**UNITED STATESSECURITIES 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 June 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) |
|                                                           |                                                                 |        |                                        |        |

 

----

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d)of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past90 days. Yes ýNo o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o   No ý

 

Indicate the number of shares outstanding ofthe registrant’s common stock, as of the latest practicable date: 44,533,886shares as of August 13, 2003.

 

 

----

 

**FORM 10-QQUARTERLY REPORT**

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

 
| PART I:    | FINANCIAL  INFORMATION                                                                                                       |
|------------|------------------------------------------------------------------------------------------------------------------------------|
| Item 1.    | Financial  Statements                                                                                                        |
|       | Balance  Sheets as of June 30, 2003 (unaudited) and December 31, 2002 (audited)                                              |
|       | Statements of Operations for the three and  six month periods ended June 30, 2003 (unaudited) and June 30, 2002  (unaudited) |
|       | Statements of Cash Flows for the six months  ended June 30, 2003 (unaudited) and June 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                                                                                                        |
| 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

----

 

**NATURADE, INC.**

 

**BalanceSheets**

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

 
|                                                                                                                                                                                                                                                                                                        |   | **June 30,  2003** |      | **December  31, 2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|-----------|------------------------|--------|
|                                                                                                                                                                                                                                                                                                        |   | **(Unaudited)**    |      | **(Audited)**          |   |
| ASSETS                                                                                                                                                                                                                                                                                                      |   |               |      |                   |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Current assets:                                                                                                                                                                                                                                                                                             |   |               |      |                   |   |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                   |   | $                  | 383,335   |                   | $      | 722,583 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                                                    |   | 1,601,655          |      | 1,427,058              |   |
| Inventories, net                                                                                                                                                                                                                                                                                            |   | 1,189,011          |      | 1,689,131              |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                   |   | 325,784            |      | 105,135                |   |
| Total current assets                                                                                                                                                                                                                                                                                        |   | 3,499,785          |      | 3,943,907              |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Property and equipment, net                                                                                                                                                                                                                                                                                 |   | 190,672            |      | 228,723                |   |
| Other assets                                                                                                                                                                                                                                                                                                |   | 57,549             |      | 49,594                 |   |
| Total assets                                                                                                                                                                                                                                                                                                |   | $                  | 3,748,006 |                   | $      | 4,222,224 |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| LIABILITIES  AND STOCKHOLDERS’ DEFICIT                                                                                                                                                                                                                                                                 |   |               |      |                   |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Current liabilities:                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Accounts payable                                                                                                                                                                                                                                                                                            |   | $                  | 2,406,733 |                   | $      | 2,750,477 |   |
| Accrued expenses                                                                                                                                                                                                                                                                                            |   | 753,235            |      | 604,194                |   |
| Current portion of Note Payable to Related  Party                                                                                                                                                                                                                                                           |   | 202,345            |      | 202,345                |   |
| Current portion of long-term debt                                                                                                                                                                                                                                                                           |   | 1,529,186          |      | 1,816,662              |   |
| Total current liabilities                                                                                                                                                                                                                                                                                   |   | 4,891,499          |      | 5,373,678              |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Long-term portion of Notes Payable to  Related Parties, less current maturities                                                                                                                                                                                                                             |   | 450,000            |      | 0                      |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Long-term debt, less current maturities                                                                                                                                                                                                                                                                     |   | 21,992             |      | 37,735                 |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                                                                                                               |   |               |      |                   |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| REDEEMABLE CONVERTIBLE PREFERRED STOCK                                                                                                                                                                                                                                                                      |   |               |      |                   |   |
| Redeemable convertible preferred stock,  Series B, less discount of $1,571,429 at June 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 June 30, 2003 and December 31, 2002  ($2,000,000 redemption value) |   | 510,597            |      | 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 June  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  June 30, 2003 and December 31, 2002                                                                                                                                                |   | 12                 |      | 12                     |   |
|                                                                                                                                                                                                                                                                                                        |   |               |      |                   |   |
| Additional paid-in capital                                                                                                                                                                                                                                                                                  |   | 18,987,458         |      | 18,987,458             |   |
| Accumulated deficit                                                                                                                                                                                                                                                                                         |   | (21,618,005        | )         | (20,937,224            | )      |
| Total stockholders’ deficit                                                                                                                                                                                                                                                                            |   | (2,626,082         | )         | (1,945,301             | )      |
| Total liabilities and stockholders’ deficit                                                                                                                                                                                                                                                            |   | $                  | 3,748,006 |                   | $      | 4,222,224 |   |

 

See accompanying notes to financial statements.

 

3

----

 

**NATURADE, INC**

 

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

**Ended June 30, 2003 and June 30, 2002**

 

 
|                                                                                       |   | **Three  Months  Ended** |      | **Three  Months  Ended** |      | **Six Months  Ended** |      | **Six Months  Ended** |      |
|--------------------------------------------------------------------------------------------|--------|--------------------------|-----------|--------------------------|-----------|-----------------------|-----------|-----------------------|-----------|
|                                                                                       |   | **June 30,  2003**       |      | **June 30, 2002**        |      | **June 30,  2003**    |      | **June 30,  2002**    |      |
|                                                                                       |   | **(Unaudited)**          |      | **(Unaudited)**          |      | **(Unaudited)**       |      | **(Unaudited)**       |      |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Net sales                                                                                  |   | $                        | 4,082,684 |                     | $         | 3,235,269             |      | $                     | 7,948,739 |   | $ | 6,608,285 |   |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Cost of sales                                                                              |   | 2,242,068                |      | 1,974,193                |      | 4,320,304             |      | 3,859,306             |      |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Gross profit                                                                               |   | 1,840,616                |      | 1,261,076                |      | 3,628,435             |      | 2,748,979             |      |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Costs and expenses:                                                                        |   |                     |      |                     |      |                  |      |                  |      |
| Selling, general and  administrative expenses                                         |   | $                        | 2,009,352 |                     | 1,878,506 |                  | 3,942,481 |                  | 3,988,561 |   |
| Depreciation and amortization                                                              |   | 18,853                   |      | 21,822                   |      | 38,051                |      | 45,085                |      |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Total operating costs and expenses                                                         |   | 2,028,205                |      | 1,900,328                |      | 3,980,532             |      | 4,033,646             |      |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Operating loss                                                                             |   | (187,589                 | )         | (639,252                 | )         | (352,097              | )         | (1,284,667            | )         |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Other expense:                                                                             |   |                     |      |                     |      |                  |      |                  |      |
| Interest expense                                                                           |   | $                        | 48,622    |                     | 30,783    |                  | 78,917    |                  | 62,575    |   |
| Other expense (income)                                                                     |   | (2,574                   | )         | (9,737                   | )         | (5,518                | )         | (21,133               | )         |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Loss before provision for income taxes                                                     |   | (233,637                 | )         | (660,298                 | )         | (425,496              | )         | (1,326,109            | )         |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Provision for income taxes                                                                 |   | 800                      |      | —                   |      | 800                   |      | —                |      |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Net loss                                                                                   |   | $                        | (234,437  | )                        | $         | (660,298              | )         | $                     | (426,296  | ) | $ | (1,326,109 | ) |
| Less:                                                                                      |   |                     |      |                     |      |                  |      |                  |      |
| Preferred Stock Dividend                                                                   |   | (56,504                  | )         | (50,000                  | )         | (111,628              | )         | (100,000              | )         |
| Deemed Dividend                                                                            |   | (71,428                  | )         | (71,429                  | )         | (142,857              | )         | (142,858              | )         |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Net loss applicable to common shares                                                       |   | $                        | (362,369  | )                        | $         | (781,727              | )         | $                     | (680,781  | ) | $ | (1,568,967 | ) |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Basic and Diluted Loss per share                                                           |   | $                        | (0.01     | )                        | $         | (0.02                 | )         | $                     | (0.02     | ) | $ | (0.04 | ) |
|                                                                                       |   |                     |      |                     |      |                  |      |                  |      |
| Weighted Average Number of Shares used in  Computation of Basic and Diluted Loss per Share |   | 44,533,886               |      | 43,813,494               |      | 44,533,886            |      | 43,614,655            |      |

 

See accompanying notes to financial statements

 

4

----

 

**NATURADE, INC**

 

**Statementsof Cash Flows for the Six Months**

**Ended June 30, 2003 and June 30, 2002**

 
|                                                                                           |   | **Six Months  Ended** |     | **Six Months  Ended** |   |
|------------------------------------------------------------------------------------------------|--------|-----------------------|----------|-----------------------|--------|
|                                                                                           |   | **June 30,  2003**    |     | **June 30,  2002**    |   |
| Cash flows from operating activities:                                                          |   |                  |     |                  |   |
| Net loss                                                                                       |   | $                     | (426,296 | )                     | $      | (1,326,109 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:                   |   |                  |     |                  |   |
| Depreciation and amortization                                                                  |   | 38,051                |     | 45,085                |   |
| Provision for uncollectable accounts  receivable                                               |   | (116,894              | )        | (171,735              | )      |
| Provision for excess and obsolete  inventories                                                 |   | (16,018               | )        | (273,796              | )      |
| Expense for stock options, warrants and  convertible debt                                      |   | —                |     | 18,888                |   |
| Changes in assets and liabilities:                                                             |   |                  |     |                  |   |
| Accounts receivable                                                                            |   | (57,704               | )        | 1,312,000             |   |
| Inventories                                                                                    |   | 516,138               |     | 179,807               |   |
| Prepaid expenses and other current assets                                                      |   | (220,649              | )        | 254,570               |   |
| Other assets                                                                                   |   | (7,955                | )        | (24,342               | )      |
| Accounts payable and accrued expenses                                                          |   | (194,702              | )        | (715,927              | )      |
| Net cash used in operating activities:                                                         |   | (486,029              | )        | (701,559              | )      |
|                                                                                           |   |                  |     |                  |   |
| Cash flows from investing activities:                                                          |   |                  |     |                  |   |
| Purchase of property and equipment                                                             |   | —                |     | (1,450                | )      |
| Net cash used in investing activities:                                                         |   | —                |     | (1,450                | )      |
|                                                                                           |   |                  |     |                  |   |
| Cash flows from financing activities:                                                          |   |                  |     |                  |   |
| Net borrowings under line of credit                                                            |   | (288,683              | )        | (518,760              | )      |
| Proceeds from issuance of debt to related  parties                                             |   | 450,000               |     | —                |   |
| Payments of long-term debt                                                                     |   | (14,536               | )        | (16,841               | )      |
| Proceeds from issuance of equity                                                               |   | —                |     | 2,312,898             |   |
| Net cash provided by financing activities:                                                     |   | 146,781               |     | 1,777,297             |   |
|                                                                                           |   |                  |     |                  |   |
| Net increase (decrease) in cash and cash  equivalents                                          |   | (339,248              | )        | 1,074,288             |   |
| Cash and cash equivalents, beginning of  period                                                |   | 722,583               |     | 55,388                |   |
| Cash and cash equivalents, end of period                                                       |   | $                     | 383,335  |                  | $      | 1,129,676 |   |
|                                                                                           |   |                  |     |                  |   |
|                                                                                           |   |                  |     |                  |   |
| **Supplemental Disclosures of Cash Flow  Information**                                         |   |                  |     |                  |   |
| **Cash paid during the period for:**                                                           |   |                  |     |                  |   |   |   |
| Interest                                                                                       |   | $                     | 64,854   |                  | $      | 62,727 |   |
| Taxes                                                                                          |   | $                     | 800      |                  | $      | 800 |   |
|                                                                                           |   |                  |     |                  |   |
| **Non-cash financing activities:**                                                             |   |                  |     |                  |   |
| Conversion of notes payable to related  party to common stock                                  |   | $                     | 0        |                  | $      | 5,315,702 |   |
| 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 |   |
| Equity Transaction                                                                             |   | $                     | 0        |                  | $      | 47,500 |   |
| Preferred stock dividend accrued                                                               |   | $                     | 111,628  |                  | $      | 100,000 |   |
| Deemed dividend                                                                                |   | $                     | 142,857  |                  | $      | 142,858 |   |
|                                                                                                |        |                       |          |                       |        |  |  |  |  |

 

See accompanying notes to financial statements

 

5

----

 

**NATURADE, INC.**

**Notesto Financial Statements**

 

1.                                       Theaccompanying unaudited financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all ofthe information and footnotes required by accounting principles generallyaccepted in the United States for complete financial statements. Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

 

The results ofoperations for the interim periods shown in this report are not necessarilyindicative of results to be expected for the fiscal year. In the opinion ofmanagement, the information contained herein includes all adjustments necessaryfor fair presentation of the financial statements. All such adjustments are ofa normal recurring nature. These financial statements do not include alldisclosures associated with the Company’s annual financial statements onForm 10-K and accordingly, should be read in conjunction with suchstatements.

 

2.                                       Inventoriesare stated at the lower of weighted average cost or market. Weighted averagecost is determined on a first-in, first-out basis. Inventories at June 30, 2003and December 31, 2002 consisted of the following:

 
|                                               |   | **June 30, 2003** |      | **December 31, 2002** |   |
|----------------------------------------------------|--------|-------------------|-----------|-----------------------|--------|
|                                               |   | **(Unaudited)**   |      | **(Audited)**         |   |
|                                               |   |              |      |                  |   |
| Raw Materials                                      |   | $                 | 164,325   |                  | $      | 224,033 |   |
| Finished Goods                                     |   | 1,080,769         |      | 1,537,199             |   |
| Subtotal                                           |   | 1,245,094         |      | 1,761,232             |   |
| Less: Reserve for Excess and Obsolete  Inventories |   | (56,083           | )         | (72,101               | )      |
|                                               |   | $                 | 1,189,011 |                  | $      | 1,689,131 |   |

 

3.                                       TheCompany rents property and equipment under certain noncancellable operatingleases expiring in various years through 2006. Future minimum commitments underoperating leases as of June 30, 2003 are as follows:

 
| **Year**             |   | **Amount** |      |
|----------------------|--------|------------|-----------|
|                 |   |       |      |
| 2003 (July-December) |   | $          | 203,956   |   |
| 2004                 |   | 414,305    |      |
| 2005                 |   | 427,624    |      |
| 2006                 |   | 283,056    |      |
| Total                |   | $          | 1,328,941 |   |

 

4.*                                       CreditAgreement with Majority Shareholder—*In August 1999, the Companyentered into a Credit Agreement (the “Credit Agreement”) with Health Holdingsand Botanicals, LLC (“Health Holdings”), the majority stockholder of theCompany. The Credit Agreement allows for advances (the “Advances”) of$4 million at an interest rate of 8% per annum with a due date ofJuly 31, 2004. During the year ended December 31, 2001, HealthHoldings 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 described more fully in Note 7, Health Holdingsconverted into Common Stock all of the Company’s Credit Agreement debt due toHealth Holdings, plus accrued interest of $67,013 for a

 

6

----

 

total debtconversion of $4,563,206.

 

5.               *Loan Agreement with Majority Shareholder and OtherInvestors—*In August 2000, the Company entered into a LoanAgreement (the “Loan Agreement”) with Health Holdings and other investors (the“Lender Group”). The Loan Agreement allowed for advances (the “Loan Advances”)of up to $1.2 million at an interest rate of 8% per annum with due datesof September 11, 2002 for $50,000 and August 31, 2003 for theremaining balance outstanding. Interest only payments were to be required on aquarterly basis. On June 13, 2001, two investors converted their totaldebt of $150,000 plus accrued interest of $2,400 into Common Stock, receiving atotal of 476,250 shares of the Company’s Common Stock based on the then fairmarket value of $0.32. As part of the *PrivateEquity Transaction* on January 2, 2002 as described more fullyin Note 7, Health Holdings converted into Common Stock all of theCompany’s Loan Agreement debt due to Health Holdings, plus accrued interest of$11,051 for a total debt conversion of $752,496.

 

The LoanAgreement further provided that the Lender Group could elect to convert all orany part of the Loan Advances into shares of the Company’s Common Stock at aconversion price equal to the lower of (a) the average closing bid of theCompany’s Common Stock for the ten trading days prior to the making of a LoanAdvance or (b) the average closing bid of the Company’s common stock forthe ten trading days prior to the date of receipt of notice of conversion. OnAugust 8, 2002, one investor (a member of the Board of Directors) converteddebt of $50,000 which was due September 11, 2002 plus accrued interest of $427into Common Stock, receiving a total of 720,392 shares of the Company’s commonStock based on the then fair market value of $0.07.

 

On April 14,2003, the Company entered into a loan agreement (the “Loan Agreement”) withHealth Holdings and Botanicals, LLC, a principal shareholder of the Company,and certain other lenders (the “Lender Group”), pursuant to which the LenderGroup has agreed to lend the Company $450,000 and, subject to the discretion ofthe Lender Group, up to an additional $300,000.  All advances under the Loan Agreement bear interest at the rateof 15% per annum, are due on December 31, 2004, are secured by substantiallyall of the assets of the Company, and are subordinated to the Company’sindebtedness to Wells Fargo Business Credit, Inc. (“Wells Fargo”).  The advances under the Loan Agreement willbe used for the Company for working capital and general corporatepurposes.  In consideration of theextension of credit under the Loan Agreement, Wells Fargo waived all defaults ofthe Company as of December 31, 2002 under the Credit and Security Agreementdated as of February 27, 2000 and amended the agreement to, among other things,reduce the covenants regarding minimum net income and minimum book net worthand increased the interest rate to the prime rate plus 4.5%.

 

6.*                                       Lineof Credit—* On January 27, 2000, the Company entered into a three yearCredit and Security Agreement with Wells Fargo Business Credit, Inc. (WellsFargo) that initially allowed for maximum borrowings of up to $3,000,000, basedon certain percentages of eligible accounts receivable and inventories asdefined. As more fully described in Note 7, *PrivateEquity Transaction*, on December 20, 2001, terms of the Credit andSecurity Agreement were modified to include waiving the enforcement of existingdefaults as of December 20, 2001, increasing the credit available to theCompany to a maximum of $4,500,000 with an inventory maximum subline of$2,000,000, increasing the floating rate to the prime rate plus 2% and extendingthe maturity date to December 31, 2003. OnSeptember 19, 2002, the terms of the Credit and Security Agreement weremodified to include waiving the enforcement of existing defaults, reducing thecredit availability of the Company to a maximum of $4,325,000, requiring thatthe Company maintain certain minimum levels of cash, and reducing the covenantsregarding minimum net income and minimum book net worth.  In consideration of the extension ofcredit under the Loan Agreement on April 14, 2003, Wells Fargo waived alldefaults of the Company as of December 31, 2002 under the Credit and SecurityAgreement dated as of February 27, 2000 and amended the agreement to, amongother things, reduce the covenants regarding minimum net income and minimumbook net worth and increased the interest rate to the prime rate plus 4.5%.Borrowings under the Credit and Security Agreement, which totaled $1,498,315 atJune 30, 2003, are collateralized by substantially all assets of the Company.At June 30, 2003 the prime rate was 4.0% and the interest charge under theCredit and Security Agreement was 8.50%. The Credit and Security Agreementcontains covenants, which, among other things, require that certain financialratios be met. As of June 30, 2003, the Company was in compliance with allcovenants.

 

7

----

 

7.*             PrivateEquity Transaction—* On January 2, 2002, the Company privately sold13,540,723 shares of Series B Convertible Preferred Stock (the “shares”) for $2million, and warrants to purchase an additional 33,641,548 shares of Series BConvertible Preferred Stock at an aggregate exercise price of $3.5 million (the“Warrants”), for $500,000. The shares and Warrants were purchased by WestgateEquity Partners, L.P. (“Westgate”). The Series B Convertible Preferred Stockbears dividends at a rate of 10% per annum, which will accumulate and compoundsemi-annually if not paid in cash. On the seventh anniversary of its issuance,the Series B Convertible Preferred Stock will be automatically redeemed by theCompany at the original issuance price plus accrued and unpaid dividends,provided the Company is legally able to do so. Two members of the Board ofDirectors of the Company were elected exclusively by the holders of the SeriesB Convertible Preferred Stock voting as a separate class.

 

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

 

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

 

As part ofthis transaction, the Company entered into a Management Services Agreementunder which certain principals of Westgate or its affiliates will providemanagement and consulting services to the Company and amended and extended theemployment agreement with the Company’s CEO. Also, on December 20, 2001 as partof this transaction and effective on its completion, Wells Fargo agreed tomodify terms of its Credit and Security Agreement with the Company, to includewaiving the enforcement of existing defaults, increasing credit available tothe Company to a maximum of $4,500,000, increasing the floating rate to theprime rate plus 2% and extending the maturity date to December 31, 2003, asmore fully described under Footnote 6.

 

Under theterms of the Private Equity Transaction, if Westgate exercises the warrants infull, Westgate would hold a total of 47,182,271 shares of Series B ConvertiblePreferred Stock which would be convertible into the same number of shares ofCommon Stock, or 51% of the Company’s Common Stock on a fully diluted basis.

 

After thecompletion of the Private Equity Transaction, Westgate asserted that theCompany’s representations and warranties concerning the Company’scapitalization in the Purchase Agreement were inaccurate in that they omittedto disclose the fact that certain outstanding promissory notes of the 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 $202,345 in Convertible Notes remain outstanding andwere convertible into 6,744,833 shares as of August 14, 2003.

 

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

 

8

----

 

The netproceeds of the transactions have been used by the Company for working capitaland general corporate purposes.

 

*8.**              Stock-BasedCompensation*

 

*Employee StockOption Plan**–***In February 1998, the Companyadopted an Incentive Stock Option Plan (the “Plan”) to enable participatingemployees to acquire shares of the Company’s common stock. The Plan providedfor the granting of incentive stock options up to an aggregate of 850,000shares, as amended. In October 2001, the Company amended the Plan by increasingto 2,000,000 the number of shares of the Company’s common stock which may besubject to awards granted pursuant to the Plan. The actual number of incentivestock options that may be granted to employees is determined by the CompensationCommittee based on the parameters set forth in the Plan. Under the terms of thePlan, incentive stock options may be granted at not less than 100% of the fairmarket 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 594,450 incentive options under the Planat the weighted average exercise price per share of $0.34 as of June 30, 2003.These options expire seven years from the date of grant.

 

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

 

*Warrants**–***On January 2,2002, the Company sold warrants to purchase 33,641,548 shares of Series BConvertible Common Stock. The aggregate purchase price of the warrants was$500,000 and the aggregate exercise price is $3.5 million. This transaction isdescribed more fully in Note 7, *Private Equity Transaction.*

 

In 1999, theCompany granted 600,000 warrants in conjunction with certain financingagreements. These warrants expire ten years from the date of grant. As part ofthe *Private Equity Transaction*described in Note 7, the holders of the warrants agreed they would beexercisable for Non-Voting Common Stock.

 

As part of arestructuring of the Company in 1991, equity holders exchanged their shares fornew common stock and Class A and Class B Warrants. The Class A Warrants expiredat December 31, 1996. The Class B Warrants allowed for the purchase of oneshare of common stock for $1.25 per share. Between December 31, 1999 andJanuary 14, 2000, 588 warrants were exercised. On January 15, 2000, theremaining 324,520 unexercised Class B warrants expired.

 

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

 
|                             |   | **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                          |   | 0                     |   |                                              |   |                    |       |                                   |   |
| Exercised                        |   | 0                     |   |                                              |   |                    |       |                                   |   |
| Expired                          |   | (20,000               | )      | $                                                 | 3.30   |                    |       |                                   |   |   |
| Outstanding at March 31, 2003    |   | 34,453,548            |   | $                                                 | 0.11   |                    | 34,311,673 |                                   | $      | 0.12 |   |
| Granted                          |   | 0                     |   |                                              |   |                    |       |                                   |   |
| Exercised                        |   | 0                     |   |                                              |   |                    |       |                                   |   |
| Expired                          |   | (130,000              | )      | $                                                 | 1.02   |                    |       |                                   |   |   |
| Outstanding at June 30, 2003     |   | 34,323,548            |   | $                                                 | 0.11   |                    | 34,215,423 |                                   | $      | 0.11 |   |

 

9

----

 

The followingtable summarizes information about stock options and warrants outstanding atJune 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 |   |
| $ 0.15-.875                   |   | 559,500                                 |   | 3                                                         |   | $                                      | 0.30   |                                    | 458,625    |                                                                | $      | 0.29 |   |
| $ 1.03 -1.13                  |   | 122,500                                 |   | 2                                                         |   | $                                      | 1.04   |                                    | 115,250    |                                                                | $      | 1.04 |   |
|                          |   |                                    |   |                                                      |   |                                   |   |                                    |       |                                                                |   |
|                          |   | 34,323,548                              |   |                                                      |   | $                                      | 0.11   |                                    | 34,215,423 |                                                                | $      | 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** |     | **Six Months  Ended** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------|-----------------------|--------|
|                                                                                                                                                |   | **June 30,  2003**      |     | **June 30,  2002**    |   | **June 30,  2003** |   | **June 30,  2002** |   |
|                                                                                                                                                |   |                    |     |                  |   |   |   |   |   |
| Net loss: As reported                                                                                                                               |   | $                       | (362,369 | )                     | $      | (781,727 | ) | $ | (680,781 | ) | $ | (1,568,967 | ) |
|                                                                                                                                                |   |                    |     |                  |   |   |   |   |   |
| 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 |   | (68,386                 | )        | (89,745               | )      | (136,773 | ) | (179,489 | ) |
|                                                                                                                                                |   |                    |     |                  |   |   |   |   |   |
| Pro forma                                                                                                                                           |   | $                       | (430,755 | )                     | $      | (871,472 | ) | $ | (817,554 | ) | $ | (1,748,456 | ) |
|                                                                                                                                                |   |                    |     |                  |   |   |   |   |   |
| Basic and Diluted                                                                                                                                   |   |                    |     |                  |   |   |   |   |   |
| Net loss per share: As reported                                                                                                                     |   | $                       | (0.01    | )                     | $      | (0.02 | ) | $ | (0.02 | ) | $ | (0.04 | ) |
| Pro forma                                                                                                                                           |   | $                       | (0.01    | )                     | $      | (0.02 | ) | $ | (0.02 | ) | $ | (0.04 | ) |

 

10

----

 

9.                                       *Segment Reporting -* Operating segments aredefined as components of an enterprise about which separate financialinformation is available that is evaluated regularly by the Company’s chiefdecision-maker, or decision-making group, in deciding how to allocate resourcesand in assessing performance.

 

The Company’sreportable operating segments include health food specialty stores and massmarket categories. The Company does not allocate operating expenses to thesesegments, nor does it allocate specific assets to these segments. Therefore,segment information reported includes only sales, cost of sales and grossprofit.

 

Operatingsegment data for the three and six months ended June 30, 2003 and June 30, 2002was as follows:

 
|                             |   | **Distribution Channels** |      |            |   |
|----------------------------------|--------|---------------------------|-----------|-----------------|--------|
|                             |   | **Health Food**           |      | **Mass Market** |   | **Total** |   |
|                             |   |                      |      |            |   |   |   |
| Three months ended June 30, 2003 |   |                      |      |            |   |   |   |
| Sales                            |   | $                         | 1,925,086 |            | $      | 2,157,598 |   | $ | 4,082,684 |   |
| Cost of Sales                    |   | 1,074,735                 |      | 1,167,333       |   | 2,242,068 |   |
| Gross Profit                     |   | $                         | 850,351   |            | $      | 990,265 |   | $ | 1,840,616 |   |
|                             |   |                      |      |            |   |   |   |
| Three months ended June 30, 2002 |   |                      |      |            |   |   |   |
| Sales                            |   | $                         | 1,854,591 |            | $      | 1,380,678 |   | $ | 3,235,269 |   |
| Cost of Sales                    |   | 1,053,808                 |      | 920,385         |   | 1,974,193 |   |
| Gross Profit                     |   | $                         | 800,783   |            | $      | 460,293 |   | $ | 1,261,076 |   |
|                             |   |                      |      |            |   |   |   |
| Six months ended June 30, 2003   |   |                      |      |            |   |   |   |
| Sales                            |   | $                         | 3,951,511 |            | $      | 3,997,228 |   | $ | 7,948,739 |   |
| Cost of Sales                    |   | 2,132,556                 |      | 2,187,748       |   | 4,320,304 |   |
| Gross Profit                     |   | $                         | 1,818,955 |            | $      | 1,809,480 |   | $ | 3,628,435 |   |
|                             |   |                      |      |            |   |   |   |
| Six months ended June 30, 2002   |   |                      |      |            |   |   |   |
| Sales                            |   | $                         | 3,720,149 |            | $      | 2,888,136 |   | $ | 6,608,285 |   |
| Cost of Sales                    |   | 2,059,310                 |      | 1,799,996       |   | 3,859,306 |   |
| Gross Profit                     |   | $                         | 1,660,839 |            | $      | 1,088,140 |   | $ | 2,748,979 |   |

 

Sales areattributed to geographic areas based on the location of the entity to which theproducts were sold. Geographic segment data for the three and six months endedJune 30, 2003 and June 30, 2002 was as follows:

 
|                             |   | **United States** |      | **International** |   | **Total** |   |
|----------------------------------|--------|-------------------|-----------|-------------------|--------|-----------|--------|
|                             |   |              |      |              |   |      |   |
| Three months ended June 30, 2003 |   |              |      |              |   |      |   |
| Sales                            |   | $                 | 4,001,582 |              | $      | 81,102    |   | $ | 4,082,684 |   |
| Cost of Sales                    |   | 2,187,962         |      | 54,106            |   | 2,242,068 |   |
| Gross Profit                     |   | $                 | 1,813,620 |              | $      | 26,996    |   | $ | 1,840,616 |   |
|                             |   |              |      |              |   |      |   |
| Six months ended June 30, 2003   |   |              |      |              |   |      |   |
| Sales                            |   | $                 | 7,789,697 |              | $      | 159,042   |   | $ | 7,948,739 |   |
| Cost of Sales                    |   | 4,219,545         |      | 100,759           |   | 4,320,304 |   |
| Gross Profit                     |   | $                 | 3,570,152 |              | $      | 58,283    |   | $ | 3,628,435 |   |
|                             |   |              |      |              |   |      |   |
| Three months ended June 30, 2002 |   |              |      |              |   |      |   |
| Sales                            |   | $                 | 3,197,912 |              | $      | 37,357    |   | $ | 3,235,269 |   |
| Cost of Sales                    |   | 1,951,506         |      | 22,687            |   | 1,974,193 |   |
| Gross Profit                     |   | $                 | 1,246,406 |              | $      | 14,670    |   | $ | 1,261,076 |   |
|                             |   |              |      |              |   |      |   |
| Six months ended June 30, 2002   |   |              |      |              |   |      |   |
| Sales                            |   | $                 | 6,502,331 |              | $      | 105,954   |   | $ | 6,608,285 |   |
| Cost of Sales                    |   | 3,791,122         |      | 68,184            |   | 3,859,306 |   |
| Gross Profit                     |   | $                 | 2,711,209 |              | $      | 37,770    |   | $ | 2,748,979 |   |

 

11

----

 

During the three and six months ended June30, 2003 and 2002, the Company had sales to customers in excess of 10% of theCompany’s total net sales as 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 June 30, 2003 |   | $                | 1,021,000 |             | 25.0   |               | $      | 637,100 |   | 15.6 |   | $ | 469,000 |   | 11.5 |   |
| Six Months ended June 30, 2003   |   | $                | 1,981,100 |             | 24.9   |               | $      | 1,399,000 |   | 17.6 |   | $ | 1,030,800 |   | 13.0 |   |
| Three Months ended June 30, 2002 |   | $                | 614,800   |             | 19.0   |               | $      | 566,400 |   | 17.5 |   | $ | 554,800 |   | 17.1 |   |
| Six Months ended June 30, 2002   |   | $                | 1,162,400 |             | 17.6   |               | $      | 1,158,700 |   | 17.5 |   | $ | 1,221,400 |   | 18.5 |   |

 

10.                                 *Guarantees-*In November 2002, the FinancialAccounting Standards Board (“FASB”) issued FASB Interpretation Number (“FIN”)45 *“Guarantor’s Accounting and DisclosureRequirements for Guarantees, including Indirect Guarantees of Indebtedness ofOthers-an interpretation of FASB Statements No. 5,57 and 107 and rescission ofFIN 34.” *The following is asummary of the Company’s agreements that the company has determined is withinthe scope of FIN 45.

 

Under itsbylaws, the Company has agreed to indemnify its officers and directors forcertain events or occurrences arising as a result of the officer or director’sserving in such capacity.  The term ofthe indemnification period is for 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 officer liability insurance policy that limits itsexposure and enables it to recover a portion of any future amounts paid.  As a result of its insurance policycoverage, the Company believes the estimated fair value of theseindemnification agreements is minimal and has no liability recorded for theseagreements as of June 30, 2003.

 

The Companyenters into indemnification provisions under (i) its agreements with othercompanies in its ordinary course of business, typically business partners,contractors, and customers, landlords and (ii) its agreements withinvestors.  Under these provisions theCompany generally indemnifies and hold harmless the indemnified party for lossessuffered or incurred by the indemnified party as a result of the Company’sactivities or, in some cases, as a result of the indemnified party’s activitiesunder 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 June 30, 2003.

 

12

----

 

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

 

*This discussion contains “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. Although the Company believes that the expectations reflected insuch forward-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 anduncertainties, and actual results could differ from those described herein.Future results may be subject to numerous factors, many of which are beyond thecontrol of the Company. Such risk factors include, without limitation, therisks set forth below under “Risk Factors.” The Company undertakes noobligation to publicly release the result of any revisions to theseforward-looking statements that may be made to reflect events or circumstancesafter the date hereof or to reflect the occurrence of unexpected events.*

 

All comparisons below are forthe three and six month periods ended June 30, 2003 compared to the three andsix month periods ended June 30, 2002.

 

*General*

 

The Company is a branded natural productmarketing company focused on high growth, innovative products designed tonourish the health and well being of consumers. The Company concentrates on therapidly expanding soy food market which reached sales of almost $2.5 billion in2002 and is expected to grow 15% to 20% per year reaching $5 to $6 billionby 2005, according to Soyatech market research dated February 2001. TheCompany has purposely avoided the vitamin category, which has been flat, aswell as the herbal category, which has experienced 15% to 25% declines per yearsince the late nineties. The Company’s products include Naturade Total Soy, afull line of nutritionally complete meal replacements available in several flavorsof powders, ready-to-drink products and bars, Naturade Soy protein boosters,Aloe Vera 80 health and beauty care products and other niche dietarysupplements. The Company’s products are sold in supermarkets (e.g., Kroger,Fred Meyer, Safeway and Albertson’s), mass merchants (e.g., Wal*Mart andKmart), club stores (e.g., Sam’s Clubs and Costco),  natural food supermarkets (e.g., Whole Foods and Wild Oats) andover 5,000 independent health food stores.

 

*Critical Accounting Policies and Use of Estimates*

 

In preparing the financial statements, theCompany is required to make estimates and judgments which affect the results ofits operations and the reported value of assets and liabilities. Actual resultsmay differ from these estimates. The Company believes that the followingsummarizes critical accounting policies which require significant judgments andestimates in the preparation of its financial statements.

 

***Revenue Recognition***.Sales are recognized upon shipment and passage of title. The Company accrues forestimated returns at the time of sale. In December 1999, the Securitiesand Exchange Commission issued Staff Accounting Bulletin 101, RevenueRecognition (“SAB 101”). SAB 101 summarizes certain of the SEC staff’s views inapplying generally accepted accounting principles to selected revenuerecognition issues in financial statements. Implementation of SAB 101 wasrequired by the fourth quarter of 2000. The implementation of SAB 101 did nothave a material impact on the Company’s financial condition or results ofoperations.

 

***Inventory Valuation***.Merchandise inventories are stated at the lower of cost (first-in, first-outbasis) or market. The Company considers cost to include the direct cost offinished goods provided by co-packers as well as the cost of those componentssupplied to the co-packers. The Company regularly reviews aged and excessinventories to determine if the carrying value of such inventories exceedsmarket value with a reserve recorded to reduce the carrying value to marketvalue if necessary.

 

***Accounts ReceivableValuation***. 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.

 

13

----

 

*Results of Operations*

 

 

*Net Sales.*

 

Total net sales for three months ended June30, 2003 increased $847,415, or 26.2%, to $4,082,684 from $3,235,269 for thesame period in 2002, primarily as a market result of continued growth in themass market and health food market coupled with new distribution in certain keymass market retailers. Total net sales for the six-month period ended June 30,2003 increased $1,340,454 or 20.3% to $7,948,739 from $6,608,285 for the sameperiod in 2002 primarily due to improved distribution in the health food marketresulting from new product introductions and the strengthening of the channeloverall coupled with increasing distribution in the mass market.

 

*Mass Market Net Sales.*  For the three months ended June 30, 2003,mass market net sales increased $776,920 or 56.3% to $2,157,598 from $1,380,678for the three months ended June 30, 2002, primarily as a result of newdistribution sales initiated in 2002 converting into repeat (turn) business,combined with new distribution in club stores. Mass market net sales for the six months ended June 30, 2003 increased$1,109,092 or 38.4% to $3,997,228 from $2,888,136 for the six months ended June30, 2002 primarily due to turn business coupled with increased penetration intoclub stores such as Sam’s Club and BJ’s Wholesale.

 

*Health Food Net Sales.*  For the three months ended June 30, 2003,health food net sales increased $70,495, or 3.8%, to $1,925,086 from $1,854,591for the three months ended June 30, 2002. This increase was a result of theincreased distribution of new products combined with expansion of existingproducts into retail outlets. Health food sales for the six months ended June30, 2003 increased $231,362 or 6.2% to $3,951,511 from $3,720,149 for the sixmonths ended June 30, 2002.  Thisincrease was a result of the greater volume by a distributor who recently assumedthe sales to a major retail outlet coupled with increased penetration  by another distributor that resulted fromthe introduction of new products and increased distribution to otherestablished retail outlets.

 

*Channels of Distribution*On a percent of net sales basis, the breakdown of sales between the massmarket and health food channels for the three month period ended June 30, 2003was 47.2% for the health food channel and 52.8% for the mass market channelcompared to 57.3% in the health food channel and 42.7% in the mass marketchannel for the same period in 2002. The breakdown for the six-month period ended June 30, 2003 was 49.7% forthe health food channel and 50.3% for the mass market channel compared to 56.3%in the health food channel and 43.7% in the mass market channel for the sameperiods in 2002.  Management believesits strategy to increase mass market distribution has directly caused thisshift in distribution.

 

For the three months ended June 30, 2003, domestic net sales increased$803,670 or 25.1%, to $4,001,582 from $3,197,912 for the three months endedJune 30, 2002.  Domestic net sales forthe six months ended June 30, 2003 increased $1,287,366 or 19.8% to $7,789,697from $6,502,331 for the same period in 2002. Increases in domestic net sales are primarily due to the previouslymentioned increase in new distribution in the mass market and increased healthfood sales.  For the three months endedJune 30, 2003, international sales increased $43,745, or 117.1%, to $81,102from $37,357, and for the six months ended June 30, 2003, international netsales increased $53,088 or 50.1% to $159,042 from $105,954 as the Company’sefforts to gain new distribution in Canada have begun to produce results.

 

 

*Gross Profit*

 

Gross profit as a percentage of net sales forthe three months ended June 30, 2003 increased 6.1% to 45.1% of net sales, from39.0% for the three months ended June 30, 2002. The increase was due to lowerproduct cost related to the increased sales mix of the reformulated Naturade TotalSoy® product formula coupled with continued efforts to reduce product andpackaging costs.  Gross profit as apercentage of net sales for the six months ended June 30, 2003 increased 4.0%to 45.6% from 41.6% for the six months ended June 30, 2002 primarily due toreductions in product costs resulting from increased sales mix of reformulatedNaturade Total Soy®.

 

14

----

 

*Selling, General and Administrative Expenses*

 

Selling, general and administrative expenses(“S, G &A”) for the three months ended June 30, 2003 increased$130,846 to $2,009,352 or 49.2% of net sales from $1,878,506 or 58.1% of netsales for the three months ended June 30, 2002. This increase is primarily dueto increased sales volume.  As a percentageof sales, S,G & A expenses decreased 8.9% primarily due to a $132,300decrease in brand expenses related to managements strategy to control promotionexpenses partially offset by a $123,500 increase in overhead expenses,principally from manpower increases. As a percent of sales, brand expenses were12.7% and 17.3%, respectively, for the three months ended June 30, 2003 and2002. The decrease in brand expenses, as a percent of net sales, is primarilydue to the Company’s strategy to control overall costs and match brand expenseswith proven sales opportunities.

 

Selling, general and administrative expenses(“S, G &A”) for the six months ended June 30, 2003 decreased $46,080to $3,942,481 or 49.6% of net sales from $3,988,561 or 60.4% of net sales forthe six months ended June 30, 2002. This decrease is primarily due to a$129,200 decrease in overhead expenses, principally from manpower andconsulting fee reductions partially offset by increases related to freight andcommission expense resulting form increased sales volume.  Brand expenses for the period were 13.8% ofnet sales down 2.6% from 16.4% 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*

 

Interest expense for the three months endedJune 30, 2003 increased $17,839 compared to the three months ended June 30,2002 due to borrowings on the Loan Agreement with a majority shareholder, morefully explained in Note 5, partially offset by lower borrowing levels combinedwith lower base cost of money on the Company’s credit facility.

 

*Cash Flows*

 

Net cash provided by inventories was $516,138for the six months ended June 30, 2003 as compared to net cash provided byinventories of $179,807 for the six months ended June 30, 2002 primarily due tolower December sales in 2002 and higher inventories at the end of the periodresulting in an increase in cash provided when inventories were worked down tonormal levels.

 

Net cash used in accounts receivable was$57,704 for the six month period ended June 30, 2003 compared to net cashprovided from accounts receivable of $1,312,000 for 2001 principally due todecreased sales volume in December 2002 resulting in lower accounts receivableat December 31, 2002 then at December 31, 2001.

 

Net cash used in accounts payable and accruedexpenses was $194,702 for the six month period ended June 30, 2003 compared tonet cash used of $715,927 for 2002 principally due to lower purchase ofinventory related to lower December 2002 sales resulting in lower vendorpayables at December 2002 combined with increased vendor terms negotiated withkey vendors during 2003.

 

The provision for excess and obsoleteinventory used $16,018 in cash for the six month period ended June 30, 2003compared to $273,796 used in 2002 principally due to the disposal of excessproduct lines in 2002 and the implementation of an inventory management systemin 2003 decreasing excess inventory levels.

 

Net cash used by prepaid expenses was$220,649 for the six month period ended June 30, 2003 compared to net cashprovided in 2002 of $254,570 principally due to increased prepaid insurancecosts related to Directors & Officers insurance premiums.

 

15

----

 

*Liquidity and Capital Resources*

 

The Company used cash of $486,029 fromoperating activities in the six months ended June 30, 2003, compared to a useof cash of $701,559 in operating activities for the six months ended June 30,2002. This decrease in cash used from operating activities is primarily due tothe reduction in the Company’s operating loss of $899,813 compared to the sameperiod in 2002 partially offset by an increase in receivables of $57,704, areduction in inventories of $516,138 and a reduction of payables and accruedexpenses of $194,702 for the six months ended June 30, 2003.

 

The Company’s working capital increased$38,057 from ($1,429,771) at December 31, 2002 to ($1,391,714) at June 30,2003. This increase was largely due to the increases in inventory as a resultof increased service levels partially offset by a decrease in accounts payableand borrowings on the Company’s credit facility.

 

Cash used in investment activities during thesix months ended June 30, 2003 was $0 compared to $1,450 for the six monthsended June 30, 2002.

 

The Company’s cash provided by financingactivities was $146,781 for the six months ended June 30, 2003, compared tocash provided by financing activities of $1,777,297 for the six months endedJune 30, 2002. The June 30, 2003 amount was the result of the Loan Agreement(described in Note 6) partially offset by net pay downs on the Company’s lineof credit.  The June 30, 2002 amount wasthe result of the $2.5 million from the Private Equity Transaction,conversion into equity of the Health Holdings Credit Agreement and LoanAgreement debt, and a decrease in borrowings under the Credit and SecurityAgreement. See Notes 4, 5 and 7 to the Financial Statements.

 

As of June 30, 2003, the Company was incompliance with all of the covenants of the Credit and Security Agreement withWells Fargo.

 

The accompanying financial statements havebeen prepared on a going-concern basis, which contemplates the realization ofassets and the satisfaction of liabilities in the normal course of business. AtJune 30, 2003, the Company has an accumulated deficit of $21,618,005, a networking capital deficit of $1,391,714 and a stockholders’ capital deficiency of$2,626,082, and has incurred recurring net losses. These factors, among others,raise substantial doubt about the Company’s ability to continue as a goingconcern. The financial statements do not include any adjustments that mightresult from the outcome of this uncertainty. The Company’s independent auditorsqualified their opinion on the Company’s December 31, 2002 financial statementsby including an explanatory paragraph in which they expressed substantial doubtabout the Company’s ability to continue as a going concern

 

The Company believes that its existing cashbalances and financing arrangements will provide it with sufficient funds tofinance its operations during the next twelve months, provided that Wells Fargodoes not exercise its right to terminate, or demand immediate payment of allamounts outstanding under the Credit and Security Agreement. However, theCompany may seek to raise additional funds through the sale of public orprivate equity and/or debt financings or from other sources. No assurance canbe given that additional financing will be available in the future or that, ifavailable, such financing will be obtainable on terms acceptable to the Companyor its stockholders.

 

16

----

 

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

 

The following summarizes the Company’scontractual obligations at June 30, 2003 and the effects such obligations areexpected to have on liquidity and cash flow in future periods.

 
|                                             |   | **Payments  Due by Period** |      |
|--------------------------------------------------|--------|-----------------------------|-----------|
| **Contractual  Obligations**                     |   | **Total**                   |      | **Less  than 1 Year** |   | **1-3  Years** |   | **4-5  Years** |   | **After 5  Years** |   |
|                                             |   |                        |      |   |   |   |   |   |   |   |   |
| Long-Term Debt                                   |   | $                           | 2,203,523 |   | $ | 1,731,531 |   | $ | 471,992 |   | $ | 0 |   | $ | 0 |   |
| Capital Lease Obligations                        |   | $                           | 0         |   |   |   |   |   |   |   |   |   |
|                                             |   |                        |      |   |   |   |   |   |   |   |   |
| Operating Leases                                 |   | $                           | 1,328,940 |   | $ | 203,956 |   | $ | 1,124,984 |   | $ | 0 |   | $ | 0 |   |
| Unconditional Purchase Obligations               |   | $                           | 0         |   |   |   |   |   |   |   |   |   |
| Other Long-Term Obligations                      |   | $                           | 0         |   |   |   |   |   |   |   |   |   |
| Total Contractual Cash Obligations               |   | $                           | 3,532,463 |   | $ | 1,935,487 |   | $ | 1,596,976 |   | $ | 0 |   | $ | 0 |   |
| Series B Convertible Redeemable Preferred  Stock |   | $                           | 2,000,000 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 2,000,000 |   |
|                                             |   | $                           | 5,532,463 |   | $ | 1,935,487 |   | $ | 1,596,976 |   | $ | 0 |   | $ | 2,000,000 |   |

 

*Recently Issued Statements of Financial Accounting Standards.*

 

In May 2003, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No.150, *Accounting for Certain Instruments withCharacteristics of Both Liabilities and Equity (*“FAS 150”*)*which establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  FAS 150 requires that an issuer 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 adoption of FAS 150 will require the Companyto reclassify its redeemable convertible preferred stock to a liability at itsfair value during the quarter ending September 30, 2003.  The redeemable convertible preferred stockis currently recorded on the Company’s balance sheet in a separate categorybetween liabilities and equity.

 

In January 2003, the FASB issued FASB InterpretationNo. 46, *Consolidation of Variable InterestEntities,* an interpretation of Accounting Research Bulletins (“ARB”)No. 51, *Consolidated Financial Statements*(“FIN 46”).  FIN 46 clarifies theapplication of ARB No. 51 to certain entities in which equity investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties.  The Company does not believe the adoption ofFIN 46 will have a material impact on its financial position and results ofoperations.

 

In December 2002, the FASB issued Statementof Financial Accounting Standards No. 148, *Accountingfor Stock-Based Compensation — Transition and Disclosure* (“FAS148”), which amends Statement of Financial Accounting Standards No. 123, *Accounting for Stock-Based Compensation*(“FAS 123”). FAS 148 provides alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation. In addition, FAS 148 amends the disclosure requirements of FAS123 to require more prominent and more frequent disclosures in financialstatements of the effects of stock-based compensation. The transition guidanceand annual disclosure provisions of FAS 148 are effective for fiscal yearsending after December 15, 2002. The interim disclosure provisions are effectivefor financial reports containing condensed financial statements for interimperiods beginning after December 15, 2002. The adoption of FAS 148 did not havea material impact on the Company’s consolidated balance sheet or results ofoperations as the Company intends to continue to account for its equity basedcompensation plans using the intrinsic method. The Company provided the interim disclosures required by FAS 148beginning in the first quarter of 2003.

 

In November 2002, the FASB issuedInterpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including Indirect Guaranteesof Indebtedness to Others*, an interpretation of FASB

 

17

----

 

Statements No. 5, 57 and 107 and a rescission of FASB InterpretationNo. 34. This interpretation elaborates on the disclosures to be made by aguarantor in its interim and annual financial statements about its obligationsunder guarantees issued. The interpretation also clarifies that a guarantor isrequired to recognize, at inception of a guarantee, a liability for the fairvalue of the obligation undertaken. The initial recognition and measurementprovisions of the interpretation are applicable to guarantees issued ormodified after December 31, 2002 and are not expected to have a material effecton the Company’s financial statements. The disclosure requirements areeffective for financial statements of interim and annual periods ending afterDecember 31, 2002. The Company adopted this Statement as of January 1, 2003 andit had no material impact on its financial statements.

 

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

 

                In May 2002, the FASB issued FAS 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections.* FAS145 eliminates Statement 4 (and Statement 64, as it amends Statement 4), whichrequires gains and losses from extinguishments of debt to be aggregated and, ifmaterial, classified as an extraordinary item, and thus, also the exception toapplying Opinion 30 is eliminated as well. This statement is effective foryears beginning after May, 2002 for the provisions related to the rescission ofStatements 4 and 64, and for all transactions entered into beginning May, 2002for the provision related to the amendment of Statement 13.  The adoption of SFAS 145 did not have amaterial impact on the Company’s operations and financial position.

 

 

*Risk Factors*

 

The short and long-term success of theCompany is subject to certain risks, many of which are substantial in nature.Stockholders and prospective stockholders in the Company should considercarefully the following risk factors, in addition to other informationcontained herein. This Form 10-Q contains forward-looking statements whichare subject to a variety of risks and uncertainties. The Company’s actualresults could differ materially from those anticipated in these forward-lookingstatements as a result of various factors, including those set forth below.

 

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

 

Naturade’s independent accountants havequalified their opinion on the Company’s December 31, 2002 financialstatements, expressing substantial doubt concerning the Company’s ability tocontinue as a going concern. At June 30, 2003, the Company had an accumulateddeficit of $21,618,005, net working capital deficit of $1,391,714 and astockholders’ capital deficiency of $2,626,082. The Company anticipates that itwill incur net losses for the foreseeable future and will need access to additionalfinancing for working capital and to expand its business. Moreover, as ofDecember 31, 2002, the Company was in default of the minimum book networth and minimum net income covenants in the Credit and Security Agreementwith its principal lender and only recently received a written waiver of suchdefault. Without a waiver of any future defaults that may occur, or amodification of the Credit and Security Agreement, the lender could terminatethe agreement and demand immediate payment of the full amount of indebtedness.Management has taken a number of steps to address this situation, including thePrivate Equity Transaction completed on January 2, 2002, the LoanAgreement entered into on April 14, 2003 under which the Company can borrow,subject to certain conditions, $450,000 and can borrow up to an additional$300,000 at the discretion of the lenders and efforts to decrease operatinglosses by expanding sales and reducing costs. Nevertheless, the Company expectsto incur operating losses for some time in the future and cannot give assurancethat additional financing will be available when needed or that it will obtainneeded waivers or modifications of the Credit and Security Agreement. Ifunsuccessful in those efforts, Naturade could be forced to cease operations andinvestors in Naturade’s Common Stock could lose their entire investment.

 

18

----

 

***Dependence oncurrent and ongoing financing***

 

The Company’s success is dependent on itscurrent financing as well as new financing to support its working capitalrequirements and fund its operating losses. Starting in 2000, the Companyembarked on a strategy to rollout the Naturade Total Soy® product line to themass market, which requires a high level of marketing expenditures. Althoughthe Company obtained $2.5 million as part of the Private EquityTransaction on January 2, 2002, and entered into the Loan Agreement as ofApril 14, 2003 under which the Company can borrow $450,000 and can borrow up toan additional $300,000 at the discretion of the lenders, the Company may nothave adequate financial resources to fund this strategy. Further, no assurancecan be given that the Company will have access to additional funds or, if fundscan be obtained, that the terms on which they can be obtained will besatisfactory. In such event, the Company’s business and results of operations,and its ability to continue as a going concern, will be materially adverselyaffected.

 

 

***Future Sales ofEquity Securities Could Dilute the Company’s Common Stock***

 

The Company may seek to obtain new financingfrom various sources, including the sale of its securities. Future sales ofCommon Stock or securities convertible into Common Stock at or below recentmarket prices could result in dilution of the Common Stock. In addition, theconversion of the 13.5 million shares of Series B ConvertiblePreferred Stock originally sold to Westgate Equity Partners, L.P. (“Westgate”),for $2 million, together with conversion of the 35,989,555 shares ofSeries B Convertible Preferred Stock issuable on exercise of warrants heldby Westgate, which have an exercise price of approximately $0.104 per share(and, including the original cost of the warrant, a total consideration ofapproximately $0.119 per share), has resulted in dilution of the Common Stock.The perceived risk of dilution may cause some of the Company’s stockholders tosell their shares, which could further reduce the market price of the CommonStock.

 

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

 

Naturade’s business depends on the free flowof products and services through the channels of commerce. Recently, inresponse to terrorist activities and threats aimed at the U.S., transportation,mail, financial and other services have been slowed or stopped altogether.Further delays or stoppages in transportation, mail, financial or otherservices could have a material adverse effect on the Company’s business,results of operations and financial condition. Furthermore, the Company mayexperience an increase in operating costs, such as costs for transportation,insurance and security, as a result of the terrorist activities and potentialactivities. The Company may also experience delays in receiving payments frompayers that have been affected by terrorist activities and potentialactivities. The U.S. economy in general is being adversely affected by theterrorist activities and potential activities and any economic downturn couldadversely impact the Company’s results of operations, impair its ability toraise capital or otherwise adversely affect its ability to grow its business.

 

***Impact of governmentregulation***

 

The Company’s operations, properties andproducts are subject to regulation by various foreign, federal, state and localgovernment entities and agencies, including the FDA and FTC. Among othermatters, such regulation is concerned with statements and claims made inconnection with the packaging, labeling, marketing and advertising of theCompany’s products. The governmental agencies have a variety of processes andremedies available to them, including initiating investigations, issuingwarning letters and cease and desist orders, requiring corrective labeling oradvertising, requiring consumer redress, seeking injunctive relief or productseizure, imposing civil penalties and commencing criminal prosecution.

 

As a result ofthe Company’s efforts to comply with changes in applicable statutes andregulations, the Company has from time to time reformulated, eliminated orrelabeled certain of its products and revised certain aspects of its sales,marketing and advertising programs. The Company may be subject in the future toadditional laws or regulations administered by federal, state, local or foreignregulatory authorities, the repeal or amendment of laws or regulations

 

19

----

 

which the Company considersfavorable, such as DSHEA, or more stringent interpretations of current laws orregulations. The Company cannot predict the nature of future laws, regulations,interpretations or applications, nor can the Company predict what effectadditional governmental regulations or administrative orders, when and ifpromulgated, would have on the Company’s business in the future. Such futurelaws and regulations could, however, require the reformulation of products tomeet new standards, the recall or discontinuance of products that cannot bereformulated, the imposition of additional record keeping requirements,expanded documentation of product efficacy, expanded or modified labeling andscientific 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.

 

***Technologicalchanges***

 

The Company currently is engaged indeveloping nutraceuticals, which are characterized by extensive and costlyresearch efforts and rapid technological progress and change. New processdevelopments are expected to continue at a rapid pace in both industry andacademia. The Company’s future success will depend on its ability to developand commercialize its existing product candidates and to develop new products.There can be no assurance that the Company will successfully complete thedevelopment of any of its existing product candidates or that any of its futureproducts will be commercially viable or achieve market acceptance. In addition,research and development and discoveries by others could render some or all ofthe Company’s programs or potential product candidates uncompetitive orobsolete.

 

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

 

The Company’s three largest customerstogether account for 55.5% of sales revenue for the six-month period ended June30, 2003. One mass market customer, Wal*Mart and Sam’s Club, representedapproximately 24.9% of Naturade’s total sales, and two health food distributorsaccounted for 30.6% of total sales for the six-month period ended June 30,2003. The loss of such customers could have a material adverse effect on theCompany’s results of operations. From time to time, major customers of Naturadehave experienced financial difficulties. Naturade does not have long-termcontracts with any of its customers and, accordingly, there can be no assurancethat any customer will continue to place orders with Naturade to the sameextent it has in the past, or at all.

 

***Dependence onthird-party manufacturers***

 

The use of contract manufacturers and theresulting loss of direct control over production could result in the Company’sfailure to receive timely delivery of products of acceptable quality. Althoughthe Company believes that alternative sources of contract manufacturingservices are available, the loss of one or more contract manufacturers couldhave a material adverse effect on the Company’s results of operations until analternative source is located and has commenced producing the Company’sproducts.

 

Although the Company requires that itscontract manufacturers comply with FDA manufacturing guidelines, Naturadecannot assure that these third-party companies will always act in accordance tothese regulations. If the manufacturing facilities used by the Company’sthird-party manufacturers did not meet those standards, the production of theCompany’s products could be delayed until the necessary modifications are madeto comply with those standards or alternate manufacturers are located.Furthermore, the potential exists for circumstances to arise which wouldrequire Naturade to seek out alternate manufacturers who operate in compliancewith the FDA’s requirements.

 

***Competition***

 

The market for nutraceutical products ishighly competitive. Many of the Company’s competitors have substantiallygreater capital resources, research and development capabilities, andmanufacturing and marketing resources, capabilities and experience than theCompany. The Company’s competitors may succeed in developing products that aremore effective or less costly than any products that may be developed by theCompany.

 

20

----

 

***Dependence onqualified personnel***

 

The Company’s success is dependent upon itsability to attract and retain qualified sales, marketing, scientific andexecutive management personnel. To commercialize its products and productcandidates, the Company must maintain and expand its personnel, particularly inthe areas of product sales and marketing. The Company faces intense competitionfor such personnel from other companies, academic institutions, governmententities and other research organizations. There can be no assurance that theCompany will be successful in hiring or retaining qualified personnel.Moreover, managing the integration of such new personnel could pose significantrisks to the Company’s development and progress and increase its operatingexpenses.

 

***Variability ofquarterly results***

 

The Company has experienced, and expects tocontinue to experience, variations in its net sales and operating results fromquarter to quarter. The Company believes that the factors which influence thisvariability of quarterly results include the timing of the Company’s introductionof new product lines, the level of consumer acceptance of each product line,general economic and industry conditions that affect consumer spending andretailer purchasing, the availability of manufacturing capacity, the timing oftrade shows, the product mix of customer orders, the timing of placement orcancellation of customer orders, the weather, transportation delays, theoccurrence of chargebacks in excess of reserves and the timing of expendituresin anticipation of increased sales and actions of competitors. Accordingly, acomparison of the Company’s results of operations from period to period is notnecessarily meaningful, and the Company’s results of operations for any periodare not necessarily indicative of future performance.

 

***Product liabilityexposure***

 

Product liability risk is inherent in thetesting, manufacture, marketing and sale of the Company’s products and productcandidates, and there can be no assurance that the Company will be able toavoid significant product liability exposure. The Company may be subject tovarious product liability claims, including, among others, that its productsinclude inadequate instructions for use or inadequate warnings concerningpossible side effects and interactions with other substances. The Company currentlymaintains a general liability insurance policy and a product liabilityinsurance policy. There can be no assurance that the Company will be able tomaintain insurance in sufficient amounts to protect the Company against suchliabilities at a reasonable cost. Any future product liability claim againstthe Company could result in the Company paying substantial damages, which maynot be covered by insurance and may have a material adverse effect on thebusiness and financial condition of the Company.

 

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

 

In addition to internal expansion of itsexisting business, Naturade has a strategy to expand its business externally byidentifying compatible companies for strategic alliances and strategicinvestments in Naturade. Naturade may not succeed in identifying thesepotential strategic partners or may be unable to conclude agreements with them.If so, Naturade’s future growth may be limited, and it may be unable to achieveprofitability.

 

21

----

 

***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 thehealth food market, has recently built a presence in the mass market. Whileyielding increased revenue, selling to the mass market has also resulted insignificant new costs and risks for Naturade. Mass market sales require greater expenditures for branding.  Mass market brand expenses were 10.8% of netsales as compared to health food brand expenses of 10.1% of net sales for thesix months ended June 30, 2003. Compared to sales in the health food market, the aggregate volume ofmass market orders can vary significantly from period to period and tends to bemore sensitive to short term or local variations in market conditions. Theinstability can make planning difficult and can cause unexpected reductions insales, or in orders that exceed Naturade’s short-term capacity, in either caseresulting in lost revenue. Failure to manage the costs and risks associatedwith the mass market could cause material adverse harm to Naturade’s business.

 

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

 

Naturade’s business consists primarily ofselling natural products and functional foods, including soy protein basedproducts. While Naturade’s sales decreased in 2002, the soy foods category as awhole has recently experienced increased sales. Other categories of dietarysupplements have experienced reduced sales in recent periods after severalyears of dramatic growth. In particular, revenues in both the herbal and healthfood store categories have significantly declined. There can be no assurancethat this general consumer trend will not be experienced by Naturade’s productcategories as well. Even if Naturade is successful in increasing sales withinits market category, a decline in the overall market for natural products or functionalfoods could have a material adverse affect on Naturade’s business.

 

***Effect of adversepublicity***

 

The Company’s products are formulated withvitamins, minerals, herbs and other ingredients that the Company regards assafe when taken as suggested by the Company and that scientific studies havesuggested may involve health benefits. While the Company conducts extensivequality control testing on its products, the Company generally does not conductor sponsor clinical studies relating to the benefits of its products. TheCompany is highly dependent upon consumers’ perception of the overall integrityof its business, as well as the safety and quality of its products and similarproducts distributed by other companies which may not adhere to the same qualitystandards as the Company. The Company could be adversely affected if any of theCompany’s products, or any similar products distributed by other companies,should prove or be asserted to be harmful to consumers or should scientificstudies provide unfavorable findings regarding the effectiveness of suchproducts. The Company’s ability to attract and retain distributors could beadversely affected by negative publicity relating to it or to other directsales organizations or by the announcement by any governmental agency ofinvestigatory proceedings regarding the business practices of the Company orother direct sales organizations.

 

***Intellectualproperty protection***

 

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

 

Currently, the Company has 18 U.S. trademarksas well as a California registration of one trademark. The Company alsomaintains trademark registrations in approximately eleven foreign countries.Because of its limited financial resources, the Company cannot in all casesexhaustively monitor the marketplace for trademark violations. It

 

22

----

 

will evaluate and pursue potential infringement on a case-by-case basisin accordance with its business needs and financial resources. If the Companyis not aware of some infringing uses or elects not to pursue them, the value ofits trademarks could be substantially weakened. If the Company takes action toenforce its property rights, litigation may be necessary. Any such litigationcould be very costly and could distract the Company’s personnel. Due to limitedfinancial resources, Naturade may be unable to pursue some litigation matters.In matters it does pursue, Naturade can provide no assurance of a favorableoutcome. An unfavorable outcome in any proceeding could have a material adverseeffect on the Company’s business, financial condition and results ofoperations.

 

***Introduction of newproducts***

 

Each year, the Company introduces newproducts to meet consumer demands and counter competitive threats. These newproducts include product line extensions, such as new flavors to currentlyexisting products, as well as new formulations or configurations, such asready-to-drink products and bars. The Company experiences significant costs informulating new products, designing packaging and merchandising. While theCompany conducts extensive market research to determine consumer trends in boththe mass market and health food market, there can be no assurance that theCompany’s new products will be accepted by consumers and retailers. In addition,there can be no assurance that once new products are initially distributed tomass market and health food retailers, there will be repeat orders for thesenew products. Furthermore, expensive introductory retailer charges foradditional shelf space may negate any initial increase in sales.

 

***Stock price***

 

The market price of the Company’s CommonStock is likely to be volatile and could be subject to significant fluctuationsin response to the factors such as quarterly variations in operating results, operatingresults which vary from the expectations of securities analysts and investors,changes in financial estimates, changes in market valuations of competitors,announcements by the Company or its competitors of a material nature, loss ofone or more customers, additions or departures of key personnel, future salesof Common Stock and stock market price and volume fluctuations. Also, generalpolitical and economic conditions such as recession, or interest rate orcurrency rate fluctuations may adversely affect the market price of theCompany’s Common Stock.

 

***Closely controlledstock***

 

At June 30, 2003, Westgate Equity Partners,L.P. beneficially owned approximately 55.0% of the Company’s Common Stock,Health Holdings beneficially owned 41.5% of the Company’s Common Stock, andexecutive officers and directors of the Company as a group beneficially owned97.5% of the Company’s Common Stock. Shares “beneficially owned” include sharesthat a person owns or has a right to acquire within 60 days, either directlyor through affiliates. Accordingly, Westgate Equity Partners, LLC and HealthHoldings have the ability to control the outcome on all matters requiringstockholder approval, including, but not limited to, the election and removalof directors, any merger, sale, consolidation or sale of substantially all ofthe assets of the Company, and to control the Company’s management and affairs.

 

23

----

 

**ITEM 3****. Quantitative and Qualitative Disclosures AboutMarket Risk**

 

 

The Company’s earnings areaffected by fluctuations in the value of the U.S. dollar as compared to foreigncurrencies as a result of international purchases. As a result, the Companybears the risk of exchange rate gains or losses that may result in the futureas a result of this financing structure. The Company’s exposure to market riskfor changes in interest rates relates primarily to the Company’s long-termdebt.

 

The Company’s long-term debt primarilyconsists of a $4.5 million line of credit originally entered into onJanuary 27, 2000 and amended on April 14, 2003, a $450,000 Loan Agreementwith a majority shareholder and other investors and a $252,345 Loan Agreementwith investors, after giving affect to the Health Holdings debt-to equityconversion on January 2, 2002 as part of the Private Equity Transaction asdescribed more fully in Note 7 to the Financial Statements. The$4 million Credit Agreement with the majority shareholder of the Companywas converted into equity on January 2, 2002 as part of the Private EquityTransaction. The line of credit bears interest at prime rate plus 4.5%. TheLoan Agreement with a majority shareholder and other investors bears interestat 15% per annum and is due on December 31, 2004.  The Loan Agreement bears interest at 8% per annum with due datesof September 11, 2002 for $50,000 and of August 2003 for theremaining balance. However, given the fixed interest rate on the LoanAgreement, interest rate changes generally will have no effect on the interestrates under the Loan Agreement or on the Company’s results of operations. Giventhe variable interest rate on the line of credit, the impact of interest ratechanges on the line of credit could have a material impact on the Company’sresults of operations. For, the six month period ended June 30, 2003 theinterest expense on the line of credit was $53,756. If the interest rate on theline of credit for the six month period ended June 30, 2003 had increased byone percent to prime rate plus 5.5%, this would result in an interest expenseof $60,272.

 

**ITEM 4****. Controls and Procedures**

 

 

The Company’s Chief Executive Officer, BillD. Stewart and Chief Financial Officer Stephen M. Kasprisin, with theparticipation of the Company’s management, carried out an evaluation of the effectivenessof the Company’s disclosure controls and procedures pursuant to Exchange ActRule 13a-14.  Based upon thatevaluation, the Chief Executive Officer and the Chief Financial Officer believethat, as of the end of the period covered by this report, the Company’sdisclosure controls and procedures are effective in making known to themmaterial information relating to the Company (including its consolidatedsubsidiaries) required to be included in this report.

 

Disclosure controls and procedures, no matterhow well designed and implemented, can provide only reasonable assurance ofachieving an entity’s disclosure objectives. The likelihood of achieving such objectives is affected by limitationsinherent in disclosure controls and procedures.  These include the fact that human judgment in decision-making canbe faulty and that breakdowns in internal control can occur because of humanfailures such a simple errors or mistakes or intentional circumvention of theestablished process.

 

                There was no change in the Company’s internalcontrol over financial reporting, known to the Chief Executive Officer or theChief Financial Officer that occurred during the period covered by the reportthat has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

24

----

 

**PART II****. Other Information**

 

**ITEM 1. LegalProceedings**

 

NONE

 

**ITEM 2. Changesin Securities**

 

NONE

 

**ITEM 3. Defaultsupon Senior Securities**

 

NONE.

 

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

 

At the Annual Meeting of the Shareholders onJuly 31, 2003, the stockholders re-elected four members of the Board ofDirectors, as follows:

 
|                     |   | **Number of Shares** |   |
|--------------------------|--------|----------------------|--------|
|                     |   | **For**              |   | **Withheld** |   | **Abstain** |   |
|                     |   |                 |   |   |   |   |   |
| Lionel P. Boissiere, Jr. |   | 42,722,596           |   | 0 |   | 647,886 |   |
| William B. Doyle, Jr.    |   | 42,722,596           |   | 0 |   | 647,886 |   |
| Bill D. Stewart          |   | 42,722,596           |   | 0 |   | 647,886 |   |
| David Weil               |   | 42,722,596           |   | 0 |   | 647,886 |   |

 

At the Annual Meeting, the holder of Company’s Series B ConvertiblePreferred Stock, voting as a separate class, re-elected two members of theBoard of Directors, as follows:

 
| Jay W. Brown     |   | 13,540,723 |   | 0 |   | 0 |   |
|------------------|--------|------------|--------|---|--------|---|--------|
| Robert V. Vitale |   | 13,540,723 |   | 0 |   | 0 |   |

 

At the Annual Meeting, the stockholders also voted to ratify theappointment of BDO Seidman, LLP as the Company’s independent certified publicaccountants for the fiscal year ending December 31, 2003, as follows:

 
| For     |   | 42,730,213 |   |
|---------|--------|------------|--------|
| Against |   | 757        |   |
| Abstain |   | 639,512    |   |

 

**ITEM 5. OtherInformation**

 

NONE

 

25

----

 

**ITEM 6. Exhibits**

 
| **Exhibit  No.** |   | **Description**                                                                                                                                      |
|------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31               |   | 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                                         |

 

**ITEM12. Reports on Form 8-K**

 

None

 

26

----

 

**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned hereunto duly authorized.

 
|                        |   | NATURADE, INC.      |
|-----------------------------|--------|--------------------------|
|                        |   | (Registrant)             |
|                        |   |                     |
|                        | By     |                     |
| DATE: August  14, 2003      |   | /s/ Bill D.  Stewart     |   |
|                        |   | Bill D.  Stewart         |
|                        |   | Chief  Executive Officer |
|                        |   |                     |
|                        | By     |                     |
| DATE:  August 14, 2003 |   | /s/Stephen  M. Kasprisin |   |
|                        |   | Stephen M.  Kasprisin    |
|                        |   | Chief  Financial Officer |
|                             |        |                          |  |  |

 

27

----