**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, DC  20549**

 

**FORM 10-Q**

 

**QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly periodended:  October 31, 2004 **

**Commission File Number:  1-14091**

 

**SHERWOOD BRANDS, INC.**

(Exact name of Registrantas specified in its charter)

 

| **North  Carolina**                                                | **56-1349259**                         |
|--------------------------------------------------------------------|----------------------------------------|
| (State or other  jurisdictions of   incorporation or organization) | (I.R.S. Employer   Identification No.) |

 

**1803Research Boulevard, Suite 201Rockville, MD 20850**

(Address of principalexecutive offices)

 

Registrant’s telephone number, including area code:  **(301) 309-6161**

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports and (2) has been subjectto such filing requirement for the past 90 days.

 

Yes ý        No o

 

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

 

Yes o        No ý

 

The number of shares outstanding of the registrant’sClass A Common Stock, $.01 par value per share, as of December 13, 2004 was3,036,561. The number of shares outstanding of the registrant’s Class B CommonStock, $.01 par value per share, as December 13, 2004 was 1,000,000. The ClassB Common Stock is not publicly traded.

 

Transitional Small Business Disclosure Format (checkone):

 

Yes o       No ý

 

 

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**SHERWOOD BRANDS, INC.**

** **

**INDEX**

 
| PART I | FINANCIAL INFORMATION                                                                                   |                                                                                        |
|--------|---------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|
|   |                                                                                                    |                                                                                        |
|   | Item 1.                                                                                                 | FINANCIAL STATEMENTS                                                                        |   |
|   |                                                                                                    |                                                                                        |   |
|   | Consolidated Balance Sheets - October 31,  2004 (unaudited) and July 31, 2004                 |                                                                                        |
|   |                                                                                                    |                                                                                        |
|   | Consolidated  Statements of Operations - Three months ended October 31, 2004 and 2003  (unaudited) |                                                                                        |
|   |                                                                                                    |                                                                                        |
|   | Consolidated  Statements of Cash Flows - Three months ended October 31, 2004 and 2003  (unaudited) |                                                                                        |
|   |                                                                                                    |                                                                                        |
|   | 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 6.                                                                                                 | Exhibits and  Reports on Form 8-K                                                           |   |
|   |                                                                                                    |                                                                                        |   |
|   | SIGNATURES                                                                                              |                                                                                        |
|        |                                                                                                         |                                                                                             |  |  |

 

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**SHERWOODBRANDS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETSUNAUDITED**

** **
| ** **                                                                                                                   | ** ** | **October 31, 2004** | ** ** | **July 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|------------------------|------------|
| ** **                                                                                                                   | ** ** | ** **                | ** ** | ** **             | ** ** |
| Assets                                                                                                                       |       |                      |       |                   |       |
| Current assets                                                                                                               |       |                      |       |                   |       |
| Cash and cash  equivalents                                                                                                   |       | $                         | 13,801     |                   | $          | 10,808 |   |
| Accounts  receivable, less allowance of $134,000 and $103,000                                                                |       | 10,087,185                |       | 1,038,123              |       |
| Inventory                                                                                                                    |       | 12,949,310                |       | 9,591,268              |       |
| Income taxes  receivable                                                                                                     |       | —                    |       | 54,681                 |       |
| Other current  assets                                                                                                        |       | 631,272                   |       | 581,411                |       |
| Deferred taxes  on income                                                                                                    |       | 864,000                   |       | 864,000                |       |
| Total current  assets                                                                                                        |       | 24,545,568                |       | 12,140,291             |       |
| Net property and  equipment                                                                                                  |       | 5,866,430                 |       | 6,103,880              |       |
| Goodwill                                                                                                                     |       | 2,001,330                 |       | 2,001,330              |       |
| Other assets                                                                                                                 |       | 180,502                   |       | 160,952                |       |
| TOTAL ASSETS                                                                                                                 |       | $                         | 32,593,830 |                   | $          | 20,406,453 |   |
| Liabilities and  Stockholders’ Equity                                                                                   |       |                      |       |                   |       |
| Current  liabilities                                                                                                         |       |                      |       |                   |       |
| Line of credit                                                                                                               |       | $                         | 12,471,850 |                   | $          | 5,610,903 |   |
| Short-term Debt                                                                                                              |       | 467,800                   |       | —                 |       |
| Current portion  of long-term debt                                                                                           |       | 376,850                   |       | 465,239                |       |
| Current portion  of subordinated debt                                                                                        |       | 3,352,140                 |       | 3,397,140              |       |
| Current portion  of capital lease obligation                                                                                 |       | 16,688                    |       | 16,688                 |       |
| Accounts Payable                                                                                                             |       | 5,637,116                 |       | 3,241,708              |       |
| Accrued expenses                                                                                                             |       | 3,452,446                 |       | 1,761,894              |       |
| Total current  liabilities                                                                                                   |       | 25,774,890                |       | 14,493,572             |       |
| Deferred taxes  on income                                                                                                    |       | 864,000                   |       | 864,000                |       |
| Long-term debt                                                                                                               |       | 583,055                   |       | 617,774                |       |
| Obligations  under capital lease                                                                                             |       | 403,125                   |       | 407,204                |       |
| TOTAL  LIABILITIES                                                                                                           |       | 27,625,070                |       | 16,382,550             |       |
| Stockholders’  equity                                                                                                   |       |                      |       |                   |       |
| Preferred stock,  $.01 par value, 5,000,000 shares authorized; no shares issued or outstanding                               |       | —                    |       | —                 |       |
| Common stock,  Class A, $.01 par value, 30,000,000 shares authorized, 3,036,561 and  3,036,561 shares issued and outstanding |       | 30,366                    |       | 30,366                 |       |
| Common stock,  Class B, $.01 par value, 5,000,000 shares authorized, 1,000,000 shares issued  and outstanding                |       | 10,000                    |       | 10,000                 |       |
| Additional  paid-in-capital                                                                                                  |       | 9,893,349                 |       | 9,893,349              |       |
| Retained  earnings (deficit)                                                                                                 |       | (4,964,955                | )          | (5,909,812             | )          |
|                                                                                                                         |       |                      |       |                   |       |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                             |       | 4,968,760                 |       | 4,023,903              |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                             |       | $                         | 32,593,830 |                   | $          | 20,406,453 |   |

** **

See accompanying notes to consolidated financial statements.

 

1

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**SHERWOODBRANDS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS**UNAUDITED

** **
| ** **                                    | ** ** | **Three Months Ended October 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|                                          |       |                                    |       |   |   |
| Net sales                                     |       | $                                       | 11,692,537 |   | $ | 17,420,813 |   |
| Cost of sales                                 |       | 8,352,639                               |       | 12,384,142 |   |
| Gross profit                                  |       | 3,339,898                               |       | 5,036,671 |   |
| Selling, general  and administrative expenses |       | 1,166,121                               |       | 2,231,517 |   |
| Salaries and  related expenses                |       | 921,024                                 |       | 1,062,982 |   |
| Total operating  expenses                     |       | 2,087,145                               |       | 3,294,499 |   |
| Income from  operations                       |       | 1,252,753                               |       | 1,742,172 |   |
| Other income  (expense)                       |       |                                    |       |   |   |
| Interest income                               |       | 3                                       |       | 19 |   |
| Interest expense                              |       | (297,763                                | )          | (236,766 | ) |
| Other  (expense)income                        |       | (10,136                                 | )          | 4,537 |   |
| Total other  (expense)income                  |       | (307,896                                | )          | (232,210 | ) |
| Income before  provision for taxes on income  |       | 944,857                                 |       | 1,509,962 |   |
| Provision for  taxes on income                |       | —                                  |       | — |   |
| Net income                                    |       | $                                       | 944,857    |   | $ | 1,509,962 |   |
| Net income per  share-basic                   |       | $                                       | 0.23       |   | $ | 0.38 |   |
| -diluted                                      |       | 0.23                                    |       | 0.37 |   |
| Weighted average  shares outstanding-basic    |       | 4,036,561                               |       | 3,996,199 |   |
| -diluted                                      |       | 4,146,017                               |       | 4,136,235 |   |

 

See accompanying notes to consolidated financial statements.

 

2

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**SHERWOODBRANDS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWSUNAUDITED**

** **
| ** **                                                                    | ** ** | **Three months ended October 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                    | ** ** | **2004**                                | ** ** | **2003** | ** ** |
|                                                                          |       |                                    |       |   |   |
| Cash flows used  in operating activities                                      |       |                                    |       |   |   |
| Net income                                                                    |       | $                                       | 944,857    |   | $ | 1,509,962 |   |
| Adjustments to  reconcile net income to net cash used in operating activities |       |                                    |       |   |   |
| Depreciation  expense                                                         |       | 237,450                                 |       | 248,444 |   |
|                                                                          |       |                                    |       |   |   |
| Provision for  doubtful accounts                                              |       | 30,396                                  |       | 75,682 |   |
| (Increase)  decrease in assets                                                |       |                                    |       |   |   |
| Accounts receivable                                                           |       | (9,079,458                              | )          | (13,421,200 | ) |
| Income taxes  receivable                                                      |       | 54,681                                  |       | (49 | ) |
| Inventory                                                                     |       | (3,358,042                              | )          | (3,012,118 | ) |
| Other current  assets                                                         |       | (49,861                                 | )          | 88,878 |   |
| Other assets                                                                  |       | (19,550                                 | )          | (5,000 | ) |
| Increase  (decrease) in liabilities                                           |       |                                    |       |   |   |
| Accounts payable                                                              |       | 2,395,408                               |       | 2,877,533 |   |
| Accrued expenses                                                              |       | 1,690,552                               |       | 1,631,901 |   |
|                                                                          |       |                                    |       |   |   |
| Net cash used in  operating activities                                        |       | (7,153,567                              | )          | (10,005,966 | ) |
| Cash flows from  investing activities                                         |       |                                    |       |   |   |
| Proceeds from  sales of assets                                                |       | —                                  |       | 142,750 |   |
| Capital  expenditures                                                         |       | —                                  |       | (111,992 | ) |
| Net cash  provided by investing activities                                    |       | —                                  |       | 30,759 |   |
| Cash flows from  financing activities                                         |       |                                    |       |   |   |
| Net borrowings  on line of credit                                             |       | 6,860,947                               |       | 9,995,531 |   |
| Borrowing on  short-term debt                                                 |       | 467,800                                 |       | — |   |
| Payments on  subordinated debt                                                |       | (45,000                                 | )          | — |   |
| Payments on long  term debt                                                   |       | (127,187                                | )          | (126,266 | ) |
| Net cash  provided by financing activities                                    |       | 7,156,560                               |       | 9,869,265 |   |
| Net increase in  cash and cash equivalents                                    |       | 2,993                                   |       | (105,943 | ) |
| Cash and cash  equivalents, at beginning of period                            |       | 10,808                                  |       | 227,352 |   |
| Cash and cash  equivalents, at end of period                                  |       | $                                       | 13,801     |   | $ | 121,409 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**SHERWOODBRANDS, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED**)

 

**1.             BASIS OF PRESENTATION**

** **

The consolidated financial statements include theaccounts of Sherwood Brands, Inc., and its direct and indirect wholly-ownedsubsidiaries, Sherwood Brands, LLC, a Maryland limited liability company, SherwoodBrands of RI Inc., a Rhode Island corporation, Sherwood Brands Overseas, Inc.,a Bahamas entity (“Overseas”), and Asher Candy, Inc., a Wyoming corporation(collectively referred to herein as, “we”, “our”, “us” or, the “Company”). Allmaterial inter-company transactions and balances have been eliminated inconsolidation.

 

The accompanying consolidated financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States of America for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Certain informationand footnote disclosures normally included in the consolidated financialstatements prepared in accordance with accounting principles generally acceptedin the United States of America have been condensed or omitted pursuant to suchrules and regulations. These consolidated financial statements should be readin conjunction with the consolidated financial statements, and the notesthereto, included in the Company’s July 31, 2004 Annual Report and Form10-K filed on October 29, 2004.

 

**2.             ORGANIZATION AND DESCRIPTION OF BUSINESS**

** **

Sherwood Brands, Inc. was incorporated in December1982 in the state of North Carolina. Sherwood Brands, Inc. is engaged in the manufacture,marketing and distribution of a diverse line of brand name candies, cookies,chocolates and gifts. The Company manufactures lollipops, biscuits andassembles seasonal gift items including gift baskets for Christmas, ValentinesDay and Easter. The Company’s principal branded products include COWS(TM)butter toffee candies, DEMITASSE(R) biscuits, RUGER(R) wafers, SMILE POPS(R)lollipops, STRIP-O-POPS(R) lollipops, ELANA(R) chocolates, SOUR FRUIT BURST(TM)fruit-filled hard candies and  PIRATE’S GOLDCOINS(R) milk chocolates. The Company’s marketing strategy, including itspackaging of products, is designed to maximize freshness, taste and visualappeal, and emphasizes highly distinctive, premium quality products that aresold at prices that compare favorably to those of competitive products. TheCompany operates in the confectionery industry and aligns its operations intothree business segments for management to measure financial performance byproduct type.  The Company’s businesssegments are (i) Manufactured Candy and Cookies, (ii) Purchased Candy andCookies and (iii) Purchased Gift Items.

 

Sherwood Brands, Inc. is the owner of Sherwood Brands,LLC, a Maryland limited liability company. Sherwood Brands, LLC markets anddistributes its own line of confectionery products in the United States.

 

Sherwood Overseas, Inc. (a wholly-owned subsidiary ofSherwood Brands, LLC) was incorporated in July 1993 in the Bahamas tomarket and distribute the Sherwood lines of confectionery productsinternationally.

 

4

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Sherwood Brands of RI, Inc. is a wholly ownedsubsidiary of Sherwood Brands, Inc. that was incorporated in September, 1998 inthe state of Rhode Island. Sherwood Brands of RI, Inc. d/b/a E. Rosen Company,that prior to fiscal 2005, formerly manufactured hard candies and jelly beansand continues to assemble and market gift items and baskets to chains such asWal-Mart, Kmart and CVS.

 

Sherwood Acquisition Corporation, a wholly-ownedsubsidiary of the Company, was incorporated in April, 2002 in the state ofWyoming. On May 1, 2002, Sherwood Acquisition merged with and into Asher CandyAcquisition Corporation, a Wyoming corporation. Asher Candy AcquisitionCorporation is a manufacturer of candy canes and other hard candies under the “Asher”name. The surviving corporation of the merger is Asher Candy AcquisitionCorporation, which has changed its name to Asher Candy, Inc.

 

**3.             INTERIM FINANCIAL INFORMATION**

** **

The financial information as of October 31, 2004and for the three months ended October 31, 2004 and 2003 is un-audited. Inthe opinion of management, such information contains all adjustments,consisting only of normal recurring adjustments, necessary for a fairpresentation of the results for such periods. Results for interim periods arenot necessarily indicative of results to be expected for an entire year.

 

**The July 31, 2004 consolidated balance sheetamounts have been derived from the previously audited Consolidated BalanceSheet of Sherwood Brands, Inc.**

** **

**4.             INVENTORY**

** **

Inventory consists of raw materials, packaging materials, componentsused in assembly, work- in- process and finished goods and is stated at thelower of cost or market. Cost is determined by the FIFO (first-in, first-out)method. Inventory consists of the following:

 
| ** **                               | ** ** | **October 31   2004** | ** ** | **July 31   2004** | ** ** |
|------------------------------------------|------------|----------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **(unaudited)**            | ** ** | ** **              | ** ** |
| Raw materials  and ingredients           |       | $                          | 372,459    |                    | $          | 384,216 |   |
| Components used  in assembly             |       | 1,341,523                  |       | 1,043,036               |       |
| Packaging  materials                     |       | 2,802,970                  |       | 2,798,591               |       |
| Work-in-process                          |       | 84,065                     |       | 130,634                 |       |
| Finished product                         |       | 10,413,719                 |       | 7,262,339               |       |
|                                     |       |                       |       |                    |       |
|                                     |       | 15,014,736                 |       | 11,710,690              |       |
| Less reserve for  inventory obsolescence |       | (2,065,426                 | )          | (2,119,422              | )          |
|                                     |       |                       |       |                    |       |
|                                     |       | $                          | 12,949,310 |                    | $          | 9,591,268 |   |

 

5

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**5.             USE OF ESTIMATES**

** **

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosures of contingent assets andliabilities at the date of the financial statements and reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates.

 

**6.             INCOME TAXES**

** **

Income taxes are calculated using the liability methodspecified by Statement of Financial Accounting Standards No. 109, “Accountingfor Income Taxes (SFAS 109).” Under SFAS 109, deferred taxes are determinedusing the liability method, which requires the recognition of deferred taxassets and liabilities based on differences between the financial statement andthe income tax basis using presently enacted tax rates.

** **

**The income tax rate utilized on an interim basis isbased on the Company’s estimate of the effective income tax rate for the fiscalyear ending July 31, 2004. The Company has a net operating loss carryforward which management believes will offset all taxable income generated infiscal year 2004.  Therefore, the Companyestimated its effective tax rate at 0%.**

 

**7.             STOCKBASED COMPENSATION**

 

**The Company adopted the disclosureonly provisions of Statement of Financial Accounting Standards No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure-An Amendment of SFAS No.123” (“SFAS 148”), but continues to measure compensation cost for the stockoptions using the intrinsic value method prescribed by APB Opinion No. 25.  Compensation expense, if any, is measured asthe excess of the market price of the stock over the exercise price on the measurementdate.  No compensation expense isrecognized for the Company’s option grants that have an exercise price equal tothe market price on the date of the grant. As allowable under SFAS 148, theBlack-Sholes method to measure the compensation cost of stock optionsgranted.  The Company did not grant anystock options to employees in the quarters ended October 31, 2004 or 2003.**

** **

There were no adjustments made in calculating the fairvalue to account for vesting provisions, for non-transferability or risk offorfeiture. Because our employee stock options have characteristicssignificantly different from those of traded options, and because changes inthe subjective input assumptions can materially affect the fair value estimate,in management’s opinion, the existing models do not necessarily provide areliable single measure of the fair value of its employee stock options.

 

6

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If we had elected to recognize compensation cost basedon the value at the grant dates with the method prescribed by SFAS 148, netincome and earnings per share would have been changed to the pro forma amountsindicated in the following table:

 
| ** **                                                                                                                                    | ** ** | **For the three months ended October 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                                        | ** ** | **2003** | ** ** |
| Net Income                                                                                                                                    |       |                                            |       |   |   |
| As Reported                                                                                                                                   |       | $                                               | 944,857    |   | $ | 1,509,962 |   |
|                                                                                                                                          |       |                                            |       |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | —                                          |       | 26,000 |   |
|                                                                                                                                          |       |                                            |       |   |   |
| Pro Forma net  income                                                                                                                         |       | $                                               | 944,857    |   | $ | 1,483,962 |   |
| Basic Income per  Common Share:                                                                                                               |       |                                            |       |   |   |
| As Reported                                                                                                                                   |       | $                                               | 0.23       |   | $ | 0.38 |   |
| Pro Forma                                                                                                                                     |       | 0.23                                            |       | 0.37 |   |
| Diluted income  per Common Share:                                                                                                             |       |                                            |       |   |   |
| As Reported                                                                                                                                   |       | $                                               | 0.23       |   | $ | 0.37 |   |
| Pro Forma                                                                                                                                     |       | 0.23                                            |       | 0.36 |   |

** **

**8.             EARNINGS PER SHARE**

** **

Earnings per share is based on the weighted averagenumber of shares of common stock and dilutive common stock equivalentsoutstanding during the period.  Basicearnings per share includes no dilution and is computed by dividing incomeavailable to common shareholders by the weighted average number of commonshares outstanding for the period. Diluted earnings per share reflects the potential dilution of securitiesthat could share in the earnings of an entity. Antidilutive options are excluded from the earnings per sharecalculations when the option price exceeds the average market price of thecommon shares for the period. The following table presents a reconciliationbetween the weighted average shares outstanding for basic and diluted earningsper share for the three months ended October 31, 2004 and October 31,2003:

 
| **For  the three months ended October 31, 2004** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per Share Amount** | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|----------------------|------------|
|                                                  |       |       |       |       |       |                 |       |
| Basic earnings  per share                             |       |       |       |       |       |                 |       |
| Income available  to common shareholders              |       | $          | 944,857    |       | 4,036,561  |                 | $          | 0.23 |   |
| Effect of  dilutive stock options                     |       |       |       | 109,456    |       |                 |       |
| Dilutive  earnings per share                          |       | $          | 944,857    |       | 4,146,017  |                 | $          | 0.23 |   |

 

7

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| **For  the three months ended October 31, 2003** | ** ** | **Income** | ** ** | **Shares** | ** ** | **Per Share Amount** | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|----------------------|------------|
|                                                  |       |       |       |       |       |                 |       |
| Basic earnings  per share                             |       |       |       |       |       |                 |       |
| Income available  to common shareholders              |       | $          | 1,509,962  |       | 3,996,199  |                 | $          | 0.38 |   |
| Effect of  dilutive stock options                     |       |       |       | 140,036    |       |                 |       |
| Dilutive  earnings per share                          |       | $          | 1,509,962  |       | 4,136,235  |                 | $          | 0.37 |   |

 

**9.             CONTINGENCY**

** **

The Company is, from time to time, involved inlitigation incidental to the conduct of its business. The Company is currentlyinvolved in several actions.  Inparticular, the Company is currently involved as Plaintiff in a suit broughtbefore the Circuit Court for Montgomery County, Maryland, presenting claims inconnection with the merger agreement under which Sherwood Brands acquiredsecurities of Asher Candy Acquisition Corporation and agreed to sell securitiesin Sherwood Brands to prior shareholders of Asher Candy.  The complaint alleges that the Company wasfraudulently induced to enter into the merger agreement on the basis of, amongother things, material misrepresentations and omissions by the shareholders ofAsher Candy.  Sherwood Brands is seekingdeclaratory and injunctive relief and award of damages against the formershareholders of Asher Candy for violations of the merger agreement and forcommon law fraud and violations of applicable securities laws.  Pending resolution of the litigation, theCompany has refused to honor the demand of the former shareholders for theCompany to repurchase half of the shares issued to them at a price of $4.50 pershare. Certain of the shareholders have filed a counterclaim seeking $7.0million in damages.  The Company believesthat it has defenses to the counterclaim. There can be no assurance that theCompany will not be a party to other litigation in the future.

** **

**10.          LICENSING AGREEMENTS**

** **

During the quarter ended October 31, 2004, theCompany entered into two licensing agreements to incorporate products into giftsets. The royalty rates for such licenses are from 3% to 5% of net sales andexpire in range of three years.

 

The products are to be incorporated into the Company’s gift set itemsduring the Christmas and Easter holiday season. The Company paid $3,000 inadvance fees for the licenses. These advance fees will be offset against anyamounts due on royalties. There is a $5,000 minimum guaranteed license feeunder these agreements. The Company incurred $172,982 and $212,047 in royaltiesfor the quarters ended October 31, 2004 and 2003, respectively. TheCompany is currently pursuing other licenses with similar terms and conditions.

 

8

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**11.          CREDIT FACILITY**

 

During the quarter ended October 31, 2004, theCompany was in compliance with the financial covenants under its creditfacility relating to the fixed charge coverage ratio. Management believes thatthe Company will maintain compliance with the restrictive covenants for theremainder of 2005.

 

**12.          CONCENTRATIONOF CREDIT RISK AND EXPORT SALES**

 

The Company has a variety of customers, including massmerchandisers, drug stores and grocery stores throughout the United States andabroad. For the quarter ended October 31, 2004 three customers accountedfor approximately 21%, 10% and 7% of the Company’s net sales. For the quarterended October 31, 2003 the same three customers accounted forapproximately 16%, 8% and 4% of the Company’s total net sales.  The Company had sales to customers in Canada,which represent 0.64% and 0.23% of net sales for the quarters ended October 31,2004 and 2003, respectively.

 

9

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**13.          OPERATINGSEGMENTS**

 

We operate in the confectionery industry and align ouroperations into three business segments for management reporting purposes.These segments are based on product type. This alignment allows management tomeasure financial performance by product type. Our business segments are (i)Manufactured Candy and Cookies, (ii) Purchased Candy and Cookies and (iii)Purchased Gift Items. We report these as reportable segments in accordance withSFAS 131, “Disclosures about Segments of an Enterprise and Related Information.”The accounting policies of the operating segments are the same as those describedin the summary of significant accounting policies.

 

Our Chief Operating Decision Maker, who is ourChairman and Chief Executive Officer, evaluates performance based upon ameasure of segment operating profit or loss that includes an allocation of commonexpenses, but excludes some unallocated expenses. Unallocated expensesrepresent corporate expenditures that are not specifically allocated to thesegments.

 

**Ourreportable segments are strategic business units that offer differentproducts.  We have minimal assets outsideof the United States.  There is noconcentration of net sales in any one area within the United States.  Net sales outside of the United States areminimal.**

** **
| ** **                     | ** ** | ** **             | ** ** | **Three Months ended October 31, 2004** | ** ** |
|--------------------------------|------------|------------------------|------------|----------------------------------------------|------------|
| ** **                     | ** ** | **Manufactured Candy** | ** ** | **Purchased Candy**                          | ** ** | **Gift Items** | ** ** | **Other** | ** ** | **Consolidated Total** | ** ** |
| Total revenue                  |       | $                      | 2,279,846  |                                         | $          | 9,016,923 |   | $ | 395,768 |   | $ | — |   | $ | 11,692,537 |   |
| Gross margin                   |       | (832,179               | )          | 4,068,770                                    |       | 103,029 |   | — |   | 3,339,620 |   |
| Interest expense               |       | 142,926                |       | 108,438                                      |       | 46,399 |   | — |   | 297,763 |   |
| Segment assets                 |       | 8,895,676              |       | 12,943,867                                   |       | 9,790,651 |   | 963,636 |   | 32,593,830 |   |
| Depreciation and  amortization |       | 136,411                |       | 57,075                                       |       | 32,649 |   | 11,315 |   | 237,450 |   |
|                                |            |                        |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | ** **             | ** ** | **Three Months ended October 31, 2003** | ** ** |
|--------------------------------|------------|------------------------|------------|----------------------------------------------|------------|
| ** **                     | ** ** | **Manufactured Candy** | ** ** | **Purchased Candy**                          | ** ** | **Gift Items** | ** ** | **Other** | ** ** | **Consolidated Total** | ** ** |
| Total revenue                  |       | $                      | 5,605,903  |                                         | $          | 8,302,312 |   | $ | 3,515,126 |   | $ | — |   | $ | 17,420,813 |   |
| Gross margin                   |       | 90,326                 |       | 3,801,575                                    |       | 1,147,298 |   | — |   | 5,036,671 |   |
| Interest expense               |       | 113,643                |       | 86,225                                       |       | 36,893 |   | — |   | 236,766 |   |
| Segment assets                 |       | 10,731,663             |       | 17,662,819                                   |       | 12,640,937 |   | 1,355,713 |   | 42,391,132 |   |
| Depreciation and  amortization |       | 172,919                |       | —                                       |       | 33,884 |   | 41,868 |   | 248,444 |   |
|                                |            |                        |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

** **

Important InformationRegarding Forward-Looking Statements

 

This quarterly report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended. Those statements include statements regarding the intent,belief or current expectations of the company and its management.  Such forward-looking statements are subjectto a variety of risks and uncertainties, many of which are beyond our control,which could cause actual results to differ materially from those contemplatedin such forward-looking statements, including in particular the risks anduncertainties described under “Risk Factors” in our Form 10-K filed with thecommission on October 29, 2004. Existing and prospective investors arecautioned not to place undue reliance on these forward-looking statements,which speak only as of the date hereof. We undertake no obligation to update orrevise the information contained in this quarterly report on Form 10-Q, whetheras a result of new information, future events or circumstances or otherwise.

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of certain assets and liabilities at the date of the financialstatements. Significant estimates in our financial statements include theaccounts receivable and inventory reserves. We continually evaluate thesereserves based upon historical experience. Although actual results could differfrom those disclosed, management feels that the estimates used to establish thereserves are conservative in nature. Furthermore, management contends that itwould be unlikely that the reserve level would be materially different from anyother independently prudently established reserve.

 

If any of the following risks occurs, our business, financial conditionor results of operations could be adversely affected.

 

The loss of a significant customer could have anadverse effect on our business. We are dependent on a limited number ofcustomers for a significant portion of our revenues. Big Lots, Dollar Generaland Rite Aid accounted for approximately 21%, 10% and 7%, respectively, ofsales for the three months ended October 31, 2004. Big Lots, DollarGeneral and Rite Aid accounted for approximately 17%, 8% and 4%, respectively,of sales for the quarter ended October 31, 2003. Sam’s Club and Wal-Martaccounted for approximately 0% and 4% of our sales for quarter ended October 31,2004 and 12% and 8% of our sales for quarter ended October 31, 2003,respectively. We do not maintain agreements with our customers and sellproducts pursuant to purchase orders placed from time to time in the ordinarycourse of business. The loss of a significant customer could have an adverseeffect on our business.

 

We face significant competition in the marketing andsales of our products. Our products compete for consumer recognition and shelfspace with candies, cakes, cookies, chocolates and other food products whichhave achieved international, national, regional and local brand recognition andconsumer loyalty. These products are marketed by companies (which may 

 

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include our suppliers) with significantly greaterfinancial, manufacturing, marketing, distribution, personnel and otherresources than we have. Some of these competitors, such as Hershey Food Corporation,Masterfoods USA (M&M Mars), Inc., Nestle, S.A., and Kraft Foods, dominatethe markets for candy and cookie products, and have substantial promotionalbudgets which enable them to implement extensive advertising campaigns. Thefood industry is characterized by frequent introductions of new products,accompanied by substantial promotional campaigns. If we are unable to continueto compete successfully our business could be adversely affected.

 

Our success is highly dependent on consumerpreferences and industry factors. The markets for candy and cookie products areaffected by changes in consumer tastes and preferences and nutritional andhealth-related concerns. We could be subject to increased competition fromcompanies whose products or marketing strategies address these concerns. Inaddition, the markets for our products may be subject to national, regional andlocal economic conditions which affect discretionary spending, demographictrends and product life cycles, whereby product sales increase from theirintroductory stage through their maturity and then reach a stage of declineover time.

 

We have limited historical profitability and may notbe profitable in the future. We have historically, until recently, achievedlimited profitability. Our operating expenses have increased and can beexpected to continue to increase in connection with any expansion activitiesundertaken by us, including those relating to advertising and productmanufacturing. Accordingly, our profitability will depend on our ability toimprove our operating margins and increase revenues from operations.Unanticipated expenses, unfavorable currency exchange rates, increased pricecompetition and adverse changes in economic conditions could have a materialadverse effect on our operating results. If we are unable to achievesignificantly increased levels of revenues, our future operations may notcontinue to be profitable.

 

We depend on our trademarks. We hold United Statestrademark registrations for the “ELANA,” “RUGER”, “TONGUE TATTOO”, “STRIP-O-POP”,“SMILE POPS” and “demitasse” names, and have filed applications to registercertain other names, including “COWS,” and use other names for which we havenot applied for registration. We believe that our rights to these names are asignificant part of our business and that our ability to create demand for ourproducts is dependent to a large extent on our ability to exploit thesetrademarks. Our failure to protect our trademarks and other intellectualproperty rights could negatively impact the value of our brand names. We arenot aware of any other infringement claims or other challenges to our rights touse these marks.  We have requested someof our marks to be registered in countries other than the U.S. and may applyfor additional registration as appropriate, based on our needs to register ourmarks for worldwide distribution.

 

We are dependent on third party manufacturers andsuppliers. We are dependent on the ability of our manufacturers to adhere toour product, price and quality specifications and scheduling requirements. Ouroperations require us to have production orders in place in advance of shipmentto our warehouses (product deliveries typically take 60 days). Any delay bymanufacturers in supplying finished products to us would adversely affect ourability to deliver products on a timely and competitive basis. In addition, rawmaterials necessary for the 

 

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manufacture of our products at our facilities,including flour, sugar, shortening, butter and flavorings, are purchased fromthird-party suppliers. We do not maintain agreements with any such suppliersand we are, therefore, subject to risks of periodic price fluctuations,shortages and delays. If there is a material interruption in the availabilityor significant price increases for raw materials would have a material adverseeffect on our operating margins.

 

We face various risks relating to foreignmanufacturing. During the three months ended October 31, 2004 and 2003, approximately77% and 45%, as a percent of net sales, or $9,016,924 and $8,302,312,respectively, of our products were manufactured in foreign countries. We havebeen and will continue to be subject to risks associated with the manufactureof products in foreign countries, primarily in Argentina, Austria, Belgium,Brazil, China and Holland. These risks include material shipping delays,fluctuations in foreign currency exchange rates, customs duties, tariffs andimport quotas and international political, regulatory and economicdevelopments. We assume the risk of loss, damage or destruction of productswhen shipped by a manufacturer. Because we pay for some of our productsmanufactured outside the United States in foreign currencies, any weakening ofthe United States dollar in relation to relevant foreign currencies, couldresult in significantly increased costs to us. In addition, some productsmanufactured overseas are subject to import duties. Deliveries of products fromour foreign manufacturers could also be delayed or restricted by the futureimposition of quotas. If quotas were imposed, it is possible that we would notbe able to obtain quality products at favorable prices from domestic or othersuppliers whose quotas have not been exceeded by the supply of products totheir existing customers.

 

Our operating results are subject to fluctuations as aresult of new product introductions, the timing of significant operatingexpenses and customer orders, delays in shipping orders, pricing andseasonality.  We are subject togovernment regulation. We are subject to extensive regulation by the UnitedStates Food and Drug Administration, the United States Department ofAgriculture and by other state and local authorities in jurisdictions in whichour products are manufactured or sold. Among other things, such regulationgoverns the importation, manufacturing, packaging, storage, distribution andlabeling of our products, as well as sanitary conditions and public health andsafety. Applicable statutes and regulations governing our products include “standardsof identity” for the content of specific types of products, nutritionallabeling and serving size requirements and general “Good ManufacturingPractices” with respect to manufacturing processes. Our facilities and productsare subject to periodic inspection by federal, state and local authorities. Ourfailure to comply with applicable laws and regulations could subject us tocivil remedies, including fines, injunctions, recalls or seizures, as well aspotential criminal sanctions.

 

We may incur product liability claims that are notfully insured. As a manufacturer and marketer of food products, we are subjectto product liability claims from consumers. We maintain product liabilityinsurance with limits of $2,000,000 in the aggregate and $1,000,000 peroccurrence (with excess coverage of $10,000,000). These insurance amounts maynot be sufficient to cover potential claims and adequate levels of coverage maynot be available in the future at a reasonable cost. In the event of apartially or completely uninsured successful claim against us, our financialcondition and reputation would be materially adversely affected.

 

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We are dependent on key personnel and the loss ofthese key personnel could have a material adverse effect on our success. Oursuccess is dependent on the personal efforts of Uziel Frydman, our Chairman,President and Chief Executive Officer, Amir Frydman, our Vice President ofMarketing and Christopher Willi, our Chief Financial Officer. The loss orinterruption of the services of such individuals could have a material adverseeffect on our business. We maintain “key-man” insurance in the amount of $1,000,000on the life of Mr. Uziel Frydman. Our success also depends upon our ability tohire and retain additional qualified management, marketing and other personnel.Employment and retention of qualified personnel is important due to thecompetitive nature of the food industry. Our failure to hire and retainqualified personnel could adversely affect our success.

 

Our President and Chief Executive Officer controls ourcompany. Mr. Uziel Frydman, President and Chief Executive Officer, owns 400,000shares of Class A Common Stock (with a right to acquire an additional 202,984upon the exercise of options) and 1,000,000 shares of Class B Common Stock,representing, in the aggregate, approximately 38% of the outstanding CommonStock of our company and 74% of the voting control of our company, assumingthat all of Mr. Frydman’s options are exercised. Accordingly, Mr. Frydman willbe able to direct the election of all of our company’s directors, increase theauthorized capital, dissolve, merge or sell the assets of our company, andgenerally direct the affairs of our company. In addition, the level of controlexercised by Mr. Frydman may discourage investors from purchasing our CommonStock.

 

We may issue “blank check” preferred stock that wouldprevent a change of control. Our Articles of Incorporation, as amended,authorize our board of directors to issue up to 5,000,000 shares of “blankcheck” preferred stock without stockholder approval, in one or more series andto fix the dividend rights, terms, conversion rights, voting rights, redemptionrights and terms, liquidation preferences, and any other rights, preferences,privileges, and restrictions applicable to each new series of preferred stock.The issuance of shares of preferred stock in the future could, among otherthings, adversely affect the voting power of the holders of common stock and,under certain circumstances, could make it difficult for a third party to gaincontrol of our company, prevent or substantially delay a change in control,discourage bids for the Common Stock at a premium, or otherwise adverselyaffect the market price of the Common Stock.

 

We have never paid any cash dividends on our commonstock and do not anticipate paying cash dividends in the foreseeablefuture.  The payment of cash dividends isprohibited by the terms of our financing agreements.

 

For the year ended July 31, 2004 and first quarterended October 31, 2004, we had a total of eighteen licensing agreements, twosigned during first quarter ended October 31, 2004, three signed during thefiscal year ended July 31, 2004 and fifteen signed as of our fiscal year endedJuly 31, 2003. However, two were not renewed upon expiration.  The licenses are to incorporate products intogift sets and to manufacture candies and wafers. The royalty rates for suchlicenses range from 2% to 12% of net sales and expire in 2 to 3 years. Theproducts to be incorporated into our gift set items are primarily for the firstquarter and Easter selling season. We entered into a licensing agreement toproduce everyday candies and wafers. We paid a total of $939,000 in advancefees for the rights under the licensing agreement since inception. Theseadvance fees were offset against any amounts due on royalties. There were noother minimum license fees 

 

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under this agreement. We incurred $172,982 and$212,047 in royalties for the quarter ended October 31, 2004 and 2003,respectively. We are currently pursuing other licenses with similar terms andconditions. We expect the greatest impact from the agreements will occur in theyear ending July 31, 2005.

 

Christmas and Easter gift sets and gift baskets areassembled and distributed from our Massachusetts facility. We purchase productprimarily from the Pacific Rim. We are continually looking to further reducecosts by more efficient sourcing.

 

Duringthe first quarter of fiscal 2005, Sherwood Brands closed the New Hyde Park, NewYork location as of October 29, 2004. Sherwood incurred approximately $25,000 expenses in closure andseverance costs.  The company’s currentassets previously located at the New Hyde Park facility have been moved to ourChase City, Virginia facility and some will be moved to our overseas suppliersduring the second quarter ending January 31, 2005.

 

**In the fall of 2003, Sherwood Brands began movingits hard candy manufacturing to overseas suppliers.  Sherwood Brands finalized a production andmanufacturing agreement with the largest manufacturer in Argentina and SouthAmerica.  This Argentine manufacturer isone of Sherwood Brands’ key suppliers, specializing in manufacture of hardcandies, chocolates, cookies and butter toffees. The Argentine company does nothave the equipment or the facilities to completely take over the production ofall our product lines.  The Chase Cityfacility continues to produce certain products, which the Argentine companycannot yet produce.  The Chase Cityfacility also is being utilized as a warehouse for Christmas seasonal itemsthat need to be shipped to our southeast region customers.**

** **

**In Spring 2004, Sherwood entered into a productionagreement with a second Argentine company to manufacture lollipops. Sherwoodbenefits from the expertise and technology of the second Argentine company inlollipop production. The second Argentine company is using a combination ofSherwood equipment and their own equipment allowing Sherwood to increasemargins, capacity and marketability of Sherwood products.**

 

Wedid not extend the term of the lease for our Rhode Island facility and wevacated the location on March 31, 2004. Instead we are using our New Bedford, Massachusetts facility and variousWest Coast facilities to assemble and ship our products.  The proximity of these facilities to ourcustomers reduces our freight costs.

 

**EnvironmentalFactors Affecting the Performance in the Quarter Ended October 31, 2004.**

 

During the quarter ended October 31, 2004, West Coastports experienced a backup of cargo ships, railroads and truck lines, delayingshipments of Asian made goods. Offshoring, outsourcing and importing are on therise. The Commerce department recently stated that trade deficit (the amount offoreign goods imported into the United States vs. the amount of United Statesgoods shipped abroad), swelled to $54 billion in August, just shy of the $55billion record deficit in June.  Much ofthe world’s production is rapidly moving to China, which is producing toys,clothes and shoes faster than the rest of the world can import them.  Los Angeles and Long Beach receive the majorityof the Chinese imports. Volumes flowing through Los Angeles port 

 

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alone have climbed 10% this year, on top of a 20%increase in 2003.  August, September andOctober have always been busy months for the ports of Long Beach and LosAngeles because of holiday shipments, but the rise of imports by mega-retailerssuch as Wal-Mart and Target further increased traffic.  There are not enough dockworkers to unloadshipments. Machinery used to unload ships is scarce and old.  After container ships finally tie up at thedock, it takes more than 10 days to get them unloaded, rather than the usualthree to four days.  With oil prices climbingand the price of diesel fuel on the rise, a new source of backlog is beingcreated; a lack of truckers willing to haul containers. Many truckers areresponding by turning away jobs or by leaving the business, as stated in arecent article in USA Today.  The railsystems that transport most of the goods out of the Los Angeles and Long Beachports have also experienced backlogs, labor shortages and lack of equipment.The contentious relationship between the port operators and the dominant union,the International Longshore and Warehouse Union, has resulted in a shortage ofworkers and technology needed to keep up with the boom in imports.  Tensions hit a breakpoint two years ago, whencontract talks shut down the ports. Since then, port operators have been slow to hire workers.  Recently an additional 5,000 workers werebeing hired and the union is training new workers as fast as it can.

 

Our revenues for the three months ended October 31,2004 were impacted by the delays and resulted in a delay of approximately $5.0million in sales.  The remaining goodsscheduled for shipment in the first quarter will be shipped during the secondquarter of fiscal year 2004.

 

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**Resultsof Operations**

 

**ThreeMonths Ended October 31, 2004 and 2003**

 

**Net Sales**

 

Net sales for the three months ended October 31, 2004and 2003 were $11,692,537 and $17,420,813, respectively, a decrease of 32.9%,or $5,728,276.  The decline in net saleswas due to lower sales of manufactured candy of approximately $3.3 million.This was due to a decision by management to curtail manufacturing operationsand purchase goods directly from foreign suppliers.  This decrease is offset by an increase insales of purchased candy of $0.8 million and a decrease of $3.0 million onsales of gift sets largely due to similar orders being shipped in the firstquarter in the prior year that are being shipped in the second quarter of thefiscal year ending July 31, 2005. Big Lots, Dollar General, Rite Aid and DollarTree Stores accounted for approximately 21%, 10%, 7% and 7%, respectively, of salesfor the three months ended October 31, 2004. Big Lots, Dollar General, Rite Aidand Dollar Tree Stores accounted for approximately 17%, 8%, 4% and 13%,respectively, of sales for the prior year’s comparable period.

 

Netsales for each of our business segments were as follows:

 

Net sales of Manufactured Candy and Cookies decreasedfrom $5.6 million for the three months ended October 31, 2003 to $2.3 millionfor the three months ended October 31, 2004. The decrease of $3.3 million was primarily due to a decline of $2.7million of sales of manufactured candy canes, of which $2.3 million ofproduction was shifted to our overseas suppliers as Purchased Candy andCookies. The remaining decline was primarily related to $0.3 million decline inproduction of everyday lollipops, $0.2 million decline in Kastins Christmascandy and $0.1 million decline in Cows sales. These declines are primarily due to the impact of shifting our completemanufacturing operations to our overseas suppliers in Argentina and China, whicheliminates the variable costs associated with manufacturing in the UnitedStates. We are currently purchasing these items from our overseas suppliers.

 

Net sales of Purchased Candy and Cookies increasedfrom $8.3 million for the three months ended October 31, 2003 to $9.0 millionfor the three months ended October 31, 2004. The increase of $0.7 million wasprimarily due to increases in the sale of purchased candy canes of $2.3million.  This was offset by a $1.0 milliondecline of purchased gift items, which were shifted into the second quarter ofthe fiscal year ending July 31, 2005 due to the port delays on the west coast,a decrease of Halloween purchased candy of $0.8 million and an increase of $0.2million of gold coins for Christmas holiday.

 

Net sales of Purchased Gift Items decreased from $3.5million for the three months ended October 31, 2003 to $0.4 million for theperiod ended October 31, 2004.  The $3.1million decrease was primarily a result of a $3.1 million decrease of sales ofChristmas assembled goods due to shipment delays of goods not received from thewest coast ports due to delayed transportation and unloading of vessels at theports. See environmental factors effecting performance above for furtherdetails.

 

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**Gross Margins**

 

Gross margins decreased to $3.3 million for the threemonths ended October 31, 2004 from $5.0 million for the three months endedOctober 31, 2003, and decreased to 28.6% from 28.9% as percent of sales,respectively. The decrease was largely attributable to absorption ofmanufacturing facility costs at our New Hyde Park, New York facility, which wasclosed for operation in the United States on October 29, 2004.

 

Grossmargins for each of our business segments were as follows:

 

Gross margins on our Manufactured Candy and Cookiesdecreased from $0.1 million to ($0.8) million for the three months endedOctober 31, 2003 and 2004, respectively. The decrease was mainly attributable to increased labor costs andoverhead absorption expenses at our manufacturing plant in New Hyde Park, NewYork.

 

Gross margins for our Purchased Candy and Cookiesincreased from $3.8 million to $4.1 million for the three months ended October31, 2003 and 2004, respectively. The increase was primarily due to purchasedpre-packed assembled gift items that were not assembled in our New Bedford,Massachusetts facility and better pricing of purchased candy from our thirdparty overseas suppliers.

 

Gross margins on our Purchased Gift Items decreasedfrom $1.1 million to $0.1 million for the three months ended October 31, 2003and 2004, respectively.  The decrease wasdue primarily to the decrease of the number of products being assembled at ourNew Bedford, MA facility as a result of the delays in our shipments beingtransferred from the west coast ports, due to shipment delays at the west coastports due to delayed transportation and unloading of vessels at the ports.  See environmental factors effectingperformance above for further details.

 

**Operating Expenses**

 

Operatingexpenses for the three months ended October 31, 2004 decreased to $2.1 millionfrom $3.3 million for the three months ended October 31, 2003 and decreased to17.9% from 18.9%, respectively, as a percent of sales.

 

During the three months ended October 31, 2004 and2003, selling, general and administrative expenses decreased to $1.2 millionfrom $2.2 million, respectively, and decreased to 10.0% from 12.8% as a percentof sales, respectively. The decrease was largely due to decreases in thefollowing: $36,000 in travel expenses in the prior year relating to trips toChina, $340,000 of shipping and carrier costs, due to direct shipments to ourcustomers, $4,000 in building rental costs, $237,000 in broker commissions dueto better negotiated fees, $205,000 in advertising and promotional costs,$20,000 in bank fees and $158,000 in public warehouse storage costsattributable to the consolidation of public facilities into our own facilities.

 

Salaries and related expenses decreased to $921,024 forthe three months ended October 31, 2004, from $1,062,982 for the three monthsended October 31, 2003, or 7.9% from 6.1%, respectively, as a percent of sales.This decrease resulted from a decline of $142,000 in our 

 

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overhead due to our reorganization effort started inthe fourth quarter of the fiscal year ended July 31, 2004 and continued throughthe first quarter ending October 31, 2004.

 

**IncomeFrom Operations**

 

Income from operations for the three months endedOctober 31, 2004 was $1.3 million as compared to income of $1.7 million for theprior year’s comparable period, or 10.7% and 10.0% as a percent of net sales,respectfully. Most of the decrease resulted from the decrease in product salesand other expense explained in results from operating expenses.

 

**Interest Incomeand Expense**

 

For the three months ended October 31, 2004, interestincome decreased to $3 from $19 for the three months ended October 31, 2003 ascash reserves declined. For the three months ended October 31, 2004, interestexpenses increased to $297,763 from $236,766 for the three months ended October31, 2003, due to an increase in subordinated debt financing for a total of $3.3million and increased interest rates from Libor plus 2.35% which was at 4.4% toPrime plus 3.0% currently at 7.75% associated with our new bank agreementextension.

 

**OtherIncome/Expense**

 

For the three months ended October 31, 2004, otherincome/expenses increased to expense of $10,137 from income of $4,537 for thethree months ended October 31, 2003 due to $10,000 of realized losses onforeign exchange transactions.

 

**Income Tax Benefit**

 

**The income tax rate utilized on an interim basis isbased on the Company’s estimate of the effective income tax rate for the fiscalyear ending July 31, 2005. The Company has a net operating loss carry forwardwhich management believes will offset all taxable income generated in fiscalyear 2005.  Therefore, the Companyestimated its effective tax rate at 0%.**

 

**Critical AccountingPolicies and Estimates**

 

**Management has determined that the Company’s mostcritical accounting policies are those related to revenue recognition,inventory obsolescence, long-lived assets, litigation and income taxes.  The Company continues to monitor itsaccounting policies to ensure proper application.  There have been no changes to these policiesas discussed in the Company’s Annual Report on Form 10-K for the fiscal yearended July 31, 2004.**

 

**Liquidityand Capital Resources**

 

Our primary cash requirements have been to fund thepurchase, manufacture and commercialization of our products. We finance ouroperation and manufacturing with cash flow from operations and bank financing.Our working capital at October 31, 2004 and July 31, 2004 was ($1,229,321) and($2,353,281), respectively.

 

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The Company during the fiscal year ending July 31,2004 had a need to borrow $1.4 million of additional subordinated debt to meetits working capital needs and the bank provided additional out of formulaadvances against is collateral base of $1,000,000 to support the up comingseasonal activity in the Company. Management feels that it should be able tosustain positive working capital going forward into the fiscal year ending July31, 2005. In addition, the Company supplemented borrowing during the quarterended October 31, 2004 with an uncollateralized loan of $467,800 due onDecember 31, 2004 from an unrelated individual third-party at an interest rateequal to that of our subordinated debt.

 

**FinancialCondition**

 

**Assets**

 

Totalassets increased to $32,593,830 at October 31, 2004 from $20,406,453 at fiscalyear ended July 31, 2004.  This is anincrease of $12,187,377. The increase was mainly attributable to $9,049,062 inaccounts receivable and $3,358,042 in inventory, due to the increased level ofsales for the Christmas season.

 

Asof October 31, 2004, current assets increased to $24,545,568 from $12,140,291as of fiscal year ended July 31, 2004, an increase of $12,405,277 or102.2%.  The increase was primarily dueto and increase of $9,049,062 in accounts receivable and $3,358,042 ininventory, related to the levels of Christmas season orders to ship.

 

Asof October 31, 2004, plant, property and equipment decreased to $5,866,430 from$6,103,880 as of fiscal year ended July 31, 2004, a decrease of  $237,450 or 3.9%.  This decrease was associated with thedepreciation of the assets of $237,450.

 

**Liabilities**

 

As of October 31, 2004 totalliabilities increased to $27,625,070 from $16,382,550 as of the fiscal yearended July 31, 2004, an increase of $11,242,520 or 68.6%.  Theincrease primarily reflects additional borrowing of $6,860,947 on its workingcapital facility, additional borrowings of $467,800 of short-term debt, $2,395,408of accounts payables and  $1,690,552 ofaccrued expenses and offset by the payments on its long term and subordinateddebt of $172,187. The increases are primarily due to the Company’s Christmasseasonal orders being shipped to our customers in the first and second quarterof our fiscal year ending in July 31, 2005.

 

**CapitalStructure**

 

The Company hastwo classes of stock outstanding, Class A Common Stock and Class B Common Stock(collectively the “Common Stock”), that are substantially identical, exceptthat the Class A Common Stock is entitled to one vote per share and the Class BCommon Stock is entitled to seven votes per share on all matters, including theelection of directors. Uziel Frydman, Chairman, President and Chief ExecutiveOfficer of the Company, beneficially owns 400,000 shares of Class A CommonStock and all of the 1,000,000 share of Class B Common Stock outstanding andcontrols the Company.

 

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**CashFlows:**

 

**Net cash used in Operating Activities:**

 

Net cash used in operating activities for the threemonths ended October 31, 2004 and 2003, was $7,153,567 and $10,005,966,respectively. The decrease in cash used by operating activities was dueprimarily to increases in accounts receivable, inventory, accounts payable andaccrued expenses primarily related to inventory purchases and sales for theChristmas selling season.

 

**NetCash Used in Investing Activities:**

 

Net cash provided by investing activities for thethree months ended October 31, 2004 and 2003, decreased to $0 from $30,759,respectively, primarily due to no sales of assets or investment in equipment atour facilities related to moving our production to overseas suppliers.

 

**Net Cash Used by Financing Activities:**

 

Net cash provided by financing activities for thethree months ended October 31, 2004 and 2003, was $7,156,560 and $9,869,265,respectively.  This decrease from theprior year was primarily due to decreased reliance on borrowings under our lineof credit to finance working capital needs for seasonal materials, which waspartially offset by borrowings of short-term debt of $467,800.  The gross borrowings for the period endedOctober 31, 2004 were approximately $12,471,850 as compared to $16,255,795 forthe prior years comparable period.  Wehave $2,528,150 of our $15,000,000 line of credit available to meet additionalseasonal needs to purchase and manufacture inventory subject to availability ofaccounts receivable and inventory.

 

Principal payments for our long-term and subordinateddebt for the three months ended October 31, 2004, was $172,187. We believe thatcash provided by operations during the 2005 fiscal year will be sufficient tofinance our operations and fund debt service requirements for the next twelvemonths.

 

**Scheduleof Contractual Obligations**

 
| ** **                    | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------|------------|------------|------------|----------------------------|------------|
| **Contractual Obligations**   | ** ** | **Total**  | ** ** | **Less Than  1 year**      | ** ** | **1-3 years** | ** ** | **After 4 years** | ** ** |
| Long-Term Debt                |       | $          | 959,905    |                       | $          | 376,850 |   | $ | 319,664 |   | $ | 263,391 |   |
| Subordinated Debt             |       | 3,352,140  |       | 3,352,140                  |       | — |   | — |   |
| Capital Lease Obligation      |       | 419,813    |       | 16,688                     |       | 56,497 |   | 346,628 |   |
| Licensing Agreements          |       | 907,080    |       | 619,580                    |       | 272,500 |   | 15,000 |   |
| Operating Leases              |       | 835,126    |       | 164,016                    |       | 345,781 |   | 325,329 |   |
| Total Contractual Obligations |       | $          | 6,474,064  |                       | $          | 4,529,274 |   | $ | 994,442 |   | $ | 950,348 |   |

 

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**Scheduleof Commercial Commitments**

 
| ** **                   | ** ** | ** ** | ** ** | **Amount of Commitment expiration per period** | ** ** |
|------------------------------|------------|------------|------------|------------------------------------------------|------------|
| **Commercial Commitments**   | ** ** | **Total**  | ** ** | **Less Than  1 year**                          | ** ** | **1-3 years** | ** ** | **After 4 years** | ** ** |
| Line of Credit (*)           |       | $          | 15,000,000 |                                           | —     |   | $ | 15,000,000 |   | — |   |
| Total Commercial Commitments |       | $          | 15,000,000 |                                           | —     |   | $ | 15,000,000 |   | — |   |

 

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(*)   The line of creditis available for advances to finance working capital and the issuance of letterof credits.  Advances under the line ofcredit are based on a borrowing formula equal to 85% of eligible domesticaccounts receivable plus 60% of eligible finished goods and 30% of eligiblecomponents inventory. The line of credit facility varies from quarter toquarter based on working capital needs and the level of repayments.

 

**Item 3**.        Quantitativeand Qualitative Disclosures About Market Risk

 

As a result of its variable rate line of credit, weare exposed to the risk of rising interest rates. Our $15,000,000 line ofcredit had an interest rate ranging from 4.5% to 7.75% for the three monthsended October 31, 2004. Our long-term debt is at variable market tax exemptrates, which exposes us to fluctuations in the market. However, since the rateis based on the tax exempt rate, it is below the market rate.

 

**SignificantAccounting Policies and Estimates**

 

AccountsReceivable and Allowance for Doubtful Accounts.

 

Accountsreceivable are customer obligations due under normal trade terms.  We sell our products to those involved in theretail industry.  Accounts receivable arereviewed to determine if any receivables will potentially beuncollectible.  The Company records anallowance for doubtful accounts based on specifically identified amounts thatthey believe to be uncollectible along with a general reserve.  If the actual collections experience changes,revisions to the allowance may be required. Any unanticipated changes in the customer’s credit worthiness or othermatters affecting the collectability of amounts due from such customers, couldhave a material affect on the results of operations in the period in which suchchanges or events occur.  After allattempts to collect a receivable have failed, the receivable is written offagainst the allowance.  Based on theinformation available, the Company believes the allowance for doubtful accountsof $134,000 as of October 31, 2004 is adequate. However, actual write-offsmight exceed the recorded allowance.

 

Inventory

 

Inventoryconsists of raw materials, packaging materials, components used in assembly,work-in-process and finished goods and is stated at the lower of cost ormarket. Cost is determined by the 

 

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FIFO(first-in, first-out) method. We provide an allowance for slow moving inventorybased on experience and aging of products. We consider the following factors;age of product and sale through of the product in developing an estimate of ourallowance for non-moving of inventory and the overall economic environment.Although it is reasonably possible that management’s estimate of slow movinginventory could change in the near future, management is not aware of anyevents that would result in changes to its estimates which would be material toour financial position or results from operations. For the quarter endedOctober 31, 2004, we had an allowance for slow moving inventory of $2,065,426.

 

AssetImpairment

 

TheCompany periodically evaluates the carrying value of long-lived assets whenevents and circumstances warrant such a review. The carrying value of along-lived asset is considered impaired when the anticipated undiscounted cashflow from such asset is separately identifiable and is less than the carryingvalue. In that event, a loss is recognized based on the amount by which thecarrying value exceeds the fair market value of the long-lived asset. Fairmarket value is determined primarily using the anticipated cash flowsdiscounted at a rate commensurate with the risk involved.

 

Goodwill represents the excess of consideration overthe net assets acquired resulting from acquisitions of companies accounted forby the purchase method. We utilize the annual evaluation as required by SFAS142. At each Balance Sheet date, management evaluates the recoverability of thegoodwill and reviews goodwill and other long-lived assets for impairment. As ofOctober 31, 2004 there was no impairment loss.

 

RevenueRecognition

 

Salesare recognized upon shipment of products. Sales discounts and any other priceadjustments are accounted for as a reduction in revenue at the later of (1) thedate at which the related revenue is recognized by the Company or (2) the dateat which the sales incentive is offered.

 

IncomeTaxes

 

Incometaxes are calculated using the liability method specified by Statement ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes (SFAS109).” Under SFAS 109, deferred taxes are determined using the liability methodwhich requires the recognition of deferred tax assets and liability based ondifferences between the financial statement and the income tax basis usingpresently enacted tax rates. The income tax rate utilized on an interim basisis based on the Company’s estimate of the effective income tax rate for thefiscal year ending July 31, 2004. The Company has a net operating losscarry forward which management believes will offset all taxable incomegenerated in fiscal year 2005. Therefore, the Company estimated its effective tax rate at 0%.

 

Useof Estimates

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and 

 

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assumptionsthat affect the reported amounts of assets and liabilities and disclosures ofcontingent assets and liabilities at the date of the financial statements andreported amounts of revenues and expenses during the reporting period. Actualresults could differ from those estimates.

 

DerivativeFinancial Instruments

 

TheCompany formerly utilized derivative financial instruments to reduce foreigncurrency risks. The Company did not hold or issue derivative financialinstruments for trading purposes. In June 1998, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities,” which was amended in June 2000 bySFAS No. 138. SFAS No. 133, as amended, establishes accounting and reportingstandards for derivative instruments and hedging activities. It requires that acompany recognize all derivatives as either assets or liabilities in thestatement of financial condition and measure those instruments at fair value.Changes in the fair value of those instruments will be reported in earnings orother comprehensive income depending on the use of the derivative and whetherit qualifies for hedge accounting. The accounting for gains and lossesassociated with changes in the fair value or the derivative, and the effect onthe consolidated financial statements will depend on its hedge designation andwhether the hedge is highly effective in achieving offsetting changes in thefair value of cash flows of the asset or liability hedged. The Company adoptedSFAS 133, as amended in the fourth quarter of fiscal 2001.

 

 

**Seasonalityand Cylicality; Fluctuation in Quarterly Operating Results**

 

We have experienced and expect to continue toexperience variability in revenues and net income from quarter to quarter as aresult of seasonality that may accompany private or public sector budgetcycles. Sales of our products have historically been higher in the first andsecond quarters as a result of patterns of capital spending by our customers.

 

We also believe that the confectionery industry isinfluenced by general economic conditions and particularly by the level ofchange. Increased levels of change can have a favorable impact on our revenues.We also believe that the confectionary industry tends to experience periods ofdecline and recession during economic downturns. The confectionary industrycould sustain periods of decline in revenues in the future, and any decline maymaterially adversely effect us.

 

We could in the future experience quarterlyfluctuations in operating results due to the factors described above and otherfactors, including short-term nature of certain client commitments; patterns ofcapital spending by customers; loss of a major client; seasonality that mayaccompany private or public budget cycles; pricing changes in response tovarious competitive factors; market factors affecting availability of qualifiedpersonnel and general economic conditions.

** **

**Item 4**.        Controlsand Procedures

 

As of the end of the period covered by this report,our Chief Executive Officer and our Chief Financial Officer (collectively, the “certifyingofficers”) have evaluated the effectiveness of our disclosure controls andprocedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) 

 

24

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under the Exchange Act).  These disclosure controls and procedures aredesigned to ensure that the information required to be disclosed by us in ourperiodic reports filed with the Commission is recorded, processed, summarizedand reported within the time periods specified by the Commission’s rules andforms, and that the information is communicated to the certifying officers on atimely basis.

 

The certifying officers concluded, based on theirevaluation, that our disclosure controls and procedures are effective, takinginto consideration the size and nature of our business and operations.

 

Nochange in our internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) occurred duringthe last fiscal quarter that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

 

**PART II OTHERINFORMATION**

 

**Item 1**.        LegalProceedings

 

Weare from time to time involved in litigation incidental to the conduct of ourbusiness.  We are currently involved asPlaintiff in a suit brought before the Circuit Court for Montgomery County,Maryland, presenting claims in connection with the merger agreement under whichSherwood Brands acquired securities of Asher Candy Acquisition Corporation andagreed to sell securities in Sherwood Brands to prior shareholders of AsherCandy.  The complaint alleges that wewere fraudulently induced to enter into the merger agreement on the basis of,among other things, material misrepresentations and omissions by the shareholdersof Asher Candy.   We are seekingdeclaratory and injunctive relief and award of damages against the formershareholders of Asher Candy for violations of the merger agreement and forcommon law fraud and violations of applicable securities laws.  Pending resolution of the litigation, we haverefused to honor the demand of the former shareholders for us to repurchasehalf of the shares issued to them at a price of $4.50 per share. Some of theshareholders have filed a counterclaim seeking $7.0 million in damages.  We believe that we have defenses to thecounterclaim. There can be no assurance that we will not be a party to otherlitigation in the future.

** **

**Item4.**        Submission of Matters to aVote of Security Holders

 

None.

 

**Item5.**        Other Information

 

None.

 

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**Item 6.**        Exhibitsand Reports on Form 8-K

 

(a)           Exhibits

 

31.1         Certificationof the Chief Executive Officer Purusant to Section 302 of the Sarbanes-OxleyAct of 2002.

 

31.2         Certificationof the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-OxleyActo of 2002.

 

32.1         Certificationof the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-OxleyAct 2002.

 

32.2         Certificationof the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-OxleyAct of 2002.

 

(b)           Reports onForm 8-K

 

CurrentReport on Form 8-K filed on 10-29-04, with attached earnings release for thefiscal year ended July 31, 2004.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this amended report to besigned on its behalf by the undersigned thereunto duly authorized.

 
|                    | SHERWOOD BRANDS, INC.                            |
|-------------------------|--------------------------------------------------|
|                    |                                             |
| Date: December 12, 2004 | /s/ Uziel Frydman                                |   |
|                    | Chairman, President and Chief Executive  Officer |
|                    |                                             |
| Date: December 12, 2004 | /s/ Christopher J. Willi                         |   |
|                    | Chief Financial Officer and Secretary            |

 

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**ExhibitIndex**

 
| **Exhibit No.** | ** ** | **Description**                                                                                           |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                      |
| 31.1            |       | Certification of the Chief Executive Officer Purusant  to Section 302 of the Sarbanes-Oxley Act of 2002.  |
|            |       |                                                                                                      |
| 31.2            |       | Certification of the Chief Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Acto of 2002. |
|            |       |                                                                                                      |
| 32.1            |       | Certification of the Chief Executive Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act 2002.     |
|            |       |                                                                                                      |
| 32.2            |       | Certification of the Chief Financial Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  |

 

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