockholders.

 

***Impact ofContractual Obligations and Commercial Commitments***

 

Thefollowing summarizes the Company’s contractual obligations at September 30,2003 and the effects such obligations are expected to have on liquidity andcash flow in future periods.

 
| **Contractual**                                 |   | **Payments Due by Period** |      |
|-------------------------------------------------|--------|----------------------------|-----------|
| **Obligations**                                 |   | **Total**                  |      | **Less than 1 Year** |   | **1-3 Years** |   | **4-5 Years** |   | **After 5 Years** |   |
|                                            |   |                       |      |   |   |   |   |   |   |   |   |
| Long-Term Debt                                  |   | $                          | 2,045,946 |   | $ | 1,395,866 |   | $ | 650,080 |   | $ | 0 |   | $ | 0 |   |
| Capital Lease Obligations                       |   | $                          | 0         |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| Operating Leases                                |   | $                          | 1,238,425 |   | $ | 113,440 |   | $ | 1,124,985 |   | $ | 0 |   | $ | 0 |   |
| Unconditional Purchase Obligations              |   | $                          | 0         |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| Other Long-Term Obligations                     |   | $                          | 0         |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| Total Contractual Cash Obligations              |   | $                          | 3,284,371 |   | $ | 1,509,306 |   | $ | 1,775,065 |   | $ | 0 |   | $ | 0 |   |
| Series B Convertible Redeemable Preferred Stock |   | $                          | 2,000,000 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 2,000,000 |   |
| Total                                           |   | $                          | 5,284,371 |   | $ | 1,509,306 |   | $ | 1,775,065 |   | $ | 0 |   | $ | 2,000,000 |   |

 

*Recently Issued Statements of Financial Accounting Standards*

 

InMay 2003, the Financial Accounting Standards Board (“FASB”) issued Statement ofFinancial Accounting Standards No. 150, *Accountingfor Certain Instruments with Characteristics of Both Liabilities and Equity (*“FAS150”*),*which establishesstandards for classifying and measuring certain financial instruments withcharacteristics of both liabilities and equity.  FAS 150 requires an issuer to classify a financial instrumentthat is within its scope, which may have previously been reported as equity, asa liability (or an asset in some circumstances).  This statement is effective at the beginning of the first interimperiod beginning after June 15, 2003 for public companies.  The Company adopted this Statement as of July1, 2003 and it had no material impact on its financial statements.

 

InJanuary 2003, the FASB issued FASB Interpretation No. 46, *Consolidation of Variable Interest Entities,*an interpretation of Accounting Research Bulletins (“ARB”) No. 51, *Consolidated Financial Statements* (“FIN46”).  FIN 46 clarifies the applicationof ARB No. 51 to certain entities in which equity investors do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties.  The Company does not believe the adoption of FIN 46 will have amaterial impact on its financial position and results of operations.

 

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InDecember 2002, the FASB issued Statement of Financial Accounting Standards No.148, *Accounting for Stock-Based Compensation— Transition and Disclosure* (“FAS 148”), which amends Statement ofFinancial 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 theinterim disclosures required by FAS 148 beginning in the first quarter of 2003.

 

InNovember 2002, 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.

 

InJune 2002, the FASB issued FAS No. 146, *Accountingfor Costs Associated with Exit or Disposal Activities*, whichaddresses 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.

 

InMay 2002, the FASB issued FAS 145, *Rescissionof FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, andTechnical Corrections.* FAS 145 eliminates Statement 4 (and Statement64, as it amends Statement 4), which requires gains and losses fromextinguishments of debt to be aggregated and, if material, classified as anextraordinary item, and thus, also the exception to applying Opinion 30 iseliminated as well. This statement is effective for years beginning after May,2002 for the provisions related to the rescission of Statements 4 and 64, andfor all transactions entered into beginning May, 2002 for the provision relatedto the amendment of Statement 13.  Theadoption of SFAS 145 did not have a material impact on the Company’s operationsand financial position.

 

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*Risk Factors*

 

Theshort and long-term success of the Company is subject to certain risks, many ofwhich are substantial in nature. Stockholders and prospective stockholders inthe Company should consider carefully the following risk factors, in additionto other information contained herein. This Form 10-Q 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 and ability to continueas a going concern***

 

Naturade’sindependent accountants have qualified their opinion on the Company’s December31, 2002 financial statements, expressing substantial doubt concerning theCompany’s ability to continue as a going concern. At September 30, 2003, theCompany had an accumulated deficit of $21,982,924, net working capital deficitof $1,611,464 and a stockholders’ capital deficiency of $2,991,001. The Companyanticipates that it will incur net losses for the foreseeable future and willneed access to additional financing for working capital and to expand itsbusiness. Moreover, as of December 31, 2002, the Company was in default ofthe minimum book net worth and minimum net income covenants in the Credit andSecurity Agreement with its principal lender and only recently received awritten waiver of such default. Without a waiver of any future defaults thatmay occur, or a modification of the Credit and Security Agreement, the lendercould terminate the agreement and demand immediate payment of the full amountof indebtedness. Management has taken a number of steps to address thissituation, including the Private Equity Transaction completed onJanuary 2, 2002, the Loan Agreement entered into on April 14, 2003 underwhich the Company can borrow, subject to certain conditions, $450,000 and canborrow up to an additional $300,000 at the discretion of the lenders andefforts to decrease operating losses by expanding sales and reducing costs.Nevertheless, the Company expects to incur operating losses for some time inthe future and cannot give assurance that additional financing will beavailable when needed or that it will obtain needed waivers or modifications ofthe Credit and Security Agreement. If unsuccessful in those efforts, Naturadecould be forced to cease operations and investors in Naturade’s Common Stockcould lose their entire investment.

 

***Dependence on current and ongoingfinancing***

 

TheCompany’s success is dependent on its current financing as well as newfinancing to support its working capital requirements and fund its operatinglosses. Starting in 2000, the Company embarked on a strategy to rollout theNaturade Total Soy® product line to the mass market, which requires a highlevel of marketing expenditures. Although the Company obtained$2.5 million as part of the Private Equity Transaction on January 2,2002, and entered into the Loan Agreement as of April 14, 2003 under which theCompany can borrow $450,000 and can borrow up to an additional $300,000 at thediscretion of the lenders, the Company may not have adequate financialresources to fund this strategy. Further, no assurance can be given that theCompany will have access to additional funds or, if funds can be obtained, thatthe terms on which they can be obtained will be satisfactory. In such event,the Company’s business and results of operations, and its ability to continueas a going concern, will be materially adversely affected.

 

***Future Sales of Equity SecuritiesCould Dilute the Company’s Common Stock***

 

TheCompany may seek to obtain new financing from various sources, including thesale of its securities. Future sales of Common Stock or securities convertibleinto Common Stock at or below recent market prices could result in dilution ofthe Common Stock. In addition, the conversion of the 13.5 million sharesof Series B Convertible Preferred Stock originally sold to Westgate EquityPartners, L.P. (“Westgate”), for $2 million, together with conversion ofthe 35,989,555 shares of Series B Convertible Preferred Stock issuable onexercise of warrants held by Westgate, which have an exercise price ofapproximately $0.104 per share (and, including the original cost of thewarrant, a total consideration of approximately $0.119 per share), has resultedin dilution of the Common Stock. The perceived risk of dilution may cause someof the Company’s stockholders to sell their shares, which could further reducethe market price of the Common Stock.

 

***Dependence on continued business fromthe Company’s key customers***

 

TheCompany’s three largest customers together account for 50.8% of sales revenuefor the nine month period ended September 30, 2003. One mass market customer,Wal*Mart and Sam’s Club, represented approximately 17.5 % of Naturade’s totalsales, and two health food distributors accounted for 33.3% of total sales forthe nine month period ended September 30, 2003. The loss of such customerscould have a material adverse effect on the Company’s results of operations.From time to time, major customers of Naturade have experienced financialdifficulties. Naturade 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 Naturade to the same extent it has in the past,or at all.

 

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***Impact of government regulation***

 

TheCompany’s operations, properties and products are subject to regulation byvarious foreign, federal, state and local government entities and agencies,including the FDA and FTC. Among other matters, such regulation is concernedwith statements and claims made in connection with the packaging, labeling,marketing and advertising of the Company’s products. The governmental agencieshave 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, seekinginjunctive relief or product seizure, imposing civil penalties and commencingcriminal prosecution.

 

Asa result of the Company’s efforts to comply with changes in applicable statutesand regulations, 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 that theCompany considers favorable, such as DSHEA, or more stringent interpretationsof current laws or regulations. The Company cannot predict the nature of futurelaws, regulations, interpretations or applications, nor can the Company predictwhat effect additional governmental regulations or administrative orders, whenand if promulgated, would have on the Company’s business in the future. Suchfuture laws and regulations could, however, require the reformulation ofproducts to meet new standards, the recall or discontinuance of products thatcannot be reformulated, the imposition of additional record keepingrequirements, expanded documentation of product efficacy, expanded or modified labelingand scientific substantiation, including health warnings or restrictions onbenefits described for our products. Any of or all of such requirements couldhurt sales of our products or increase our costs, resulting in material harm tothe Company’s results of operations and financial condition.

 

***Dependence on third-partymanufacturers***

 

Theuse of contract manufacturers and the resulting loss of direct control overproduction could result in the Company’s failure to receive timely delivery ofproducts of acceptable quality. Although the Company believes that alternativesources of contract manufacturing services are available, the loss of one ormore contract manufacturers could have a material adverse effect on theCompany’s results of operations until an alternative source is located and hascommenced producing the Company’s products.

 

Althoughthe Company requires that its contract manufacturers comply with FDAmanufacturing guidelines, Naturade cannot assure that these third-partycompanies will always act in accordance to these regulations. If themanufacturing facilities used by the Company’s third-party manufacturers didnot meet those standards, the production of the Company’s products could bedelayed until the necessary modifications are made to comply with thosestandards or alternate manufacturers are located. Furthermore, the potentialexists for circumstances to arise which would require Naturade to seek outalternate manufacturers who operate in compliance with the FDA’s requirements.

 

***Naturade may not be able to identifysuitable strategic partners to realize the Company’s growth strategy.***

 

Inaddition to internal expansion of its existing business, Naturade has astrategy to expand its business externally by identifying compatible companiesfor strategic alliances and strategic investments in Naturade. Naturade may notsucceed in identifying these potential strategic partners or may be unable toconclude agreements with them. If so, Naturade’s future growth may be limited,and it may be unable to achieve profitability.

 

***Competition***

 

Themarket for nutraceutical products is highly competitive. Many of the Company’scompetitors have substantially greater capital resources, research anddevelopment capabilities, and manufacturing and marketing resources,capabilities and experience than the Company. The Company’s competitors maysucceed in developing products that are more effective or less costly than anyproducts that may be developed by the Company.

 

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***Dependence on qualified personnel***

 

TheCompany’s success is dependent upon its ability to attract and retain qualifiedsales, marketing, scientific and executive management personnel. Tocommercialize its products and product candidates, the Company must maintainand expand its personnel, particularly in the areas of product sales andmarketing. The Company faces intense competition for such personnel from othercompanies, academic institutions, government entities and other researchorganizations. There can be no assurance that the Company will be successful inhiring or retaining qualified personnel. Moreover, managing the integration ofsuch new personnel could pose significant risks to the Company’s developmentand progress and increase its operating expenses.

 

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

 

Naturade,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 new costs and risks forNaturade.  Mass market sales requiregreater expenditures for branding.  Massmarket brand expenses were 14.4% of net sales as compared to health food brandexpenses of 8.9% of net sales for the nine months ended September 30,2003.  Compared to sales in the healthfood market, the aggregate volume of mass market orders can vary significantlyfrom period to period and tends to be more sensitive to short term or localvariations in market conditions. The instability can make planning difficultand can cause unexpected reductions in sales, or in orders that exceedNaturade’s short-term capacity, in either case resulting in lost revenue.Failure to manage the costs and risks associated with the mass market couldcause material adverse harm to Naturade’s business.

 

***Closely controlled stock***

 

AtSeptember 30, 2003, Westgate Equity Partners, L.P. beneficially ownedapproximately 55.0% of the Company’s Common Stock, Health Holdings beneficiallyowned 40.6% of the Company’s Common Stock, and executive officers and directorsof the Company as a group beneficially owned 97.5 % of the Company’s CommonStock. Shares “beneficially owned” include shares that a person owns or has aright to acquire 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.

 

***Technological changes***

 

TheCompany currently is engaged in developing nutraceuticals, which arecharacterized by extensive and costly research efforts and rapid technologicalprogress and change. New process developments are expected to continue at arapid pace in both industry and academia. The Company’s future success willdepend on its ability to develop and commercialize its existing productcandidates and to develop new products. There can be no assurance that theCompany will successfully complete the development of any of its existingproduct candidates or that any of its future products will be commerciallyviable or achieve market acceptance. In addition, research and development anddiscoveries by others could render some or all of the Company’s programs orpotential product candidates uncompetitive or obsolete.

 

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

 

Naturade’sbusiness depends on the free flow of products and services through the channelsof commerce. Recently, in response to terrorist activities and threats aimed atthe U.S., transportation, mail, financial and other services have been slowedor stopped altogether. Further delays or stoppages in transportation, mail,financial or other services could have a material adverse effect on theCompany’s business, results of operations and financial condition. Furthermore,the Company may experience an increase in operating costs, such as costs fortransportation, insurance and security, as a result of the terrorist activitiesand potential activities. The Company may also experience delays in receivingpayments from payers that have been affected by terrorist activities andpotential activities. The U.S. economy in general is being adversely affectedby the terrorist activities and potential activities and any economic downturncould adversely impact the Company’s results of operations, impair its abilityto raise capital or otherwise adversely affect its ability to grow itsbusiness.

 

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***Variability of quarterly results***

 

TheCompany has experienced, and expects to continue to experience, variations inits net sales and operating results from quarter to quarter. The Companybelieves that the factors that influence this variability of quarterly resultsinclude the timing of the Company’s introduction of new product lines, thelevel of consumer acceptance of each product line, general economic andindustry conditions 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’sresults of operations from period to period is not necessarily meaningful, andthe Company’s results of operations for any period are not necessarilyindicative of future performance.

 

***Product liability exposure***

 

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 dietary supplement industry as awhole is experiencing a decline in sales.***

 

Naturade’sbusiness consists primarily of selling natural products and functional foods,including soy protein based products. While Naturade’s sales decreased in 2002,the soy foods category as a whole has recently experienced increased sales.Other categories of dietary supplements have experienced reduced sales inrecent periods after several years of dramatic growth. In particular, revenuesin both the herbal and health food store categories have significantlydeclined. There can be no assurance that this general consumer trend will notbe experienced by Naturade’s product categories as well. Even if Naturade issuccessful in increasing sales within its market category, a decline in theoverall market for natural products or functional foods could have a materialadverse affect on Naturade’s business.

 

***Effect of adverse publicity***

 

TheCompany’s products are formulated with vitamins, minerals, herbs and otheringredients that the Company regards as safe when taken as suggested by theCompany and that scientific studies have suggested may involve health benefits.While the Company conducts extensive quality control testing on its products,the Company generally does not conduct or sponsor clinical studies relating tothe benefits of its products. The Company is highly dependent upon consumers’perception of the overall integrity of its business, as well as the safety andquality of its products and similar products distributed by other companieswhich may not adhere to the same quality standards as the Company. The Companycould be adversely affected if any of the Company’s products, or any similarproducts distributed by other companies, should prove or be asserted to beharmful to consumers or should scientific studies provide unfavorable findingsregarding the effectiveness of such products. The Company’s ability to attractand retain distributors could be adversely affected by negative publicityrelating to it or to other direct sales organizations or by the announcement byany governmental agency of investigatory proceedings regarding the businesspractices of the Company or other direct sales organizations.

 

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***Intellectual property protection***

 

TheCompany’s success depends in part on its ability to preserve its trade secretsand know-how, and operate without infringing on the property rights of thirdparties. The Company does not have any patents, and as a result another companycould replicate one or more of Naturade’s products. The Company’s policy is topursue registrations for all of the trademarks associated with its keyproducts. The Company relies on common law trademark rights to protect itsunregistered trademarks as well as its trade dress rights. Common law trademarkrights generally are limited to the geographic area in which the trademark isactually used, while a U.S. federal registration of a trademark enables theregistrant to stop the unauthorized use of the trademark by any third partyanywhere in the U. S. The Company intends to register its trademarks in certainforeign jurisdictions where the Company’s products are sold. However, theprotection available, if any, in such jurisdictions may not be as extensive asthe protection available to the Company in the U.S.

 

Currently,the Company has 18 U.S. trademarks as well as a California registration of onetrademark. 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 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. Ifthe Company takes action to enforce its property rights, litigation may benecessary. Any such litigation could be very costly and could distract theCompany’s personnel. Due to limited financial resources, Naturade may be unableto pursue some litigation matters. In matters it does pursue, Naturade canprovide no assurance of a favorable outcome. An unfavorable outcome in anyproceeding could have a material adverse effect on the Company’s business,financial condition and results of operations.

 

***Introduction of new products***

 

Eachyear, the Company 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 Companyexperiences significant costs in formulating new products, designing packagingand merchandising. While the Company conducts extensive market research todetermine consumer trends in both the mass market and health food market, therecan be no assurance that the Company’s new products will be accepted byconsumers and retailers. In addition, there can be no assurance that once newproducts are initially distributed to mass market and health food retailers,there will be repeat orders for these new products. Furthermore, expensiveintroductory retailer charges for additional shelf space may negate any initialincrease in sales.

 

***Stock price***

 

Themarket price of the Company’s Common Stock is likely to be volatile and couldbe subject 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 financial estimates,changes in market valuations of competitors, announcements by the Company orits competitors of a material nature, loss of one or more customers, additionsor departures of key personnel, future sales of Common Stock and stock marketprice and volume fluctuations. Also, general political and economic conditionssuch as recession, or interest rate or currency rate fluctuations may adverselyaffect the market price of the Company’s Common Stock.

 

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**ITEM 3. Quantitative and Qualitative Disclosures About MarketRisk**

 

The Company’s earnings are affected by fluctuations in the value of theU.S. dollar as compared to foreign currencies as a result of internationalpurchases. As a result, the Company bears the risk of exchange rate gains orlosses that may result in the future as a result of this financing structure.The Company’s exposure to market risk for changes in interest rates relatesprimarily to the Company’s long-term debt.

 

TheCompany’s long-term debt primarily consists of a $4.5 million line ofcredit originally entered into on January 27, 2000 and amended on April14, 2003, a $450,000 Loan Agreement with a majority shareholder and otherinvestors and $182,345 in Investor Notes, after giving affect to the HealthHoldings debt-to equity conversion on January 2, 2002 as part of thePrivate Equity Transaction as described more fully in Note 7 to theFinancial Statements. The $4 million Loan Agreement with the majorityshareholder of the Company was converted into equity on January 2, 2002 aspart of the Private Equity Transaction. The line of credit bears interest atprime rate plus 4.5%. The Loan Agreement with a majority shareholder and otherinvestors bears interest at 15% per annum and is due on December 31, 2004.  The Investor Notes bear interest at 15% perannum with due dates of September 15, 2003 and October 15, 2003 for $20,000each, installments of $10,000 each on January 15, 2004 thru July 15, 2004 andthe remaining balance on August 15, 2004. However, given the fixed interestrate on the Loan Agreement, interest rate changes generally will have no effecton the interest rates under the Loan Agreement or on the Company’s results ofoperations. Given the variable interest rate on the line of credit, the impactof interest rate changes on the line of credit could have a material impact onthe Company’s results of operations. For the nine month period ended September30, 2003 the interest expense on the line of credit was $84,061. If the interestrate on the line of credit for the nine month period ended September 30, 2003had increased by one percent to prime rate plus 5.5%, this would result in aninterest expense of $93,951.

 

**ITEM 4.Controls and Procedures**

 

TheCompany’s Chief Executive Officer, Bill D. Stewart and Chief Financial OfficerStephen M. Kasprisin, with the participation of the Company’s management,carried out an evaluation of the effectiveness of the Company’s disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-14.  Based upon that evaluation, the ChiefExecutive Officer and the Chief Financial Officer believe that, as of the endof the period covered by this report, the Company’s disclosure controls andprocedures are effective in making known to them material information relatingto the Company (including its consolidated subsidiaries) required to beincluded in this report.

 

Disclosurecontrols and procedures, no matter how well designed and implemented, canprovide only reasonable assurance of achieving an entity’s disclosureobjectives.  The likelihood of achievingsuch objectives is affected by limitations inherent in disclosure controls andprocedures.  These include the fact thathuman judgment in decision-making can be faulty and that breakdowns in internalcontrol can occur because of human failures such a simple errors or mistakes orintentional circumvention of the established process.

 

Therewas no change in the Company’s internal control over financial reporting, knownto the Chief Executive Officer or the Chief Financial Officer that occurredduring the period covered by the report that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART II.Other Information**

 

**ITEM 1.Legal Proceedings**

 

NONE

 

**ITEM 2.Changes in Securities and Use of Proceeds**

 

NONE

 

**ITEM 3.Defaults upon Senior Securities**

 

NONE.

 

**ITEM 4.Submission of Matters to a Vote of Security Holders**

 

NONE

 

**ITEM 5. OtherInformation**

 

NONE

 

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**ITEM 6.Exhibits**

 
| **Exhibit No.** |   | **Description**                                                                                                                                      |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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                                        |

 

**ITEM 12. Reports on Form 8-K**

 

None

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                    |   | NATURADE, INC.      |
|-------------------------|--------|--------------------------|
|                    |   | (Registrant)             |
|                    |   |                     |
|                    | By     |                     |
| DATE:  October 31, 2003 |   | /s/  Bill D. Stewart     |   |
|                    |   | Bill  D. Stewart         |
|                    |   | Chief  Executive Officer |
|                    |   |                     |
|                    | By     |                     |
| DATE:  October 31, 2003 |   | /s/Stephen  M. Kasprisin |   |
|                    |   | Stephen  M. Kasprisin    |
|                    |   | Chief  Financial Officer |
|                         |        |                          |  |  |

 

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