**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-K**

 

**ANNUAL REPORTPURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

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

 

**CommissionFile Number: 1-14091**

 

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**SHERWOOD BRANDS, INC.**

(Exact Name ofRegistrant as Specified in Its Charter)

 

| **North  Carolina**                                                           |   | **56-1349259**                        |
|-------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of  Incorporation)                              |   | (IRS Employer  Identification Number) |
|                                                                          |   |                                  |
|                                                                          |   |                                  |
| **1803  Research Blvd., Suite 201  Rockville, Maryland**                      |   | **20850**                             |
| (Address of  Principal Executive Offices)                                     |   | (Zip Code)                            |
|                                                                          |
| Registrant’s  telephone number, including area code: **(301)  309-6161** |
|                                                                          |
| Securities  Registered Pursuant to Section 12(b) of the Act:                  |
| **None**                                                                      |
|                                                                          |
| Securities  Registered Pursuant to Section 12(g) of the Act:                  |
| **Class  A Common Stock, $.01 Par Value**                                     |

 

Check whether theissuer (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter period that theissuer was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ýNo o

 

Check if there isno disclosure of delinquent filers in response to Item 405 of Regulation S-Kcontained in this form, and no disclosure will be contained, to the best ofissuer’s knowledge, in definitive proxy or information statements incorporatedby reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

 

Indicate by checkmark whether the Registrant is an accelerated filer (as defined in Exchange ActRule 12b-2).   Yes oNo ý.

 

The aggregatemarket value of the voting and non-voting stock held by non-affiliates of theRegistrant as of October 21, 2003 (computed by reference to the last reportedsale price of the Registrant’s Common Stock on the American Stock Exchange onsuch date) was $7,208,340.

 

The number ofshares outstanding of Registrant’s Class A Common Stock, $.01 par value pershare, as of October 21, 2003 was 3,003,475. Number of shares outstanding ofRegistrant’s Class B Common Stock, $.01 par value per share was 1,000,000. TheClass B Common Stock is not publicly traded.

 

DOCUMENTSINCORPORATED BY REFERENCE

 

Certain portionsof the Registrant’s definitive Proxy Statement pursuant to Regulation 14A ofthe Securities Exchange Act of 1934, as amended, which will be filed with theCommission subsequent to the date hereof, are incorporated by reference intoPart III of this Form 10-K.

 

 

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TABLE OF CONTENTS

 

 
| PART I   |
|----------|
|     |   |
| ITEM 1.  | BUSINESS |
|     |   |
| ITEM 2.  | PROPERTIES |
|     |   |
| ITEM 3.  | LEGAL PROCEEDINGS |
|     |   |
| ITEM  4. | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS |
|     |   |
| PART II  |
|     |
| ITEM 5   | MARKET FOR  REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS |
|     |   |
| ITEM 6   | SELECTED FINANCIAL  DATA |
|     |   |
| ITEM 7   | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
|     |   |
| ITEM  7A | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
|     |   |
| ITEM 8   | FINANCIAL STATEMENTS AND  SUPPLEMENTARY DATA |
|     |   |
| ITEM 9   | CHANGE IN ACCOUNTANTS |
|     |   |
| ITEM 9A  | CONTROLS AND  PROCEDURES |
|     |   |
| PART III |
|     |   |
| ITEM 10  | DIRECTORS  AND EXECUTIVE OFFICERS OF THE REGISTRANT |
|     |   |
| ITEM 11  | EXECUTIVE COMPENSATION |
|     |   |
| ITEM 12  | SECURITY OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS |
|     |   |
| ITEM 13  | CERTAIN RELATIONSHIP AND  RELATED TRANSACTIONS |
|     |   |
| ITEM 14  | PRINCIPAL  ACCOUNTANT FEES AND SERVICES |
|     |   |
| PART IV  |
|     |   |
| ITEM 15. | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K |
|     |   |
|     | SIGNATURES |

 

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PART I.

 

Item 1. Business

 

General

 

Sherwood Brands,Inc. (the “Company”) was incorporated in December 1982 in the state of NorthCarolina. Sherwood Brands, Inc. is engaged in the manufacture, marketing anddistribution of a diverse line of brand name candies, cookies, chocolates andgifts. The Company manufactures lollipops, biscuits and assembles seasonal giftitems including gift baskets for Christmas, Valentines Day and Easter. TheCompany’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 and ELANA(R) chocolates, SOUR FRUIT BURST(TM)fruit-filled hard candies and PIRATE’S GOLD COINS(R) milk chocolates. TheCompany’s marketing strategy, including its packaging of products, is designedto maximize freshness, taste and visual appeal, and emphasizes highlydistinctive, premium quality products that are sold at prices that comparefavorably to those of competitive products. The Company aligns its operationsinto three business segments for management to measure financial performance byproduct type.  The Company’s businesssegments are (i) Manufactured Candy, (ii) Purchased Candy and (iii) Gift Items.

 

Sherwood Brands,Inc. is the owner of Sherwood Brands, LLC, a Maryland limited liabilitycompany. Sherwood Brands, LLC markets and distributes its own line ofconfectionery products in the United States.

 

Sherwood Overseas,Inc. (a wholly-owned subsidiary of Sherwood Brands, LLC) was incorporated inJuly 1993 in the Bahamas to market and distribute the Sherwood lines ofconfectionery products internationally.

 

Sherwood Brands ofRI, Inc. is a wholly owned subsidiary of Sherwood Brands, Inc. that wasincorporated in September, 1998 in the state of Rhode Island. Sherwood Brandsof RI, Inc. d/b/a E. Rosen Company manufactures hard candies and jelly beansand assembles and markets gift items and baskets to chains such as Wal-Mart,Kmart and CVS.

 

SherwoodAcquisition Corporation, a wholly-owned subsidiary of the Company, wasincorporated in April, 2002 in the state of Wyoming. On May 1, 2002, SherwoodAcquisition merged with and into Asher Candy Acquisition Corporation, a Wyomingcorporation. Asher Candy Acquisition Corporation is a manufacturer of candycanes and other hard candies under the “Asher” name. The surviving corporationof the merger is Asher Candy Acquisition Corporation, which has changed itsname to Asher Candy, Inc. The Company issued an aggregate of 270,559 shares ofits common stock valued at $1,675,000 to the shareholders of Asher CandyAcquisition Corporation in consideration for the transaction, subject toescrows for indemnification and adjustments based on a final audit, as well aswarrants exercisable for shares of the Company’s common stock valued at$108,000. The Company valued the common shares at the closing market price onApril 30, 2002 and valued the warrants using the Black-Scholes options pricingmethod.

 

Market Overview

 

Sales of candy andcookie products in the United States have increased significantly in recentyears. According to the United States Department of Commerce, manufacturers’domestic shipments of confectionery products (excluding chewing gum) haveincreased from approximately $9 billion in 1990 to $21.3 billion in 2002. TheChocolate Manufacturers Association/National Confectioners Association hasestimated that total retail sales of confectionery products in the UnitedStates in 2002 were approximately $24.1 billion, comprised of $13.1 billion inchocolate, $7.6 billion in non-chocolate products, $2.8 billion in gum productsand $600 million in other products. Despite the growth, the United States ranksonly fifth in per capita candy consumption among the industrialized nations.

 

Halloween generatesthe highest volume of sales ($2.0 billion), followed by Easter ($1.81 billion),Christmas ($1.50 billion) and Valentine’s Day ($1.09 billion).  Candy Sales for 2002 were up 1.5% over theprior year. During 2002, 1,401 new confectionery products were introduced,comprised of 639 chocolate items, 640 non-chocolate items, 72 gum items, and 50other confectionary items. Novelty/interactive candies growth slowed after a nearly 70% growth rateover the previous five years.  Everydaycandy sales increased slightly last year while holiday sales dipped slightly.The Company believes that the expanding candy market in the United Statespresents attractive growth opportunities for its business, and is focusing onintroducing new products in these holiday categories as well as achievinggreater brand recognition and market penetration for all of the Company’sproducts.

 

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The markets forcandy and cookie products are dominated by a number of large, well capitalizedcorporations. In the candy market, these companies include Hershey FoodCorporation, Masterfoods USA (M&M Mars) and Nestle S.A. The cookie andbiscuit market is dominated by Kraft foods. In addition to domesticmanufacturers, foreign candy and cookie companies, such as Lindt ofSwitzerland, Bahlsen KG, and Storck, have established their products in theUnited States. The Company believes that the remainder of the market is highlyfragmented, with numerous manufacturers and hundreds of products and distributionchannels, such as mass merchandisers, drug stores, club stores, vendingcompanies and gourmet distributors.

 

In the currentbusiness environment, small and medium sized companies are exploring foreignmanufacturing opportunities as a route to increased competitiveness.  Unfortunately, with no sugar price relief insight, and despite such high-profile closings as Kraft’s LifeSavers plant inMichigan and Brach’s move to Argentina, the situation is likely to continue.  Also of growing interest are the moves anumber of confectioners have made to outsource manufacturing to China, lured byincreasing numbers of high quality, low-cost manufacturing facilities, and themarket opening concessions the Chinese government made to gain entry to theWorld Trade Organization.  The trendstarted several years ago with co-packing agreements, primarily for noveltyitems such as tubes-toppers, but has quickly expanded to include productdevelopment and co-manufacturing operations. According to Candy Business, for the first 10 months of last year, thevalue of sugar confectionery items imported to the U.S from mainland Chinanearly doubled when compared to the same period the previous year, rising from$19.4 million in 2001 to $36.8 million during 2002.  Add to this the more than three-fold increase in the value ofitems imported from Hong Kong during the same 10-month period ($2.27 million in2001 to nearly $10 million last year), and China outpaces Argentina as thefourth largest importer to the U.S. Management believes that the Company’sexperience in these markets and distribution channels, coupled with itsexpanded manufacturing capabilities with its suppliers overseas, should enablethe Company to capitalize on growth opportunities in these markets.

 

Products

 

Purchased Candy

 

The following is adescription of products that the Company sells, which are purchased fromthird-party sources located outside of the United States:

 

COWS(TM): COWS isa line of butter toffee candy offering both a soft and chewy toffee and a dairybutter and cream hard candy. COWS butter toffee candies are made with realdairy butter and cream and are sold in 7 oz. bags, in tubs, and in bulk, andare packed in foil fresh packs to preserve freshness and extend shelf life.COWS butter toffee candies are also packaged as gift items in decorative tinsand milk jars.

 

COWPOKES(TM)LOLLIPOPS: COWPOKES are an extension of the COWS line and are made with a harddairy butter and cream candy on the outside and a soft, chewy butter toffee onthe inside. Cowpokes are available in 6.4 oz. bags and are also distributed in60-count check-out stand display cartons for single-item sales.

 

SOUR FRUITBURST(TM) HARD CANDIES: SOUR FRUIT BURST is a line of fruit-filled hard candiesthat are available in a variety of flavors, are sold in 3 oz. and 12 oz. bags,and in a variety of other packages.

 

RUGER(R) WAFERS:RUGER wafers is a line of wafer cookie, including sugar free varieties,available in four flavors: chocolate, vanilla, lemon and coffee. The RUGERwafer cookie formula, designed by the Company, utilizes an aeration processwhich gives RUGER wafers its very light and delicate filling. RUGER wafers aredistributed in a mylar packaging material that resists sunlight and humidityand is designed to preserve freshness and extend shelf life.

 

ELANA(R) BELGIANCHOCOLATES: ELANA Belgian chocolate bars are sold in a variety of flavors,including mint, caramel, mocca, truffle, crispers, and almonds.

 

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COUNTDOWN TOCHRISTMAS(TM) CHOCOLATE CALENDARS: COUNTDOWN TO CHRISTMAS chocolate calendarsare advent calendars made with 24 milk-chocolate candies behind numbered doors.The calendar is marketed domestically for the Christmas holiday season.

 

PIRATE’S GOLDCOINS(TM) FOIL-WRAPPED CHOCOLATE COINS: PIRATE’S GOLD COINS is a milk chocolate candy product designed in coinshapes and wrapped in embossed gold foil. They are offered in two sizes of meshbags, 2lb. 10oz. tubs and in bulk, and are marketed primarily for the Christmasholiday season.

 

Manufactured Candy

 

The following is adescription of products the Company manufactures:

 

STRIP O POPS(TM)LOLLIPOPS: STRIP O POPS(TM) are a line of hard candy lollipops merchandised inhanging strips. They are available in a variety of flavors and are designed forthe holiday season as well as year round sales.

 

SMILE POPS(TM)LOLLIPOPS: SMILE POPS(TM) are a line of candy iced lollipops individuallywrapped and sold in tubs, poly bags or in hanging strips. Each pop is decoratedwith a smiling face.

 

TONGUE TATTOO(TM)LOLLIPOPS: TONGUE TATTOO lollipops are a line of hard candy lollipops embossedwith candy icing images. The iced image transfers when pressed on the tonguecreating a tongue tattoo.

 

COWSCARAMELS(TM):COWSCARAMELS is a line of caramel candy. Flavored fillings include vanilla,cappuccino and butter and cream. The candies are offered in both a soft andchewy toffee and as a dairy butter and cream hard candy. The COWSCARAMELproduction line is certified kosher by the Orthodox Union.

 

DEMITASSE(TM)BISCUITS: DEMITASSE is a line of tea biscuits offered in a variety of flavorsincluding the traditional tea biscuit, “Petit Beurre” (with real butter),cinnamon honey, coconut and chocolate. The DEMITASSE biscuit line is certifiedkosher by the Orthodox Union.

 

CANDY CANES: TheCompany manufactures a variety of packages, sizes, color and flavors, rangingfrom traditional peppermint canes to high-end gourmet lines. In addition, theCompany manufactures premium flavor candy canes which include amaretto, merlot,Irish creme, Dutch chocolate, maraschino cherry and blueberry cheesecake.

 

Gift Items

 

The Companyassembles a variety of custom made gift sets and gift baskets. The gift setsand gift baskets are typically designed for a particular holiday such asChristmas, Valentine’s Day or Easter. The gift sets and gift baskets maycontain gourmet food products, candy, novelty items or seasonal merchandise. Asignificant portion of the contents of the gift sets and gift baskets areassembled from components imported from China.

 

The Company assembliesvarious products to the specification of our customer base and each Holidayseason:

 

Christmas assembleditems:

 

Elana Holiday Gifts:  The Company’s Elana holiday gifts are meshbags filled with individually gift wrapped squares of Elana premium chocolates.

 

Chocolate Santa Bears:These little Santa Bears are a Company classic, each mesh bag is filled withdelicious chocolate bears foil-wrapped in Santa suits.

 

Chocolate HolidayOrnaments:  A mesh bag is filled withsolid milk chocolate wrapped in bright holiday colored foil.  Each chocolate has its own trimming stringfor hanging on the Christmas tree, giving these bags extra novelty.

 

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Candy Filled Votive CandleHolders: House and lanterns hold standard votive candles and create a warm andfestive mood anywhere.  The ceramicpieces which are incorporated with various holiday seasonal candies and can beused as a lantern.

 

Gift Sets: The Companyexclusively designs gift sets that are tailored to its customers taste.

 

These are some of theitems which the Company assembles:

 

Starry Night: Acollector-worthy plate is the center piece, painted with a beautiful renderingof a spirited snowman under a starry Christmas sky.  Hot cocoa is packaged in two decorated tins and two mugs thatinclude candy canes that hang over the rims to give the hot chocolate apeppermint accent.

 

Botanical Mug andCanister Set:  A floral design of mugsand canister set to compliment a garden breakfast or tea time on theporch.  A heavy canister with chromedmetal latches seals air tight to keep food fresh.  Apple blossom tea is included.

 

Pasta Houses: Ceramichouses tall enough to hold a pound of linguini.  Included in each one is a package of imported gourmet pasta.  The wooden spoon tied to each house makes ita complete set.

 

Share the Spirit Mug Set:Cheerful images of the season decorate two mugs and cocoa sets.  The original artwork is appropriate for theholidays and beyond.

 

Valentines assembleditems:

 

Valentine Card and Pops: Each of the colorfulValentine cards is accompanied by one conversation pop.

 

Valentine Coin Purse: TheValentine coin purse is a reusable purse filled with chocolate coins.

 

Valentine Treasure Chest:A plastic treasure chest is filled with premium gold chocolate coins.

 

Easter assembled items:

 

Easter Baskets: Wickerbaskets of high quality wicker are made in various themes for the Easterholiday season.  These are some of ourbaskets with various themes:

 

•                  Playtime assortment: Assortment ofgames, toys and creative play sets incorporated with various candies.

 

•                  Fun and Games assortment:  Baskets are filled with summer fun toys forkids.

 

•                  Toy time assortment:  Toys that help inspire the imagination,pretend dress up, sports and creative art kits.

 

•                  Fuzzy friends plush assortment:  High quality plush fuzzy friends made ofsuper soft velvet.

 

•                  All Candy Baskets: An assortment ofvarious candy from the Company and other popular brands.

 

Suppliers

 

Some of the Company’sproducts are manufactured by third party sources to specific recipe and designspecifications developed by the Company. These third party sources are locatedin Argentina, Austria, Belgium, Holland, Germany, Italy, and Ireland. TheCompany’s operations require it to have production orders in place in advanceof shipment to the Company’s warehouses

 

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(product deliveriestypically take 60 days). Generally, the Company’s foreign suppliers deliver finishedproducts free on board to a freight forwarder, cargo consolidator or directlyto a seaport for ocean transport. The Company assumes the risk of loss, damageor destruction of products, although the Company maintains cargo insurance.Upon entry into the United States, the products are then transported by rail ortruck to one of the six regional warehouses used by the Company.

 

The Company haslong-term relationships with the manufacturers of ELANA(R) Belgian chocolates,RUGER(R) Wafers, and PIRATE’S GOLD COINS(TM) milk chocolates. Generally, thesemanufacturers have agreed not to export into the United States, and in somecases, other countries, any products similar to those produced for the Company.The Company has no formal written agreements with its manufacturers and has noformal commitment to purchase minimum volumes of products. However, on anannual basis the Company and its manufacturer will agree upon volumes andprices and establish a delivery schedule based upon the Company’s forecast.

 

The Companyrequires that its suppliers maintain product liability insurance with theCompany as an additional named insured. The loss of any one supplier would nothave a material adverse effect on the Company’s business.

 

The Companypurchases the necessary ingredients and packaging materials, which are used inits products that are manufactured at its New Hyde Park, NY and Chase City, VAproduction facilities from numerous third-party suppliers. These ingredientsand packaging materials include flour, sugar, shortening, flavorings, butter,folding cartons, shipping cartons and wrapping film. The purchases are made onan open account basis with competitive payment terms.

 

Most of thecomponents used in the Company’s line of holiday gift sets and gift baskets areassembled at its Central Falls, RI and New Bedford , MA facility and arepurchased from manufacturers located in Asia, principally China. In addition,the Company purchases some components from domestic sources on an open accountbasis.

 

Customers

 

The Company sellsits products primarily to mass merchandisers, other retail customers, groceryand drug store chains, club stores, convenience stores, specialty shops andwholesalers. The Company’s mass merchandise customers include Family Dollar,Target, Dollar General, K-Mart and Wal-Mart. For the year ended July 31, 2003,Sam’s Club and Wal-Mart accounted for 15% and 9% of the Company’s total netsales, respectively. For the year ended July 31, 2002, Sam’s Club and Wal-Martaccounted for 29% and 14%, respectively, of the Company’s total net sales.  For the year ended July 31, 2001 Wal-Martcomprised 14% of the Company’s total net sales. The loss of either Sam’s Clubor Wal-Mart as a customer would result in a significant decrease in theCompany’s revenues and profits.

 

Vending companiesare one of the Company’s major customer category. ELANA Belgian chocolates,RUGER wafers, COWS butter toffee candies and SOUR FRUIT BURST candies areavailable in vending machines as well as through traditional outlets. The Companybelieves that the visibility of its products in vending channels enhancesmarket acceptance and consumer appeal of the Company’s products in otherdistribution channels.

 

The Company alsosells its products to numerous gourmet distributors throughout the UnitedStates. These distributors in turn sell the Company’s products to a wide baseof gourmet stores. The Company believes that it has been able to penetrate thiscustomer segment because of its ability to satisfy consumer demand for premiumquality products at prices that are attractive to these distributors.

 

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Distribution Channels

 

The Companydistributes its products throughout the United States, Puerto Rico and Canada.Net sales of the Company’s products in the Canadian market accounted for lessthan 1% of the Company’s total net sales in fiscal 2003.

 

The Companyengages independent food and candy brokers in various regions throughout theUnited States for marketing to retail stores. These brokers account for amajority of the Company’s sales. Food and candy brokers are paid on acommission basis (typically 5% of sales generated by them) and are generallyresponsible in their respective geographic markets for identifying customers,soliciting orders and inspecting merchandise on store shelves. As of July 31,2003, the Company had arrangements with approximately 65 food and candy brokerorganizations. These arrangements typically prohibit the brokers from sellingcompeting products during their engagement with the Company.  The Company believes that the use ofbrokers, enhances the quality and scope of the Company’s sales operations. Inaddition, the use of brokers permits the Company to limit the costs associatedwith creating and maintaining a direct distribution network. The Company’sexecutive officers and six regional sales managers work with the brokers on anindividual basis and are responsible for managing the broker network,identifying opportunities and developing sales in their respective territories.

 

The Company usessix regional bonded public warehouses that specialize in food and confectionerystorage. These warehouses are selected based on proximity to the Company’scustomers, their ability to provide prompt customer service and their efficientand economic delivery. Generally, the Company sells its products pursuant tocustomer purchase orders and fills these orders from inventory within one totwo days of receipt.

 

Because thesepurchase orders are filled shortly after receipt, backlog is not material tothe Company’s business. Substantially all of the Company’s products aredelivered by common carrier.

 

Manufacturing andAssembly Facilities

 

The Company hastwo manufacturing facilities and three assembly facilities.

 

The Company currentlymanufactures hard candy, soft candy, jellies, Demitasse biscuits andCOWSCARAMEL Caramel candies at its Chase City, VA facility. The Chase Cityfacility consists of a brick building with 100,000 square feet (including a1,750 square foot office) situated on approximately ten acres in SouthernVirginia. The facility had approximately 25,000 square feet added toaccommodate the consolidation of the Company’s Pawtucket, RI facility, whichwas closed in May 2002. The facility is equipped with state-of-the-artequipment for the  manufacture andpackaging of cookie and candy products and employed approximately 176 skilledand unskilled workers during the year ended July 31, 2003.  Currently, the labor force at the Chase Cityfacility has been reduced to 68 employees to better meet current biscuit andcookie orders. The facility will be operating at this level through the end ofJuly 31, 2004, at which time the manufacturing operations of hard candy lineswill be transferred to the Company’s overseas suppliers. The facility iscertified kosher by the Orthodox Union. The Company also has a 73,000 squarefoot packaging and storage facility located on approximately 15 acres inKeysville, VA. Both the Chase City and Keysville facilities have access to asupply of skilled and unskilled labor. In addition, the Southern Virginia areain which the two plants are located, is readily accessible to common carriers,rail lines and a major seaport (Newport News). Management believes that bylimiting its production level to its cookies and biscuits lines in Chase Cityit is more likely that the Company will return to profitability during the yearending July 31, 2004.

 

The Company leasesapproximately 411,000 square feet of improved real estate in Pawtucket andCentral Falls, RI at which it assembles holiday gift items, stores inventory(397,000 square feet) and provides office space (14,000 square feet). BothRhode Island facilities have access to skilled and unskilled labor, and arereadily accessible to common carriers, rail lines and a major seaport (Boston).The Company did not exercise its option to extend the term of our leases on itsoffice and assembly facility in Central Falls, Rhode Island and we plan tovacate the location on March 31, 2004. After March 31, 2004, its New Bedford, Massachusetts facility togetherwith a planned West Coast assembly and distribution facility will be utilizedto improve our shipping costs and assembly of our products.

 

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The Company leasesapproximately 30,000 square feet of improved real estate in New Hyde Park, NY.The property is used for manufacturing candy canes. The location has access toboth skilled and unskilled labor, and is readily accessible to common carriersand a major seaport (New York).  Thecurrent lease expires in March 31, 2004. The Company has requested from the landlord to extend the lease anothersix months until September 30, 2004 and the Company has the right to choose toextend the lease for an additional five year option on the facility.

 

In May 2000, theCompany entered into a capital lease agreement with the New BedfordRedevelopment Authority to lease a 430,000 square foot building in New Bedford,MA. The facility is used for assembly and storage of components. Under theterms of the lease the Company made an initial payment of $400,000 and paidrent of $25,000 per annum for years one and two and is committed to pay$41,666.66 per annum for years three through twenty. The Company has an optionto purchase the building at any time during the lease term for $1,200,000 lessany amounts of rental payments made.

 

The Companycurrently employs technical and production personnel who have working knowledgeof the technical and operational aspects of the Company’s production equipment.The Company also employs personnel to conduct quality control testing at thefacilities through on-site laboratory analysis and quality assuranceinspections. The inspectors evaluate the Company’s products on the basis ofsubjective factors such as taste and appearance. The Company monitors theefficiency of the production equipment continuously and its facilities areclimate controlled where required.

 

Marketing, Sales andAdvertising

 

The Companybelieves that product recognition by retail and wholesale customers, consumersand food brokers is an important factor in the marketing of its products.Accordingly, the Company promotes its products and brand names through the useof promotional materials, including full-color product brochures and newspaperinserts, advertising in trade magazines targeted to the mass merchandisers,vending industry, gourmet trade and gift basket markets, and participation intrade shows. For the year ended July 31, 2003, the Company spent approximately$928,000 on advertising and product promotion. For the years ended July 31,2002 and 2001 the Company spent approximately $1,127,000 and $980,000,respectively, on advertising and product promotion.

 

The Company alsopromotes its products through sales discounts and advertising allowances.Promotional programs are generally used most during the initial introduction ofa new product. As distribution of the new product increases, the Companygradually shifts from promotion to direct advertising in order to reinforcetrade and consumer repeat purchasing. Management believes that thesepromotional programs have shortened the time periods necessary to achievemarket penetration of its products. The Company intends to continue to developand implement marketing and advertising programs to increase brand recognitionof its products and to emphasize favorable pricing compared to competingproducts.

 

Competition

 

The Company facessignificant competition in the marketing and sale of its products. TheCompany’s products compete for consumer recognition and shelf space withcandies, cakes, cookies, chocolates and other food products which have achievedinternational, national, regional and local brand recognition and consumerloyalty. These products are marketed by companies (which may include theCompany’s suppliers) with significantly greater financial, manufacturing,marketing, distribution, personnel and other resources than the Company.Certain of these competitors, such as Hershey Food Corporation, Masterfoods USA(M&M Mars), Inc., Nestle, S.A., and Kraft Foods, dominate the markets forcandy and cookie products, and have substantial promotional budgets whichenable them to implement extensive advertising campaigns. The food industry ischaracterized by frequent introductions of new products, accompanied bysubstantial promotional campaigns. Competitive factors in these markets includebrand identity, product quality, taste and price. The Company’s majorcompetitors for holiday gift items and gift baskets are Houston Harvest Co., SmithEnterprises, Inc. and Wonder Treats. The Company’s major competitors for candycanes are Bob’s Candies, Inc, Spangler Candy Company, and Allan Candy Company.

 

Trademarks

 

The Company holdsUnited States trademark registrations for the “ELANA,” “RUGER”, “TONGUETATTOO”, “STRIP-O-POP”, “SMILE POPS” and “demitasse” names, and has filedapplications to register for certain other names, including “COWS,” and usesother names for which it has not applied for registration. The Company believesthat its rights to these names are a significant part of the Company’s businessand that its ability to create demand for its products is

 

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dependent to a largeextent on its ability to exploit these trademarks. The Company’s failure toprotect its trademarks and other intellectual property rights could negativelyimpact the value of its brand names. The Company is currently involved in alegal proceeding involving intellectual property rights. The Company is notaware of any other infringement claims or other challenges to the Company’srights to use these marks. The Company is applying for the internationalregistration of all its trademarks.

 

Government Regulation

 

The Company issubject to extensive regulation by the United States Food and DrugAdministration, the United States Department of Agriculture and by other stateand local authorities in jurisdictions in which the Company’s products aremanufactured or sold. Among other things, such regulations govern the importing,manufacturing, packaging, storing, distribution and labeling of the Company’sproducts, as well as sanitary conditions and public health and safety.Applicable statutes and regulations governing the Company’s products include“standards of identity” for the content of specific types of products,nutritional labeling and serving size requirements and general “GoodManufacturing Practices” with respect to manufacturing processes. The Company’smanufacturing facilities and manufactured products are subject to periodicinspection by federal, state and local authorities. The Company believes thatit is in compliance with all governmental laws and regulations and maintainsall permits and licenses required for its operations.

 

Insurance

 

The Companymaintains product liability insurance with limits of $2,000,000 in theaggregate and $1,000,000 per occurrence (with excess coverage of $10,000,000),which it believes is adequate for the types of products currently offered bythe Company.

 

Employees

 

As of October 16,2003, the Company had approximately 547 full-time employees and approximately520 part-time or seasonal employees. Of the Company’s full-time workforce, 25are located at the Company’s principal office in Rockville, MD. The Company hasapproximately 68 full and part-time employees in Virginia, approximately 755full, part-time and seasonal employees in Rhode Island and Massachusetts and219 full, part-time and seasonal employees in its New Hyde Park, NY facility.Management believes that the Company’s relationship with its employees is good.The employees at the Asher Candy facility are the Company’s only employeesrepresented by labor unions under a collective bargaining agreement.

 

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Item 2. Properties

 

The followingtable sets forth, with respect to properties leased and owned by the Company atJuly 31, 2003, the location of the property, the size of the property, theannual rent, and the year in which the lease expires, if applicable, and thebusiness use which the Company makes of such facilities:

 
|                                                 |   | **Approximate** |       |       |       |             |       |                                        |       |                       |       |
|------------------------------------------------------|--------|-----------------|------------|------------|------------|------------------|------------|---------------------------------------------|------------|----------------------------|------------|
|                                                 |   | **Square**      |       | **Annual** |       | **Expiration**   |       |                                        |       |                       |       |
| **Address**                                          |   | **Feet**        |       | **Rent**   |       | **of Lease**     |       | **Business  Use**                           |       | **Segment**                |       |
|                                                 |   |            |       |       |       |             |       |                                        |       |                       |       |
| Leased Properties:                                   |   |            | ** ** |       | ** ** |             | ** ** |                                        | ** ** |                       | ** ** |
| 1803 Research  Boulevard Office  Rockville, MD 20850 |   | 5,500           |       | $116,000   |       | January 31, 2009 |       | Executive and General                       |       | —                     |       |
| 1005 Main Street  Pawtucket, RI 02860                |   | 14,000          |       | $100,893   |       | October 2004     |       | General Office                              |       | —                     |       |
| 280 Rand Street  Central Falls, RI 02863  facilities |   | 397,000         |       | $380,656   |       | March 2004       |       | Assembly facility, Storage And Distribution |       | Purchase Candy, Gift Items |       |
| 1815 Gilford  Avenue  New Hyde Park, NY              |   | 30,000          |       | $300,000   |       | March 2004       |       | Manufacturing Plant                         |       | Manufactured Candy         |       |
| 27 Healy Street  New Bedford, MA 02745               |   | 430,000         |       | $25,000    |       | June 2020        |       | Assembly facility, Storage And Distribution |       | Purchase Candy, Gift Items |       |
|                                                 |   |            |       | (Yr 1-2)   |       |             |       |                                        |       |                       |       |
|                                                 |   |            |       | $41,667    |       |             |       |                                        |       |                       |       |
|                                                 |   |            |       | (Yr 3-20)  |       |             |       |                                        |       |                       |       |
| Owned  Properties:                                   |   |            |       |       |       |             |       |                                        |       |                       |       |
| 807 South Main  Street  Chase City, VA 23924         |   | 100,000         |       |       |       |             |       | Manufacturing Plant                         |       | Manufactured Candy         |       |
| 350 Sherwood  Drive  Keysville, VA 23947             |   | 73,000          |       |       |       |             |       | Assembly facility, Storage and distribution |       | Purchase Candy, Gift Items |       |

 

The Companybelieves that its existing facilities are well maintained and in good operatingcondition.

 

Item 3.  LegalProceedings

 

The Company is,from time to time, involved in litigation incidental to the conduct of itsbusiness. The Company is currently involved in several actions.  In particular, the Company’s landlord at itsRhode Island facility has named the Company as a defendant in an action seekingsecurity for claims relating to the lease agreement. The Company deposited$180,000 with the registry of the court relating to claims for payment of realestate taxes, water and sewer, rent of other occupied space and repairexpenses. In September 2002, the landlord claimed other breaches of the leaseagreement, alleging an obligation of $932,000 under the lease and demanded$750,000 to settle the disputes. The Company has claims against the landlord itis pursuing and continues to occupy space at the leased premises. The Companyhas accrued amounts to cover current charges. Management does not believe thatthe outcome of these actions, individually or in the aggregate, will have amaterial adverse effect on the financial condition of the Company.

 

The Company iscurrently involved as Plaintiff in a suit brought before the Circuit Court forMontgomery County, Maryland, presenting claims in connection with the mergeragreement under which Sherwood Brands acquired securities of Asher CandyAcquisition Corporation and agreed to sell securities in Sherwood Brands toprior shareholders of Asher Candy.  Thecomplaint alleges that the Company was fraudulently induced to enter into themerger agreement on the basis of, among other things, materialmisrepresentations and omissions by the shareholders of Asher Candy.   The Company seeks declaratory andinjunctive relief and award of damages against the former shareholders of AsherCandy for violations of the merger agreement, for common law fraud andviolations of applicable securities laws. Pending resolution of the litigation, the Company has refused to honorthe demand of the former shareholders for the Company to repurchase half of theshares issued to them at a price of $4.50 per share. Some of the shareholdershave filed a counterclaim seeking $7.0 million in damages.  The Company believes that it has defenses tothe counterclaim. There can be no assurance that the Company

 

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will not be a party toother litigation in the future.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matters weresubmitted to a vote of security holders during the fourth quarter of the fiscalyear ended July 31, 2003.

 

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PART II

 

Item 5.  Market for the Company’sCommon Equity and Related Stockholder Matters

 

Market Price

 

The Company’sClass A Common Stock is traded on the American Stock Exchange (“AMEX”) (symbol:SHD). The following table shows The high and low sales prices as reported onthe AMEX for the Class A Common Stock for each quarter within the last twofiscal years:

 
| **Price Period**                 |   | **High** |   | **Low** |   |
|----------------------------------|--------|----------|--------|---------|--------|
|                             |   |     |   |    |   |
| Fiscal Year Ended July 31, 2002: |   |     |   |    |   |
| First Quarter                    |   | $        | 7.20   |    | $      | 4.36 |   |
| Second Quarter                   |   | $        | 9.19   |    | $      | 4.90 |   |
| Third Quarter                    |   | $        | 7.25   |    | $      | 5.45 |   |
| Fourth Quarter                   |   | $        | 6.89   |    | $      | 4.05 |   |
| Fiscal Year Ended July 31, 2003: |   |     |   |    |   |
| First Quarter                    |   | $        | 5.10   |    | $      | 2.90 |   |
| Second Quarter                   |   | $        | 3.50   |    | $      | 2.46 |   |
| Third Quarter                    |   | $        | 2.60   |    | $      | 1.57 |   |
| Fourth Quarter                   |   | $        | 2.33   |    | $      | 1.60 |   |

 

As of October 28,2003, there were 29 holders of record of the Class A Common Stock and oneholder of record of the Class B Common Stock. The Company believes that thereare more than 311 beneficial holders of its Class A Common Stock.  

 

Dividend Policy

 

The Company hasnever declared or paid any cash dividends on the Class A and Class B CommonStock and has no present intention to declare or pay cash dividends on theClass A and Class B Common Stock in the foreseeable future. It intends toretain earnings, if any, which it may realize in the foreseeable future tofinance its operations. The Company is subject to various financial covenantswith its lenders that could limit and/or prohibit the payment of dividends inthe future. See “Management’s Discussion and Analysis of Financial Conditionand Results of Operations.” The payment of future cash dividends on the Class ACommon Stock will be at the discretion of the Board of Directors and willdepend on a number of factors, including future earnings, capital requirements,the financial condition and prospects of the Company and any restrictions undercredit Agreements existing from time to time.

 

Item 6. Selected Financial Data

 

The selectedfinancial data set forth below have been derived from the consolidatedfinancial statements of the Company and the related notes thereto. Thestatement of operations data for the five years ended July 31, 2003 and thebalance sheet data as of July 31, 2003, 2002, 2001, 2000 and 1999 are derivedfrom the consolidated financial statements of the Company which have beenaudited by BDO Seidman, LLP, independent certified public accountants. Thefollowing selected financial data should be read in conjunction with theCompany’s consolidated financial statements and the related notes thereto and“Management Discussion and Analysis of Financial Condition and Results fromOperations”, which are included elsewhere herein.

 

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| **For the years ended July 31,**                             |   | **2003**   |             | **2002**   |   | **2001**         |   | **2000**      |             | **1999**   |   |
|--------------------------------------------------------------|--------|------------|------------------|------------|--------|------------------|--------|---------------|------------------|------------|--------|
|                                                         |   |       |             |       |   |             |   |          |             |       |   |
| Net sales                                                    |   | $          | 49,162,787  |       | $      | 52,782,341  |   | $             | 58,316,716  |       | $      | 42,104,645  |   | $ | 25,299,806 |   |
| Cost of sales                                                |   | 37,680,097 |             | 37,714,680 |   | 41,796,184       |   | 32,183,885    |             | 19,218,718 |   |
| Write down of Inventory                                      |   | 2,192,005  |             | —     |   | —           |   | —        |             | —     |   |
| Gross profit                                                 |   | 9,290,685  |             | 15,067,661 |   | 16,520,532       |   | 9,920,760     |             | 6,081,088  |   |
| Selling, general and administrative expenses                 |   | 8,192,774  |             | 8,313,603  |   | 8,006,416        |   | 6,675,177     |             | 4,922,082  |   |
| Salaries and related expenses                                |   | 5,057,115  |             | 5,100,167  |   | 4,806,061        |   | 3,285,850     |             | 2,450,096  |   |
| Non-recurring costs                                          |   | 1,932,075  |             | 707,551    |   | —           |   | —        |             | 213,112    |   |
| Total operating expenses                                     |   | 15,181,964 |             | 14,121,321 |   | 12,812,477       |   | 9,961,027     |             | 7,585,290  |   |
| Income (Loss) from operations                                |   | (5,891,279 | )                | 946,340    |   | 3,708,055        |   | (40,267  | )                | (1,504,202 | )      |
|                                                         |   |       |             |       |   |             |   |          |             |       |   |
| Other income (expense)                                       |   |       |             |       |   |             |   |          |             |       |   |
| Interest income                                              |   | 2,636      |             | 4,881      |   | 11,182           |   | 36,016        |             | 83,258     |   |
| Interest expense                                             |   | (623,201   | )                | (468,687   | )      | (539,971         | )      | (434,978      | )                | (153,832   | )      |
| Other income (expense)                                       |   | 274,728    |             | 90,535     |   | 132,209          |   | 693,413       |             | (7,821     | )      |
| Total other income (expense)                                 |   | (345,837   | )                | (373,271   | )      | (396,580         | )      | 294,451       |             | (78,395    | )      |
| Income (Loss) before provision (benefit) for taxes on income |   | (6,237,116 | )                | 573,069    |   | 3,311,475        |   | 254,184       |             | (1,582,597 | )      |
| Provision (Benefit) for taxes on income                      |   | (866,224   | )                | 248,039    |   | 1,093,100        |   | 98,100        |             | (319,700   | )      |
| Net income (loss)                                            |   | $          | (5,370,892       | )          | $      | 325,030     |   | $             | 2,218,375   |       | $      | 156,084  |   | $ | (1,262,897 | ) |
| Net income (loss) per share                                  |   |       |             |       |   |             |   |          |             |       |   |
| —basic                                                  |   | $          | (1.34            | )          | $      | 0.09             |   | $             | 0.60             |       | $      | 0.04 |   | $ | (0.34 | ) |
| —diluted                                                |   | (1.34      | )                | 0.08       |   | 0.56             |   | 0.04          |             | (0.34      | )      |
| Weighted average common shares outstanding                   |   |       |             |       |   |             |   |          |             |       |   |
| —basic                                                  |   | 3,996,199  |             | 3,778,375  |   | 3,700,000        |   | 3,700,000     |             | 3,700,000  |   |
| —diluted                                                |   | 3,996,199  |             | 4,312,762  |   | 3,954,428        |   | 3,700,000     |             | 3,700,000  |   |

 
| **For the years ended July 31,** |   | **2003**   |    | **2002**   |   | **2001**   |   | **2000**   |      | **1999**   |   |
|----------------------------------|--------|------------|---------|------------|--------|------------|--------|------------|-----------|------------|--------|
|                             |   |       |    |       |   |       |   |       |      |       |   |
| Balance Sheet Data:              |   |       |    |       |   |       |   |       |      |       |   |
| Working Capital                  |   | $          | 669,015 |       | $      | 6,218,382  |   | $          | 7,485,168 |       | $      | 6,020,265 |   | $ | 6,992,533 |   |
| Total Assets                     |   | 26,502,471 |    | 31,390,954 |   | 22,804,112 |   | 20,618,891 |      | 16,575,370 |   |
| Total Long Term Debt             |   | 1,574,405  |    | 2,266,414  |   | 1,221,162  |   | 1,755,170  |      | 1,604,526  |   |
| Total Liabilities                |   | 18,427,800 |    | 18,003,614 |   | 11,575,121 |   | 11,590,004 |      | 7,702,567  |   |
| Stockholders’ Equity        |   | 8,074,671  |    | 13,387,340 |   | 11,228,991 |   | 9,028,887  |      | 8,872,803  |   |
|                                  |        |            |         |            |        |            |        |            |           |            |        |  |  |  |  |  |

 

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Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations

 

IMPORTANT INFORMATIONREGARDING FORWARD-LOOKING STATEMENTS

 

This annual reporton Form 10-K contains forward-looking statements within the meaning of Section27A of the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. Those statements includestatements regarding the intent, belief or current expectations of the Companyand its management. Such statements are subject to a variety of risks anduncertainties, many of which are beyond the Company’s control, which couldcause actual results to differ materially from those contemplated in suchforward-looking statements, including in particular the risks and uncertaintiesdescribed below. Investors are cautioned not to place undue reliance on thoseforward-looking statements, which speak only as of the date hereof. The Companyundertakes no obligation to update or revise the information contained in thisAnnual Report on Form 10-K, whether as a result of new information, futureevents or circumstances or otherwise.

 

If any of thefollowing risks occurs, our business, financial condition or results ofoperations could be adversely affected.

 

The loss of asignificant customer could have an adverse effect on our business. We aredependent on a limited number of customers for a significant portion of ourrevenues. Sam’s Club and Wal-Mart accounted for approximately 15% and 9%,respectively, of our sales for the year ended July 31, 2003. We do not maintainagreements with our customers and sell products pursuant to purchase ordersplaced from time to time in the ordinary course of business. The loss of asignificant customer could have an adverse effect on our business.

 

We facesignificant competition in the marketing and sales of our products. Ourproducts compete for consumer recognition and shelf space with candies, cakes,cookies, chocolates and other food products which have achieved international,national, regional and local brand recognition and consumer loyalty. Theseproducts are marketed by companies (which may include our suppliers) withsignificantly greater financial, manufacturing, marketing, distribution,personnel and other resources than we have. Some of these competitors, such asHershey Food Corporation, Masterfoods USA (M&M Mars), Inc., Nestle, S.A.,and Kraft Foods, dominate the markets for candy and cookie products, and havesubstantial promotional budgets which enable them to implement extensiveadvertising campaigns. The food industry is characterized by frequentintroductions of new products, accompanied by substantial promotionalcampaigns. If we are unable to continue to compete successfully our businesscould be adversely affected.

 

We face variousrisks relating to a recent acquisition. We recently acquired the business ofAsher Candy Acquisition Corporation. Asher Candy Acquisition Corporationmanufactured candy canes, a product which we had no prior experience inmanufacturing. If we are unable to successfully produce a quality product, andmaintain or increase the customer base, our profitability could be adverselyaffected.

 

Our success ishighly dependent on consumer preferences and industry factors. The markets forcandy and cookie products are affected by changes in consumer tastes andpreferences and nutritional and health-related concerns. We could be subject toincreased competition from companies whose products or marketing strategiesaddress these concerns. In addition, the markets for our products may besubject to national, regional and local economic conditions which affectdiscretionary spending, demographic trends and product life cycles, wherebyproduct sales increase from their introductory stage through their maturity andthen reach a stage of decline over time.

 

We have limitedhistorical profitability and may not be profitable in the future. We havehistorically, until recently, achieved limited profitability. Our operatingexpenses have increased and can be expected to continue to increase inconnection with any expansion activities undertaken by us, including thoserelating to advertising and product manufacturing. Accordingly, our profitabilitywill depend on our ability to improve our operating margins and increaserevenues from operations. Unanticipated expenses, unfavorable currency exchangerates, increased price competition and adverse changes in economic conditionscould have a material adverse effect on our operating results. If we are unableto achieve significantly increased levels of revenues, our future operationsmay not continue to be profitable.

 

We depend on ourtrademarks. We hold United States trademark registrations for the “ELANA,”“RUGER”, “TONGUE TATTOO”, “STRIP-O-POP”, “SMILE POPS” and “demitasse” names,and have filed applications to register certain other names, including “COWS,”and use other names for which

 

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we have not applied forregistration. We believe that our rights to these names are a significant partof our business and that our ability to create demand for our products isdependent to a large extent on our ability to exploit these trademarks. Ourfailure to protect our trademarks and other intellectual property rights couldnegatively impact the value of our brand names. We are requested some of ourmarks in countries other than the U.S. and may apply for additionalregistration as appropriate.

 

We are dependenton third party manufacturers and suppliers. We are dependent on the ability ofour manufacturers to adhere to our product, price and quality specificationsand scheduling requirements. Our operations require us to have productionorders in place in advance of shipment to our warehouses (product deliveriestypically take 60 days). Any delay by manufacturers in supplying finishedproducts to us would adversely affect our ability to deliver products on atimely and competitive basis. In addition, raw materials necessary for themanufacture of our products at our facilities, including flour, sugar,shortening, butter and flavorings, are purchased from third-party suppliers. Wedo not maintain agreements with any such suppliers and we are, therefore, subjectto risks of periodic price fluctuations, shortages and delays. If there is amaterial interruption in the availability or significant price increases forraw materials would have a material adverse effect on our operating margins.

 

We face variousrisks relating to foreign manufacturing. During the fiscal years ended July 31,2001, 2002 and 2003, approximately 23%, 23% and 33%, respectively, of ourproducts were manufactured in foreign countries. We have been and will continueto be subject to risks associated with the manufacture of products in foreigncountries, primarily in Argentina, Austria, Belgium, China, Holland andIreland. These risks include material shipping delays, fluctuations in foreigncurrency exchange rates, customs duties, tariffs and import quotas andinternational political, regulatory and economic developments. We assume therisk of loss, damage or destruction of products when shipped by a manufacturer.Because we pay for some of our products manufactured outside the United Statesin foreign currencies, any weakening of the United States dollar in relation torelevant foreign currencies, could result in significantly increased costs tous. In addition, some products manufactured overseas are subject to importduties. Deliveries of products from our foreign manufacturers could also bedelayed or restricted by the future imposition of quotas. If quotas wereimposed, it is possible that we would not be able to obtain quality products atfavorable prices from domestic or other suppliers whose quotas have not beenexceeded by the supply of products to their existing customers.

 

Our operatingresults fluctuate and we are subject to seasonality. Our operating results aresubject to fluctuations as a result of new product introductions, the timing ofsignificant operating expenses and customer orders, delays in shipping orders,pricing and seasonality. Our sales increase during the first and secondquarters of our fiscal year, due to the holidays that occur during thosequarters. During the fiscal years ended July 31, 2001, 2002 and 2003,approximately 70%, 70% and 77%, respectively, of our annual sales occurred inthe first two quarters of the fiscal year. If we are unable to meet thedelivery schedules of our customers during the first two quarters of our fiscalyear our profitability would be adversely affected during that fiscalyear.    We are subject to governmentregulation. We are subject to extensive regulation by the United States Foodand Drug Administration, the United States Department of Agriculture and byother state and local authorities in jurisdictions in which our products aremanufactured or sold. Among other things, such regulation governs theimportation, manufacturing, packaging, storage, distribution and labeling ofour products, as well as sanitary conditions and public health and safety.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 incurproduct liability claims that are not fully insured. As a manufacturer andmarketer of food products, we are subject to product liability claims fromconsumers. We maintain product liability insurance with limits of $2,000,000 inthe aggregate and $1,000,000 per occurrence (with excess coverage of$10,000,000). These insurance amounts may not be sufficient to cover potential claimsand adequate levels of coverage may not be available in the future at areasonable cost. In the event of a partially or completely uninsured successfulclaim against us, our financial condition and reputation would be materiallyaffected.

 

We are dependenton key personnel and the loss of these key personnel could have a materialadverse effect on our success. Our success is dependent on the personal effortsof Uziel Frydman, our Chairman, President and Chief Executive Officer, AmirFrydman, our Vice President

 

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of Marketing andChristopher Willi, our Chief Financial Officer. The loss or interruption of theservices of such individuals could have a material adverse effect on ourbusiness. We maintain “key-man” insurance in the amount of $1 million on thelife of Mr. Uziel Frydman. Our success also depends upon our ability to hireand 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 andChief Executive Officer controls our company. Mr. Uziel Frydman, President andChief Executive Officer of our company, owns 400,000 shares of Class A CommonStock (with a right to acquire an additional 202,984 upon the exercise ofoptions) and 1,000,000 shares of Class B Common Stock, representing, in theaggregate, approximately 43% of the outstanding Common Stock of our company and76% of the voting control of our company, assuming that all of the warrants areexercised. Accordingly, Mr. Frydman will be able to direct the election of allof our company’s directors, increase the authorized capital, dissolve, merge orsell the assets of our company, and generally direct the affairs of ourcompany. In addition, the level of control exercised by Mr. Frydman maydiscourage investors from purchasing our Common Stock.

 

We may issue“blank check” preferred stock that would prevent a change of control. OurArticles of Incorporation, as amended, authorize our board of directors toissue up to 5,000,000 shares of “blank check” preferred stock withoutstockholder approval, in one or more series and to fix the dividend rights,terms, conversion rights, voting rights, redemption rights and terms,liquidation preferences, and any other rights, preferences, privileges, andrestrictions applicable to each new series of preferred stock. The issuance ofshares of preferred stock in the future could, among other things, adverselyaffect the voting power of the holders of common stock and, under certaincircumstances, could make it difficult for a third party to gain control of ourcompany, prevent or substantially delay a change in control, discourage bidsfor the Common Stock at a premium, or otherwise adversely affect the marketprice of the Common Stock.

 

We are prohibitedfrom paying dividends by the terms of our financing agreements. We have neverpaid any cash dividends on our common stock and do not anticipate paying cashdividends in the foreseeable future. The payment of cash dividends isprohibited by the terms of our financing agreements.

 

CAUTIONARY NOTEREGARDING FORWARD-LOOKING STATEMENTS

 

This 10-K reportcontains some forward-looking statements, within the meaning of federalsecurities laws, about our financial condition, results of operations andbusiness. You can find many of these statements by looking for words like“will,” “should,” “believes,” “expects,” “project,” “could,” “anticipates,”“estimates,” “intends,” “may,” “pro forma” or similar expressions used in this10-K report. These forward-looking statements are subject to numerousassumptions, risks and uncertainties that may cause our actual results orperformance to be materially different from any future results or performanceexpressed or implied by the forward-looking statements. The risks anduncertainties include those risks and uncertainties identified under theheading “Risk Factors” in this 10-K report. Because these forward-lookingstatements are subject to risks and uncertainties, we caution you not to placeundue reliance on these statements, which speak only as of the date of this10-K report. We do not undertake any responsibility to review or confirmanalysts’ expectations or estimates or to release publicly any revisions tothese forward-looking statements to take into account events or circumstancesthat occur after the date of this 10-K report. Additionally, we do not undertakeany responsibility to update you on the occurrence of unanticipated eventswhich may cause actual results to differ from those expressed or implied bythese forward-looking statements.

 

Overview

 

The Company isengaged in the manufacture, marketing and distribution of a diverse line ofbrand name candies, cookies, chocolates and gifts. Through fiscal year endedJuly 31, 2001, the Company had experienced continued revenue growth. Thisgrowth was a direct result of the Company’s introduction of gift items, giftbaskets and new candy products. The new gift products enabled the Company toexpand its customer base to include mass-merchandisers.

 

With net salesgrowing from approximately $18 million in fiscal 1998 to over $49 million infiscal 2003, management began to take steps to reduce costs in future years byconsolidating operations and continuing to build its infrastructure. Theobjectives are to establish new production and assembly facilities with moreefficient and effective cost structures. The Company began implementing theseplans during the year ended July 31, 2003.

 

Over the past two fiscal years ended July 31, 2003 and 2002, theCompany had seen

 

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declines in its net sales largely attributable to decreased consumerconfidence and spending and the weak environment. The following highlights theattributing factors for the declines:

For fiscal year ended July 31, 2002

 

•                  Jellypricing not meeting Company’s profitability levels, declined orders of $2.7million.

•                  AfterSeptember 11, 2001, the total consumer market experienced a major slow down.Major chains that ordered products delaying their shipments. The Company heldonto $4,000,0000 of inventory for these major chains for over twelve months.

 

For fiscal year ended July 31, 2003

 

•                  Salesto Sam’s Club and Wal-mart declined from prior year 2002 as a result of a onetime order of specialty gift items as part of their Easter seasonal items,including shadow boxes, steamer trunks and leather clocks which  accounted for $4.4 million of gift itemssales decline.

•                  TheChase City manufacturing facility inefficiencies and capacity levels running at 38% on a daily basis.  The impact of this transition  resulted in approximately $1.9 million ofpre-production start up costs, or 4% of net sales and resulted in a write downof obsolete film and packaging inventory of approximately $2.2 million or 4.6%of net sales. The inventory write down was a direct result of our decision inthe third quarter ending April 30, 2003 to shift certain production to ouroverseas third party manufacturing suppliers. We have reduced our work forcefrom 280 employees to 68 at the Chase City facility, and are currently in theprocess of moving hard and soft candy production to our third partymanufacturing suppliers overseas. We anticipate that additional expenses mayarise due to movement from Chase City to our overseas suppliers.

 

•                  OnSeptember 30, 2002, 29 west coast ports were shut down abruptly and remainedclosed as contract negotiations between dock-workers and shipping companiesbroke off negotiations for new contracts. The shut down occurred during theCompany’s peak inventory shipping period for orders for the holiday season. Theshut down had an effect on our first quarter of shipments to our customers. Alarge portion of containers, which were to be received, remained either atports or on shipping vessels on the water. In addition, empty containers werenot brought back to ports in the Pacific Rim, which we needed to move some ofour other products. A slow down by the long shore-men on shipping products wasstill prevalent. Our first quarter revenues were impacted by the shut down andresulted in a delay of approximately $6.0 million in sales.  Approximately $3.5 million was shipped outduring the second quarter and approximately $2.5 million of the remaininginventory will be shipped during the first and second quarter of fiscal year2004.

 

On May 1, 2002, we acquired all of the outstandingcommon stock of Asher Candy Acquisition Corporation, a Wyoming corporation withoperations located in New Hyde Park, New York, that manufactured candy canesand other hard candies under the “Asher” name. The purchase price paid to theshareholders of Asher Candy Acquisition Corporation in consideration for thetransaction was approximately $1,783,000, consisting of an aggregate of 270,559shares of our Class A common stock valued at $6.20 per share, or $1,675,000,subject to claims for indemnification, and warrants exercisable for 38,652 sharesof our Class A common stock, which warrants were valued at $108,000. We valuedthe common shares at the closing market price on April 30, 2002 and valued thewarrants using the Black-Scholes options pricing method.  During the fiscal year ended July 31, 2003,we included the operating results of Asher Candy in our consolidated results.Asher Candy generated $10.2 million in net sales for fiscal year ended July 31,2003.

 

During the yearended July 31, 2003, the Company had a total of fifteen licensing agreements,  nine during the fiscal year ended July 31,2003 and six in fiscal year ended July 31, 2002, to incorporate its productsinto gift sets and to manufacturing of candies and wafers. The royalty ratesfor such licenses are from 2% to 12% of net sales and expire in range of two tothree years. The products to be incorporated into the Company’s gift set itemsare primarily for the first quarter and Easter selling season. The Companyentered into a licensing agreement to produce everyday candies and wafers. TheCompany paid $232,000 in advance fees for the rights under the licensingagreements. These advance fees were be offset against any amounts due onroyalties. There was no other minimum license fees under these agreements. TheCompany incurred $227,000 in royalties during the year ended July 31, 2003. TheCompany is currently pursuing other licenses with similar terms and conditions.The Company expects to see increased revenue for products related to theagreements beginning in the year ending July 31, 2004.

 

The Company’sRhode Island manufacturing facility, which occupied five stories in an old

 

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building, closed on May31, 2002. All the production equipment, together with the electrical, piping,steam and air-conditioning were disassembled and transferred to the Company’sexpanded Chase City, VA facility. This 75,000 square feet facility, with anadditional 25,000 square feet from a recent expansion, and the 73,000 squarefoot facility at Keysville, VA (about 20 miles from Chase City, VA), wouldbecome the single manufacturing and distribution facility under one plantmanagement for all products produced at the Chase City facility. The Companyincurred start up costs of approximately $1,900,000 in 2003 in an attempt tomeet planned production schedules and product quality standards.  Ultimately, in the third quarter of 2003,the Company decided to transfer production overseas to third party suppliers.  Also, in the third quarter, the Companywrote down inventory by approximately $2,200,000 since certain packagingmaterials could no longer be used.  TheCompany will continue to manufacture certain biscuits and cookie products atthe Chase City facility and has concluded that there is no asset impairment ateither April 30, 2003 or July 31, 2003.

 

Christmas, Eastergift sets and gift baskets are assembled and distributed at the Rhode Islandand Massachusetts facilities. The Company purchases product primarily from thePacific Rim. The Company is continually looking to further reduce costs by moreefficient sourcing.

 

We did notexercise the options on our office and assembly facility in Rhode Island andplan to vacate the location on March 31, 2004. After March 31, 2004, our New Bedford, Massachusetts facility togetherwith a planned West Coast assembly and distribution facility will be utilizedto improve our shipping costs and assembly of our products.

 

Environmental FactorsAffecting the Performance in the Year Ending July 31, 2003.

 

On September 30,2002, 29 west coast ports were shut down abruptly and remained closed ascontract negotiations between dock-workers and shipping companies broke offnegotiations for new contracts. The shut down occurred during the Company’speak inventory shipping period for orders for the holiday season. Inmid-October 2002, the President of the United States of America signed an orderunder the Taft-Hartley Act to reopen the ports and put a moratorium on thestrike for 60 days. The shut down had an effect on our first quarter ofshipments to our customers. A large portion of containers, which were to bereceived, remained either at ports or on shipping vessels on the water. Inaddition, empty containers were not brought back to ports in the Pacific Rim,which we needed to move some of our other products. In mid-October 2002, ourinventory began to be released for shipment to our facility in New Bedford, MA.A slow down by the long shore-men on shipping products was still prevalent. Ourfirst quarter revenues were impacted by the shut down and resulted in a delayof approximately $6.0 million in sales. Approximately $3.5 million was shipped out during the second quarter andapproximately $2.5 million of the remaining inventory will be shipped duringthe first and second quarters of fiscal year 2004.

 

Results of Operations

 

Fiscal Year Ended July 31, 2003 compared to Fiscal Year ended July 31,2002

 

Net sales for theyears ended July 31, 2003 and 2002 were $49,162,787 and $52,782,341,respectively, a decrease of 6.85%.  Sam’sClub, Big Lots and Wal-Mart accounted for approximately 16%, 10.2% and 9.5% ofsales, respectively, during the fiscal year ended July 31, 2003, and Sam’sClub, Wal-Mart and Big Lots accounted for approximately 29%, 14% and 8% ofsales, respectively, for the prior year’s comparable period.  Net sales for each of our business segmentswas as follows:

 

Net sales ofManufactured Candy increased from $13.6 million for the year ended July 31,2002 to $17.1 million in the year ended July 31, 2003.  The increase of $3.5 million was primarilydue to $10.0 million of sales in manufactured candy canes in connection withour acquisition of Asher Candy.  Thisincrease was partially offset by a $6.5 million decrease in our manufactureditems for the Valentine and Easter seasons which was comprised of the followingdecreases: $2.4 million in cookie sales; $2.7 million in biscuit sales; and$1.4 million in Cows sales.

 

Net sales ofPurchased Candy increased from $11.9 million for the year ended July 31, 2002to $15.9 million for the year ended July 31, 2003. The increase of $4.0 millionwas primarily due to the sale of Christmas purchased gift items, which had beenassembled at the Company’s New Bedford, Massachusetts facility in the priorfiscal year.

 

Net sales of GiftItems decreased from $27.2 million for the year ended July 31, 2002 to $16.1million for the year ended July 31, 2003. The $11.1 million decrease was primarily a result of the shift of $5.7million of Christmas assembled goods to purchased assembled goods, $1.0 millionof HBA items and a one time order by Sam’s Club and Wal-mart for $4.4 millionof specialty gift items as part of their Easter seasonal items in fiscal year2002.

 

For the fiscalyears ended July 31, 2003 and 2002, gross margins decreased to $9,290,685 from$15,067,661, respectively, and decreased to 18.9% and 28.5% as percent ofsales, respectively.  Gross margins foreach of our business segments was as follows:

 

Gross margins onour Manufactured Candy decreased due to low capacity and efficiency levels atour Chase City, Virginia facility.  Thefacility ran at 38% capacity for most of fiscal year ended July 31, 2003.  The decrease in the production levelscreated unfavorable labor costs and material variances in packaging and rawmaterials of approximately $3.06 million, or a 6.2% effect on gross margins forthe fiscal year ended July 31, 2003.  Wehave expensed these unfavorable variances as incurred. The write down ofinventory of $2,192,005, or 4.5% for the third quarter of the fiscal year endedJuly 31, 2003, resulted from

 

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film and packaging materials that became obsolete due to the transferof certain product manufacturing to third party overseas suppliers and areduction of products manufactured at our Chase City, Virginia facility.

 

Gross margins forour Purchased Candy increased by $2.3 million primarily due to the purchase ofassembled gift items that were not assembled in our New Bedford, Massachusettsfacility.

 

Gross margins onour Gift Items decreased by $5.8 million due primarily to shifts of productlines from assembled to purchase candy and the one time order by Sam’s Club andWal-mart for $4.4 million of gift items in fiscal 2002 and $515,000 ofadditional freight and duty costs associated with the west coast dockworkersstrike.

 

We may incuradditional expenses in the first and second quarters of fiscal year 2004 as wecontinue to reorganize the plant’s operations.

 

During the fiscal year ended July 31, 2003 and 2002, selling, generaland administrative expenses decreased to $8,192,774 from $8,313,603,respectively, and increased to 16.7% from 15.8% as a percent of sales,respectively. The increase was largely due to $174,000 in travel expenses, ofwhich approximately $85,000 was for trips to China, $48,000 of shippingviolation fees resulting from our inability to meet shipping dates for ourcustomers due to the dockworkers strike, $23,000 in building rental costs,$159,000 in professional fees, $56,000 in shipping and carrier cost associatedwith samples, and $143,000 of warehouse transfer costs, which was partiallyoffset by a decrease of $159,000 of brokers commissions.

 

Pre-productions startup costs increased to $1,932,075 during the fiscalyear ended July 31, 2003 compared to $707,551 from prior year’s comparableperiod, or increase to 3.9% from 1.3% as percent of sales, respectively, as aresult of the training required for new employees at our Chase City, Virginiafacility.

 

During the fiscal year ended July 31, 2003, salaries and relatedexpenses decreased to $5,057,115 from $5,100,167 during the fiscal ended July31, 2002, or 10.3% from 9.7%, respectively, as a percent of sales. Thisdecrease resulted  from a decline of$45,000 in the Company’s overhead due to its restructuring effort in the fourthquarter of the fiscal year ended July 31, 2003, offset by an increase in Healthinsurance premiums.

 

As a result, operating expenses for the fiscal year ended July 31, 2003increased to $15,181,964 from $14,121,321 for the fiscal year ended July 31,2002 and increased to 30.9% from 26.8%, respectively, as a percent of sales.

 

Loss from operations for the fiscal year ended July 31, 2003 was$5,891,279, as compared to income of $946,340 for the prior year’s comparableperiod. Most of the loss resulted from the write down of film and packagingmaterials that had become obsolete due to production transferring to our thirdparty overseas suppliers and reduction of product lines manufactured at ourChase City, Virginia facility of approximately $2.2 million and pre productionstart up costs of approximately $2.0 million, $515,000 of additional freightand duty costs associated with the west coast dockworkers strike and otherexpense explained in results from operating expenses along with reducedrevenues from product sales.

 

For the fiscal year ended July 31, 2003, interest income decreased to$2,636 from $4,881 for the fiscal year ended July 31, 2002 as reservesdeclined. For the fiscal year ended July 31, 2003, interest expenses increasedto $623,201 from $468,687 for the fiscal year ended July 31, 2002 due to anincrease in our term debt financing of $1.3 million associated with the mergerwith Asher Candy and interest in the subordinated debt the Company entered intoduring the fiscal year ended July 31, 2003.

 

For the fiscal year ended July 31, 2003, other income increased to$274,728 from $90,535 for the fiscal year ended July 31, 2002 due to $248,000of realized losses on foreign exchange transactions, legal settlement on tradeinfringement of $580,000 offset by $149,000 in legal expenses associated withthe settlement.

 

We recognized an income tax benefit of approximately $866,000 for thecarryback of the net operating loss to recover income taxes previously paid.

 

Fiscal Year Ended July 31, 2002 compared to Fiscal Year ended July 31,2001

 

Net sales for the years ended July 31, 2002 and 2001 were $52,782,341and $58,316,716, respectively, a decrease of 9.5%.  Sam’s Club,  Wal-Mart andBig Lots accounted for approximately 29%, 14% and 8% of sales, respectively,during the fiscal year ended July 31, 2002, and Sam’s Club, Wal-Mart and DollarGeneral accounted for approximately 27%, 14% and 8% of sales, respectively, forthe prior year’s comparable period.  Netsales for each of our business segments was as follows:

 

Net sales of Manufactured Candy decreased from $16.3 million for theyear ended July 31, 2001 to $13.6 million in the year ended July 31, 2002.  The decrease of $2.7 million was primarilydue to $3.1 million of sales in manufactured jellies in connection with ourEaster Season.  The Company could notjustify selling product at below profitable levels to maintain this businessand this decrease was partially offset by a $0.5 million increase in ourmanufactured Cows .

 

Net sales of Purchased Candy decreased from $13.4 million for the yearended July 31, 2001 to $11.9 million for the year ended July 31, 2002. Thedecrease of $1.5 million was primarily due to the sale of gold coins items,$0.4 million relating to our Valentine card and pops and $0.3 million Halloweencandy.

 

Net sales of Gift Items decreased from $28.7 million for the year endedJuly 31, 2001 to $27.2 million for the year ended July 31, 2002.  The $1.5 million decrease was primarily aresult of  Christmas assembled goodspostponed by a customer, due to consumer confidence and spending and the weakeconomy.

 

For the fiscal years ended July 31, 2002 and 2001, gross marginsdecreased to $15,067,661 from $16,520,532, respectively, and decreased to 28.5%and 28.3% as percent of sales, respectively. Gross margins for each of our business segments was a follows:

 

Gross margins on our Manufactured Candy decreased $615,000, due tohigher raw material costs and overhead and burden, particularly for purchase ofrepair parts and shop supplies for machinery for our new acquisition of Ashercandy and shut down of the Rhode Island manufacturing facility.

 

Gross margins for our Purchased Candy increased by $82,000 primarilydue to lower fixed costs and pricing of goods.

 

Gross margins on our Gift Items decreased by $0.9 million due primarilyto postponed shipments and higher labor costs associated with assembly of ourEaster baskets.

 

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OperatingExpenses: Selling, general and administrative expenses for the year ended July31, 2002 increased to $8,313,603 from $8,006,416 and increased to 15.8% from13.7% as a percent of sales. The increase was largely due to an additional$98,000 general insurance costs, $26,000 in communication costs and $55,000 infacility costs (i.e., utilities, facility rents, heating oil) associated withthe Asher Candy facility. The Company also incurred $145,000 additionaladvertising expenses associated with the marketing of its licensing programsand various new gift products.

 

Salaries andrelated expenses for the year ended July 31, 2002 increased to $5,100,167 from$4,806,061, an increase of 9.7% from the prior year. Of this increase,approximately $328,000 was due to cost of living raises for existing managementand employees. During the year ended July 31 ,2002 the Company had a 18%increase in its benefits costs, primarily health insurance, which accounted forapproximately $60,000 of the increase in salaries and related expenses.

 

Non-recurringcosts for the year ended July 31, 2002 increased to $707,551 from $0 for theprior year. The increase was due to the one-time costs relating to the move ofthe Rhode Island manufacturing facility to the Chase City, VA manufacturingfacility.

 

As a result,operating expenses increased to $14,121,321 from $12,812,477, a 4.8% increasefrom the prior year. The increase was attributable to $707,551 of non-recurringexpenses relating to the move of the Company’s manufacturing facility fromRhode Island. The increase was also attributable to an increase of $145,000 inadvertising costs, an increase of $388,000 in salaries and benefits and anincrease of $58,000 in travel costs.

 

Income fromOperations: Income from operations for the year ended July 31, 2002 decreasedto $946,340 from $3,708,055, a decrease of 74.4% from prior year. The decreasewas primarily attributable to the Company’s $5.5 million decrease in sales from2001 to 2002, and the $707,551 non-recurring charges associated with the movefrom its Rhode Island manufacturing facility to its Chase City, VA facility.

 

InterestIncome:  Interest income for the yearended July 31, 2002 decreased to $4,881 from $11,182, a decrease of 56.3% fromthe prior year. The decrease was attributable to using excess funds to pay downcredit facilities to minimize interest expense during the year reducing cash onhand for daily overnight investment activity.

 

Interest Expense:Interest expense for the year ended July 31, 2002 decreased to $468,687 from$539,971, a decrease of 13.2% from the prior year. The decrease was due to adecline in the interest rate from 7.92% in fiscal 2001 to 4.58% in fiscal 2002.The Company’s average borrowings increased from $5,500,000 in fiscal 2001 to$7,300,000 in fiscal 2002, due to increased working capital needs to purchaseinventory and raw materials to support the peak seasonal needs and acquisitionof Asher Candy.

 

Other Income(Expense): Other income (expense) for the year ended July 31, 2002 decreased to$90,535 from $132,209, a decrease of 31.5% from the prior year. The decreasewas primarily due to the receipt of a $75,000 settlement in a trademarkinfringement suit the Company initiated in the prior year period.

 

Income Taxes:  The income tax rate utilized for the yearsended July 31, 2002 and 2001 was 43% and 33%, respectively. The tax rateincreased due to the recognition of dividend income for income tax reportingpurposes which was eliminated for financial reporting purposes. The Companyrecorded a tax expense of $248,039 for the year ended July 31, 2002 compared to$1,093,100 for the year ended July 31, 2001.

 

Net Income: As aresult of the foregoing, the Company earned net income of $325,030 in the yearended July 31, 2002 compared to net income of $2,218,375 in the year ended July31, 2001, a 85.2% decrease.

 

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Financial Condition

 

Assets

 

Total assetsdeclined to $26,500,000 million at July 31 ,2003 from $31,400,000 million atJuly 31 ,2002.  The decline wasprimarily due to a $2,200,000 million write down in obsolete film and packaginginventory, net collection of $500,000 income tax receivables and lower tradeaccounts receivable due to reduced revenues in the third and fourth quarters of2003.

 

As of July 31,2003, current assets decreased to $17,058,410 from $21,730,297 as of July 31,2002, a decrease of $4,671,887, or 21.50%. The decrease primarily reflecteddecreased inventories, accounts receivable and income tax receivables. TheCompany’s $46,000 increase in prepaid expenses was principally due to feesrelated to the Company’s general liability insurance and an increase in prepaidroyalty fees. The $102,000 increase in deferred taxes on income wasattributable to carryback of net operating losses related to the Company’sfiscal year end July 31, 2003.

 

As of July 31,2003, plant, property and equipment decreased to $7,100,000 from $7,400,000 asof July 31 ,2003, a decrease of approximately $300,000 or 0.4%. The decreasewas primarily due to capital additions for the Chase City facility of $740,452and offset by depreciation of assets of $961,712.

 

Liabilities

 

As of July 31,2003, total liabilities increased to $18,427,800 from $18,003,614 as of July31, 2002, an increase of $424,186 or 2.36%. The increase primarily reflects theCompany’s additional subordinated debt of $2,000,000 and is offset by thedecrease in borrowing from the Company’s revolving line of credit, an increasein trade payables, and additional accrued expenses.

 

Capital Structure

 

The Company hastwo classes of stock outstanding, Class A Common Stock and Class B Common Stock(collectively the “Common Stock”), which classes are substantially identical,except that the Class A Common Stock is entitled to one vote per share and theClass B Common Stock is entitled to seven votes per share on all matters,including the election of directors. Uziel Frydman, Chairman, President andChief Executive Officer of the Company, beneficially owns 400,000 shares ofClass A Common Stock and all of the 1,000,000 share of Class B Common Stockoutstanding and controls the Company.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Our primary cash requirements have been to fund the purchase,manufacture and commercialization of our products. We finance our operationsand manufacturing with cash flow from operations and bank financing along withfavorable payment terms from some of our vendors. Our working capital at fiscalyear end July 31, 2003 and July 31, 2002 was $639,014 and $6,218,379,respectively.

 

In May 2001, the Companyentered into a new credit facility with First Union National Bank for a $20.0million line of credit. Interest accrues on such advances at LIBOR plus 2.35%(the rate at July 31, 2001 was 6.09%) and is payable monthly. The loanagreement expires in June 2004. Advances under the credit facility are based ona borrowing formula equal to 85% of eligible domestic accounts receivable plus60% of eligible finished goods and 30% of eligible components inventory.Borrowings on inventory are capped based upon the Company’s seasonalrequirements and are limited to $9,000,000. The credit facility is alsoavailable for the issuance of letters of credit. The credit facility iscollateralized by the cash and cash equivalents, accounts receivable andinventories of the Company and its wholly-owned subsidiaries. The agreementcontains business and financial covenants, including, a minimum tangible networth, a fixed charge ratio and a limit on capital expenditures.

 

On April 30, 2002, theCompany entered into the first amendment and modification to the original loanand security agreement dated May 2001. The modification increased the maximumprincipal amount available under the revolving line of credit to $25,000,000from $20,000,000 and extended two additional term loans in the principal amountof $650,000 each. Advances under the line of credit remained the same. Thebusiness and financial covenants were modified to require a minimum tangiblenet worth of $12,500,000 at July 31, 2002, a fixed charge ratio of 1.75 to 1.0as of July 31, 2002 and a limit on capital expenditures of $2,000,000. Interestaccrues on such advances at LIBOR plus 2.35% (the rate at July 31, 2002 was4.16%) and is payable monthly. The loan agreement expires in June 2004.

 

On September 5, 2002, theCompany entered into the second amendment and modification to the original loanand security agreement dated May 2001. The modification increased the available out of formula amount above therevolving loans during the following periods: $850,000 from September 5, 2002through and including October 13, 2002 and $650,000 from October 14, 2002

 

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through and includingOctober 31, 2002.  Commencing onNovember 1, 2002 and at all times thereafter, no permitted out of formulaamount shall be available.

 

On April 7, 2003, theCompany entered into the third amendment and modification to the original loanand security agreement dated May 2001. The modification increased the availableout of formula amount above the revolving loans to $300,000 from April 7, 2003through and including May 31, 2003. Commencing on June 1, 2003 and at all times thereafter, no permitted outof formula amount shall be available. The Company agreed to seek new financing of $350,000 and all proceeds ofthe new financing would reduce the outstanding revolving loan. The interest onthe two loans with the bank will be modified to incorporate an 340 basis pointapplicable term loan margin during the time the fixed charge coverage ratio isequal or less than 1.75 to 1.0.  If thefixed charge coverage ratio is equal or greater than 1.75 to 1.0 the applicableloan margin will be 275 basis points.

 

On May 30, 2003 theCompany entered into the fourth amendment and modification to the original loanand security agreement dated May 2001. The modification extended the third amendment and modifications out offormula advance from May 31, 2003 to June 9, 2003, to enable the Company toevaluate new financing alternatives and complete the discussion on the defaultof certain loan covenants.

 

On July 30, 2003 theCompany entered into the fifth amendment and modification to the original loanand security agreement dated May 2001. The modification to the original agreements was to decrease the maximumrevolving credit to $18,000,000 from $25,000,000.  The Company executed a subordinated debt agreement with Lana, LLCa related party to the board and officers, in an amount equal to $2,000,000.The subordinated debt is collateralized by a security interest in the Company’saccounts receivable and inventory.  Thesubordinated debt is fully subordinated to all obligation and all liens,security interests, rights and remedies in favor of Lana, LLC. In addition tothe sums otherwise available to the Company as revolving loans, the Company mayborrow the following amounts for the following periods as an out of formulapermitted advance: $1,000,000 from July 30, 2003 through and including October31, 2003, $600,000 from November 1, 2003 through and including November 15,2003 and $350,000 from November 16, 2003 through and including November 30,2003. At all times after November 30, 2003, no permitted out of formula amountshall be available to the Company.  Thebank waived the Company’s compliance with the fixed charge coverage ratio andtangible net worth covenants for the fiscal periods ended October, 30, 2002,January 31 ,2003 and April 30, 2003. The fixed charged coverage ratio and tangible net worth covenants werechanged as follows: Tangible Net Worth at July 31, 2003 of $5,800,000,$6,800,000 as of October 31, 2003, $8,700,000 as of January 31, 2004,$9,100,000 as of April 30, 2004 and $7,250,000 as of July 31, 2004 and at alltimes thereafter. The fixed charged coverage ratio was changed to require theCompany to have a ratio of not less than (4.32) to 1.0 for the twelve monthsperiod ended July 31, 2003, (3.7) to 1.0 for the twelve month period endingOctober 31, 2003, (2.20) to 1.0 for the twelve month period ending January 3,2004, 0.90 to 1.0 for the twelve month period ending April 30, 2004, 1.75 to1.0 for the twelve month period ending July 31, 2004 and 1.75 to 1.0 as of theend of each fiscal quarter of the Company after July 31, 2004.  The Company was in violation of the fixedcharge covenant at July 31, 2003, however, the bank waived non compliance.

 

In June 1996 andMay 1997, the Company borrowed $935,000 and $580,000, respectively, fromIndustrial Development Authority of Mecklenburg County (“IDAMC”) for theacquisition and improvement of the Chase City facility and the purchase andinstallation of new production equipment, financed through the issuance of twoseries of Industrial Revenue Bonds (“IRB”) (Series 1996 and Series 1997). TheIRBs were backed by irrevocable letters of credit issued by Wachovia, NA .Advances on the letters of credit (which expire June 2011 and 2002,respectively) were, in turn, secured by the Company’s Chase City facility andall other real and personal property of the Company pursuant to a reimbursementagreement between Wachovia and the Company.

 

Under the reimbursementagreement, the Company made monthly interest and sinking fund payments toWachovia. Annual payments to the sinking fund for the Series 1997 IRBs were dueon June 1 of each year in the following amounts: $105,000 in 1999 and $130,000in each of 2000, 2001 and 2002. The total monthly payments varied from month tomonth and were subject to variable market tax exempt interest rates (4.40% atJuly 31, 2003). The terms of the reimbursement agreement required, among otherthings, that the Company maintain certain financial ratios and adhere tocertain covenants, including, without Wachovia’s permission, borrowingadditional funds, merging or consolidating, amending its Articles ofIncorporation and repaying subordinated debt. The current loan amounts at July31, 2002 were $0.00 for the Series 1997 IRBs and $460,000 for Series 1996 IRBs.In June 2002, the Series 1997 IRBs were paid in full.

 

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As part of thefinancing for the acquisition of the Chase City facility, in May and June 1996,the Company borrowed $400,000from IDAMC to finance equipment and borrowed$250,000 from the Lake Country Development Corporation (“LCDC”) for workingcapital, evidenced by two subordinated notes. On June 2001, the IDAMC and LCDCloans were paid in full.

 

On August 13,2002, the Company borrowed $350,000 from Lake Country Development Corporationof Mecklenburg County for the acquisition and purchase of new equipment toexpand the business facility located at Chase City, Mecklenburg County,Virginia.  The Company agreed to createsixty five jobs within a twenty four months of the completion of theproject.  If at least one job for every$10,000 borrowed (35 jobs) has not been met within the two years, the loan canbe called. A good faith effort must be made to create sixty five jobs.  The repayment of the loan is in eighty fourmonthly installments beginning on October 1, 2002 for the amount of $4,784.08at a interest rate of 4% per annum.

 

In the normalcourse of business the Company may be exposed to fluctuations in interestrates. These fluctuations can vary the costs of financing, investing andoperating transactions.

 

Schedule of ContractualObligations

 
|                         |   | **Payments  Due by Period** |      |
|------------------------------|--------|-----------------------------|-----------|
| **Contractual Obligation**   |   | **Total**                   |      | **Less Than  1 year** |   | **1-3 years** |   | **After 4  years** |   |
|                         |   |                        |      |   |   |   |   |   |   |
| Long-Term Debt               |   | $                           | 1,680,890 |   | $ | 530,377 |   | $ | 761,554  |   | $ | 388,959 |   |
| Capital Lease Obligation     |   | 439,608                     |      | 41,667 |   | 125,000 |   | 272,941 |   |
| Subordinated Debt            |   | 2,000,000                   |      | 2,000,000 |   | — |   | — |   |
| Licensing Agreements         |   | 758,659                     |      | 525,659 |   | 233,000 |   | — |   |
| Operating Leases             |   | 1,352,405                   |      | 712,748 |   | 404,813 |   | 234,844 |   |
| Total Contractual Obligation |   | $                           | 6,231,562 |   | $ | 3,810,451 |   | $ | 1,524,367 |   | $ | 896,744 |   |

 

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Schedule of Commercial Commitments

 
|                         |   | **Amount of  Commitment  expiration per period** |       |
|------------------------------|--------|--------------------------------------------------|------------|
| **Commercial Commitments**   |   | **Total**                                        | ** ** | **Less Than  1 Year** | ** ** | **1-3 years** | ** ** | **After 4  years** | ** ** |
|                         |   |                                             |       |   |   |   |   |   |   |
| Line of Credit (*)           |   | $                                                | 18,000,000 |   | —  |   | $ | 18,000,000 |   | — |   |
| Total Contractual Obligation |   | $                                                | 18,000,000 |   | —  |   | $ | 18,000,000 |   | — |   |

 

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(*) The line of credit isavailable for advances to finance working capital and the issuance of letter ofcredits. Advances under the line of credit are based on a borrowing formulaequal to 85% of eligible domestic accounts receivable plus 60% of eligiblefinished goods and 30% of eligible components inventory. The line of creditfacility varies from quarter to quarter based on working capital needs andpay-downs.

 

Cash Flows:

 

Net cash used in Operating Activities:

 

Net cash provided by operating activities for the fiscal year endedJuly 31, 2003, was $321,094  compared tocash used of $478,710 in fiscal 2002, respectively. The improvement in cashprovided by operating activities was due primarily to decreases in inventory,accounts receivable, income taxes receivable and accrued expenses, which werepartially offset by an increase in the net loss.

 

Net cash used fromoperating activities for the year ended July 31, 2002 and 2001, respectivelywas $478,710 compared to cash provided of $1,618,667. The increase in cash usedby operating activities was due primarily to increases in inventory, accruedexpenses, income tax receivable, accounts receivable offset by decreases in netincome and income taxes payable.

 

Net Cash Used in Investing Activities:

 

Net cash used in investing activities for the fiscal year ended July31, 2003 and 2002 decreased to $740,452 from $2,161,005, respectively,primarily due to the reduction in purchase of production equipment lines andcapital improvements for our facility in Chase City, Virginia.

 

Net cash used ininvesting activities increased to $2,161,005 for the year ended July 31, 2002from $1,064,259, primarily due to equipment purchases and capital improvementsfor the Company’s move of its manufacturing facility in Rhode Island to itsChase City facility.

 

Net Cash Used by Financing Activities:

 

Net cash used by financing activities for the fiscal year ended July31, 2003 and 2002 was $62,538 and cash provided of $2,963,767, respectively.This decrease was primarily due to $1,943,707 pay-down on our credit facilityoff set by additional subordinated debt financing of $2,000,000, $495,915pay-down on term debt offset by proceeds of $350,000 on additional term debt.The borrowings for the fiscal year ended July 31, 2003, were approximately$6,260,264 as compared to $8,203,971 for the prior years comparable period. Thedecrease in borrowing was largely due to restrictions imposed by our bank alongwith a lower borrowing base used to incorporate eligible collateral. TheCompany believes that the new credit facility is adequate to meet our cash flowrequirements foe fiscal 2004. The impact of lower borrowing from our line ofcredit facility and financing of subordinated debt offset somewhat the higher interestrates. We have $11,739,736, of our $18,000,000 line of credit available to meetadditional seasonal needs to purchase and manufacture inventory subject toavailability of accounts receivable and inventory.

 

Net cash provided byfinancing activities was $2,963,767 compared to cash used of $810,711 in priorperiod primarily due to reliance on borrowings on the Company’s line of creditto finance working capital needs and payoff of working operating facility withacquisition of Asher Candy. At July 31, 2002 and 2001, the Company had borrowed$8,203,971 and $3,842,297 under the line of credit and had no letters of creditoutstanding.

 

During the fiscal year ended July 31, 2003, the Company was inviolation of the fixed charge

 

25

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coverage ratiocovenant.  As of the filing date of thisannual report for the fiscal year ended July 31, 2003, the bank waived theviolation of those covenants for the fiscal 2004. We have amended the creditagreement to modify the covenants and to help ensure our compliance goingforward.  Management believes that withthe amended credit facility, the Company will be able to meet it covenants.

 

Principal payments for our long-term debt for the twelve months endingJuly 31, 2004 are $530,377. We believe that cash provided by operations will besufficient to finance our operations and fund debt service requirements for thenext twelve months.

 

Principal payments forthe Company’s long term debt for the years ended July 31, 2003 and 2002 were$495,915 and $254,748, respectively. The Company believes that cash provided byoperations will be sufficient to finance its operations and fund debt servicerequirements.

 

Principal payments forthe Company’s long term debt for the years ended July 31, 2002 and 2001 were$254,748 and $534,000, respectively. The Company believes that cash provided byoperations will be sufficient to finance its operations and fund debt servicerequirements.

 

The Company anticipatesthat its material capital expenditures for the next 12 months will consist ofimprovements to the Company’s assembly facilities of approximately $500,000. Inaddition, the Company will continue to explore opportunities to expand theCompany’s business, including possible acquisitions, although the Company hasno current agreements or commitments and is not currently engaged in anymaterial negotiations with respect to specific acquisitions. The Companybelieves that cash provided from operations and available borrowing capacitywill be sufficient to fund these expenditures.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

 

The Company utilizesderivative financial instruments to reduce foreign currency risks. The Companydoes not hold or issue derivative financial instruments for trading purposes.During the fiscal year ended July 31, 2003 the Company had no derivativefinancial instruments.

 

26

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Item 8.      Financial Statements

 

The followingconsolidated financial statements of the Company and Subsidiaries and thereport of independent certified public accountants thereon are set forth onpages 35 through 56 hereof.

 

Item 9.      Change in Accountants

 

There have been nochanges in or disagreements with our independent auditors in the last twoyears.

 

Item 9A.   Controls and Procedures

 

Based on theirevaluation, as of the end of the period covered by this annual report, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosures and procedures (as defined in Rules 13a-14(c) and 15d-14(c) underthe Securities Exchange Act of 1934, as amended) are effective.  There have been no significant changes inour internal control over financial reporting or in other factors that occurredduring the period covered by this annual report that has materially affect, oris reasonably likely to materially affect, our internal control over financialreporting.

 

27

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PART III.

 

Item 10.    Directors, ExecutiveOfficers, Promoters and Control Persons; Compliance with Section 16(A) of theExchange Act

 

Directors and ExecutiveOfficers

 

The following arethe directors and executive officers of the Company, as well as certain otherkey employees of the Company:

 
| **Name**             |   | **Age** |   | **Position**                                                                              |
|----------------------|--------|---------|--------|-------------------------------------------------------------------------------------------|
|                 |   |    |   |                                                                                      |
| Uziel Frydman        |   | 67      |   | Chairman, President and  Chief Executive Officer                                          |
| Amir Frydman         |   | 41      |   | Director, Treasurer and  Executive Vice  President—Marketing and Product Development |
| Christopher J. Willi |   | 43      |   | Chief Financial Officer  and Secretary                                                    |
| Douglas A. Cummins   |   | 61      |   | Director                                                                                  |
| Kenneth J. Lapiejko  |   | 55      |   | Director                                                                                  |
| Guy Blynn            |   | 58      |   | Director                                                                                  |
| Paul J. Splitek(1)   |   | 53      |   | Vice President—Sales                                                                 |
| Arthur Wlodarski(1)  |   | 46      |   | Vice  President—Purchasing                                                           |

 

----

(1) Messrs. Woldarski andSplitek are key employees, but not executive officers of the Company.

 

Uziel Frydman hasbeen the President and Chief Executive Officer of the Company and each of itssubsidiaries since inception. Mr. Frydman has served as the Chairman of theBoard of Directors of the Company since December 1997. Mr. Frydman served asDirector of Marketing and Planning Sciences at R.J. Reynolds Tobacco Companyfrom 1977 to 1980, and prior to that, as Manager, Planning and OperationsImprovement at Lever Brothers Company from 1971 to 1977. He also served as ProjectsManager at Sperry & Hutchinson Company and as an independent consultant tolocal governments in Turkey, Burma and Sierra Leone from 1962 to 1965. Mr.Frydman was an adjunct professor at the Graduate School of Business at RutgersUniversity from 1970 to 1975. Mr. Frydman earned a Masters of BusinessAdministration, Management Science degree from Case Western Reserve Universityin 1968 and a Bachelor of Science degree in Civil Engineering from TechnionInstitute of Technology, Haifa, Israel in 1960. Mr. Frydman is the father ofAmir Frydman.

 

Amir Frydman hasbeen a director of the Company and has served as Treasurer and Executive VicePresident—Marketing and Product Development since 1985. Prior to joining theCompany, Mr. Frydman was Commercial Branch Manager at NCNB National Bank ofFlorida, from 1984 to 1985. Mr. Frydman earned a Bachelor of Arts degree fromthe University of North Carolina in 1983. Mr. Frydman is the son of UzielFrydman.

 

Christopher J.Willi has been Chief Financial Officer since May 2001. Mr. Willi has over 19years of financial and operational experience. From 1998 until joining SherwoodBrands, Mr. Willi was Chief Financial Officer of CynterCorp, a global ITservice business. From 1992 to 1998, Mr. Willi was Corporate Controller of PGI,Inc., a global communication services company, where he directed more than adozen acquisitions. Prior to that he was Director of Finance for National TradeProductions, Inc and a Asset Manager with a unit of Canadian PacificCorporation. Before that he was with Arthur Andersen & Co., where he workedin the audit and consulting practice. Mr. Willi earned his J.D. from SouthernMethodist University Law School and his B.S. in accounting and finance from theUniversity of Utah.

 

Douglas A. Cumminshas been a director of the Company since December 1997. In 1996, Mr. Cumminsserved as President and Chief Executive Officer of the Liggett Group, amanufacturer and distributor of cigarettes. From 1993 to 1996, Mr. Cumminsserved as President and Chief Executive Officer of North Atlantic Trading Co, acigarette paper manufacturer and distributor. From 1990 to 1993, Mr. Cumminsserved as the President and Chief Executive Officer of Decision

 

28

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Marketing, an advertisingand consulting firm. From 1984 to 1990, Mr. Cummins served as the President andChief Operating Officer of Salem Carpet Mills, a carpet manufacturer, and from1981 to 1984, served as President of Stellar Group, a consulting firm. From1973 to 1981, Mr. Cummins was Director of Marketing—International and VicePresident—Foods Marketing at R.J. Reynolds Industries. Mr. Cummins currentlysits on the Boards of Carolina Biological Supply Company, Smokey MountainProducts, Inc. and the Fort Ticonderoga Association. Mr. Cummins earned aMasters of Business Administration degree from Columbia University in 1966 anda Bachelor of Arts degree from Harvard University in 1964.

 

Kenneth J.Lapiejko has been a director of the Company since January 2003. Mr. Lapiejkoserved as Executive Vice President and Chief Financial Officer for R.J.Reynolds Tobacco Holdings, Inc. from June 1999 to July 2002. From June 1995 toMay 1999, Mr. Lapiejko served as Senior Vice President and Chief FinancialOfficer of Reynolds Tobacco Company, which was an operating unit ofRJR/Nabisco. Prior to 1995 Mr. Lapiejko served in various financial roles withvarious companies. Mr. Lapiejko earned a bachelor’s degree in business fromFairleigh Dickinson University. Mr. Lapiejko completed the Young ExecutiveInstitute Program of the University of North Carolina at Chapel Hill. Mr.Lapiejko served on the board of directors of Targacept, Inc. and in July 2002resigned from his position on the Targacept, Inc. board of directors.

 

Guy M. Blynn hasserved as Vice President, Deputy General Counsel and Secretary of R.J. ReynoldsTobacco Company, a manufacturer and distributor of cigarettes, since October1989. From 1982 to 1990, Mr. Blynn was a member of the board of directors ofthe International Trademark Association. From 1980 to 1993, Mr. Blynn was a member of the AdjunctFaculty at Wake Forest University School of Law teaching Unfair TradePractices. Mr. Blynn currently sits on the board of directors of the Winston-SalemUrban League and the Anti-Defamation League. Mr. Blynn earned a Juris Doctoratedegree from Harvard Law School in 1970 and a Bachelor of Science degree ineconomics with a major in accounting from University of Pennsylvania in 1967.

 

Paul J. Splitekhas been Vice President of Sales of the Company since September 1999. Mr.Splitek has over 28 years of sales, marketing and manufacturing experience.From 1996 until being hired by the Company, Mr. Splitek was Vice President andGeneral Sales Manager of E. Rosen. Prior to joining E. Rosen, from 1991 to1996, Mr.Splitek was Vice President and General Manager of Mille Lacs MPCompany, a wholesale division of The Wisconsin Cheeseman Inc. (“TWC”), andprior to that, Operations Manager of TWC.

 

Arthur Wlodarskihas been Vice President of Purchasing of the Company since April 2000. Mr.Wlodarski has over 20 years of purchasing experience. From 1985 until 2000, MrWlodarski was Vice President of Purchasing of Houston Foods, a leading giftbasket packer responsible for purchasing components and food items from allover the world.

 

Compliance withSection 16(A) of the Securities Exchange Act of 1934

 

Section 16(a) ofthe Securities Exchange Act of 1934, as amended, requires certain officers,directors, and beneficial owners of more than ten percent (10%) of our commonstock to file reports of ownership and changes in their ownership of our equitysecurities with the Securities and Exchange Commission and Amex. Based solelyon a review of the reports and representations furnished to us during the last fiscalyear, we believe that each of the persons are in compliance with all applicablefiling requirements.

 

Audit Committee FinancialExpert

 

The Board of Directorshas determined that the Company has at least one audit committee financialexpert serving on its Audit Committee, Director, Mr. Kenneth J. Lapiejko is“independent” as that term is used in Schedule 14A, Item, 7(d)(3)(iv) under theSecurities Exchange Act of 1934, as amended.

 

29

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Item 11.    Executive Compensation

 

Informationconcerning the Executive Compensation of the Company is hereby incorporated bythe reference from the Company’s definitive proxy statement relating to itsAnnual Meeting of Shareholders to be filed with the Commission pursuant toRegulation 14A on or before November 28, 2003.

 

Item 12.    Security Ownership ofCertain Beneficial Owners and Management

 

Informationconcerning the security ownership of the Company is hereby incorporated byreference from the Company’s definitive proxy statement relating to its AnnualMeeting of Shareholders to be filed with the Commission pursuant to Regulation14A on or before November 28, 2003.

 

Item 13.    Certain Relationships andRelated Transactions

 

Informationconcerning Certain Relationships and Related Transactions of the Company ishereby incorporated by reference from the Company’s definitive proxy statementrelating to its Annual Meeting of Shareholders to be filed with the Commissionpursuant to Regulation 14A on or before November 28, 2003.

 

Item 14.    Principal Accountant Fees and Services

 

Informationconcerning Principal Accountant Fees and Services of the Company is herebyincorporated by reference from the Company’s definitive proxy statementrelating to its Annual Meeting of Shareholders to be filed with the Commissionpursuant to Regulation 14A on or before November 28, 2003.

 

30

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PART IV.

 

Item 15.    Exhibits, FinancialStatements and Reports on Form 8-K

 

(a) 1. FinancialStatements. The following financial statements, related notes and the Report ofIndependent Auditors, are included in response to Item 8 hereof.

 

Index toConsolidated Financial Statements

 
| Report  of Independent Auditors                                                                        |
|--------------------------------------------------------------------------------------------------------|
| Consolidated Balance Sheets  at July 31, 2003 and 2002                                                 |
| Consolidated  Statements of Operations for the years ended July 31, 2003, 2002 and 2001                |
| Consolidated Statements  of Shareholders’ Equity for the years ended July 31, 2003, 2002 and 2001 |
| Consolidated  Statements of Cash Flows for the years ended July 31, 2003, 2002 and 2001                |
| Summary  of Accounting policies                                                                        |
| Notes  to Consolidated Financial Statements                                                            |
| Schedule II—Valuation and Qualifying  Accounts                                                    |

 

Schedules otherthan those listed above have been omitted because they are not required or arenot applicable, or the required information has been included in theConsolidated Financial Statements or the Notes thereto.

 

(b)         Reports on Form 8-K

 

None

 
| **Number** |   | **Description**                                                                                                                                                                                                                                    |
|------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1        |   | Articles of  Incorporation, as amended, of the Registrant.(1)                                                                                                                                                                                      |
| 3.2        |   | Bylaws, as amended, of  the Registrant.(1)                                                                                                                                                                                                         |
| 4.1        |   | Form of Registrant’s  Class A Common Stock Certificate.(2)                                                                                                                                                                                    |
| 4.2        |   | Form of Underwriter’s  Warrant Agreement, including Form of Warrant Certificate.(2)                                                                                                                                                           |
| 4.3        |   | Form of Public Warrant  Agreement among the Registrant, Paragon Capital Corporation, as Underwriter  and Continental Stock Transfer & Trust Company, as Warrant Agent.(2)                                                                      |
| 4.4        |   | Form of Registrant’s  Public Warrant Certificate.(2)                                                                                                                                                                                          |
| 10.1       |   | Amended and Restated  Reimbursement Agreement between Central Fidelity National Bank and the  Registrant, dated as of May 1, 1997.(1)                                                                                                              |
| 10.2       |   | Loan Agreement between  Industrial Development Authority of Mecklenburg County, Virginia and the  Registrant, dated as of May 1, 1997.(1)                                                                                                          |
| 10.3       |   | Irrevocable Letter of  Credit dated May 15, 1997 issued on behalf of the Registrant to the Trustee  for the holders of Industrial Revenue Bonds (Series 1997) issued by the  Industrial Development Authority of Mecklenburg County, Virginia.(1)  |
| 10.4       |   | Amended and Restated  Credit Line Deed of Trust and Security Agreement, among the Registrant and Trustees,  for the benefit of Central Fidelity National Bank dated May 1, 1997.(1)                                                                |
| 10.5       |   | Pledge and Security  Agreement between the Registrant and Central Fidelity National Bank, dated as  of May 1, 1997.(1)                                                                                                                             |
| 10.6       |   | Guaranty between Uziel  Frydman, the Registrant and Central Fidelity National Bank, dated as of May  1, 1997.(1)                                                                                                                                   |
| 10.7       |   | Loan Agreement between  Industrial Development Authority of Mecklenburg County, Virginia and the  Registrant, dated as of June 1, 1996.(1)                                                                                                         |
| 10.8       |   | Irrevocable Letter of  Credit dated June 20, 1996 issued on behalf of the Registrant to the Trustee  for the holders of Industrial Revenue Bonds (Series 1996) issued by the  Industrial Development Authority of Mecklenburg County, Virginia.(1) |
| 10.9       |   | Pledge and Security  Agreement between the Registrant and Central Fidelity National Bank, dated as  of June 1, 1996.(1)                                                                                                                            |

 

31

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| **Number** |   | **Description**                                                                                                                                                                                                                                                                                                                                       |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10      |   | Company Loan Agreement  between the Industrial Development Authority of Mecklenburg County, Virginia  Loan Agreement through the Virginia Small Business Financing Administration  and the Registrant, dated as of June 20, 1996.(1)                                                                                                                  |
| 10.11      |   | Revolving Loan Fund  Agreement between the Registrant and Lake Country Development Corporation,  $250,000 Promissory Note to Lake Country Development Corporation, Guaranty of  Note by the Registrant and Uziel Frydman, and Deed of Trust between the  Registrant and Trustee for Lake Country Development Corporation, all dated  May 15, 1996.(1) |
| 10.12      |   | Loan Agreement,  Promissory Note, and Security Agreement between the Registrant and First  Union National Bank, all dated November 29, 1996, and Guaranty between Uziel  Frydman and First Union, dated November 29, 1996.(1)                                                                                                                         |
| 10.13      |   | Promissory Note issued  to Ilana Frydman by the Registrant, dated August 28, 1991.(1)                                                                                                                                                                                                                                                                 |
| 10.14      |   | Lease, as amended, for  the Registrant’s Rockville offices, executed November 30, 1992.(1)                                                                                                                                                                                                                                                       |
| 10.15      |   | 1998 Stock Option  Plan.(2)                                                                                                                                                                                                                                                                                                                           |
| 10.16      |   | Employment Agreement  between Registrant and Uziel Frydman, dated May 6, 1998.(2)                                                                                                                                                                                                                                                                     |
| 10.17      |   | Form of Employment  Agreement between Registrant and Anat Schwartz, dated May 6, 1998.(2)                                                                                                                                                                                                                                                             |
| 10.18      |   | Form of Employment  Agreement between Registrant and Amir Frydman, dated May 6, 1998.(2)                                                                                                                                                                                                                                                              |
| 10.19      |   | Receiver’s Bill of Sale  by Allen M. Shine, as receiver of E. Rosen Company, dated September 24,  1998.(3)                                                                                                                                                                                                                                       |
| 10.20      |   | Loan and Security  Agreement between the Registrant and First Union National Bank, dated June  12, 2001.(4)                                                                                                                                                                                                                                           |
| 10.21      |   | First Amendment to Loan  and Security Agreement between the Registrant and Wachovia Bank, National Association,  dated April 30, 2001.(5)                                                                                                                                                                                                             |
| 10.22      |   | First Amendment to  Employment Agreement between the Registrant and Uziel Frydman, dated August  1, 2001.(6)                                                                                                                                                                                                                                          |
| 10.23      |   | First Amendment to  Employment Agreement between the Registrant and Amir Frydman, dated August 1,  2001.(6)                                                                                                                                                                                                                                           |
| 10.24      |   | First Amendment to  Employment Agreement between the Registrant and Anat Schwartz, dated August  1, 2001.(6)                                                                                                                                                                                                                                          |
| 10.25      |   | Fifth Amendment to Loan  agreements with Wachovia dated July 30, 2003.(filed herewith)                                                                                                                                                                                                                                                                |
| 10.26      |   | Loan agreements,  Promissory Note with Lake Country Development dated August 15, 2003. (filed  herewith).                                                                                                                                                                                                                                             |
| 21.1       |   | Subsidiaries of the  Registrant.(5)                                                                                                                                                                                                                                                                                                                   |
| 23.1       |   | Consent of BDO Seidman,  LLP (filed herewith)                                                                                                                                                                                                                                                                                                         |
| 31.1       |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a)/15d-14(a). (filed herewith)                                                                                                                                                                                                                                                      |
| 31.2       |   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a)/15d-14(a). (filed herewith)                                                                                                                                                                                                                                                      |
| 32.1       |   | Certification of Chief  Executive Officer pursuant to Section 1350. (filed herewith)                                                                                                                                                                                                                                                                  |
| 32.2       |   | Certification of Chief  Financial Officer pursuant to Section 1350. (filed herewith)                                                                                                                                                                                                                                                                  |

 

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(1)          Incorporated herein byreference to the Company’s Registration Statement on Form SB-2, dated as ofJanuary 21, 1998 (Registration No. 333-44655)

 

(2)          Incorporated herein byreference to Amendment No. 2 to the Company’s Registration Statement on FormSB-2, dated as of May 4, 1998 (Registration No. 333-44655)

 

(3)          Incorporated herein byreference to the Company’s Current Report on Form 8-K, dated as of October 9,1998.

 

(4)          Incorporated herein byreference to the Registrant’s Amendment No.1 to the Registration Statement onForm 3-3/A, dated as of September 2002 (registration No. 333-92012).

 

(5)          Incorporated herein byreference to the Company’s Annual Report on Form

 

32

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10-K, filed withthe Securities and Exchange Commission on October 29, 2002

 

(6)          Incorporated herein byreference to the Company’s Definitive Proxy Statement, filed with theSecurities and Exchange Commission on November 21, 2002

 

33

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*SIGNATURES*

 

Pursuant to therequirements of Section 13 and 15(d) of the Securities Exchange Act of 1934,the Company has duly caused this Amended Report to be signed on its behalf bythe undersigned, thereunto duly authorized on the date indicated.

 
| Date: October 28, 2003 |                                                   |
|------------------------|--------------------------------------------------------|
|                   |                                                   |   |
| SHERWOOD BRANDS, INC.  |                                                   |
| By:                    | /s/     UZIEL  FRYDMAN        |   |
|                   | Uziel Frydman                                          |   |
|                   | President and  Chief Executive  Officer                |   |
|                   | Principal  Executive Officer                           |   |
|                   |                                                   |   |
|                   |                                                   |   |
| By:                    | /S/     AMIR  FRYDMAN         |   |
|                   | Amir Frydman                                           |   |
|                   | Executive Vice  President,                             |   |
|                   | Treasurer and  Director                                |   |
|                   |                                                   |   |
| By:                    | /s/     CHRISTOPHER  J. WILLI |   |
|                   | Christopher J.  Willi                                  |   |
|                   | Chief Financial  Officer,  Secretary                   |   |
|                   | Principal  Financial Officer                           |   |
|                   |                                                   |   |
| By:                    | /s/     DOUGLAS  A. CUMMINS   |   |
|                   | Douglas A.  Cummins                                    |   |
|                   | Director                                               |   |
|                   |                                                   |   |
| By:                    | /s/     KENNETH  J. LAPIEJKO  |   |
|                   | Kenneth J.  Lapiejko                                   |   |
|                   | Director                                               |   |
|                   |                                                   |   |
| By:                    | /s/     GUY  BLYNN            |   |
|                   | Guy Blynn                                              |   |
|                   | Director                                               |   |

 

34

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REPORT OF INDEPENDENTCERTIFIED PUBLIC ACCOUNTANTS’ON FINANCIAL STATEMENT SCHEDULE

 

Sherwood Brands, Inc.

 

The audits referred to inour report to Sherwood Brands, Inc. dated October 10, 2003 which is containedin this Form 10-K, include the audit of the financial statement schedule listedin the accompanying index for each of the three years in the period ended July31, 2003. This financial statement schedule is the responsibility of theCompany’s management. Our responsibility is to express an opinion on thefinancial statement schedule based on our audits.

 

In our opinion, suchschedule presents fairly, in all material respects, the information set forththerein.

 

BDO SEIDMAN, LLP

Bethesda, Maryland

October 10, 2003

 

SCHEDULE II

VALUATION ANDQUALIFYING ACCOUNTS

 
| **Description**                                     |   | **Balance  Beginning      Of Period** |    | **Charged To  Costs  And Expenses** |   | **Deduction** |   | **Balance At  End  Of Period** |       |
|-----------------------------------------------------|--------|------------------------------------------------------|---------|-------------------------------------|--------|---------------|--------|--------------------------------|------------|
| Year ended July31, 2001                             |   |                                                 |    |                                |   |          |   |                           |       |
| Allowance for doubtful accounts                     |   | $                                                    | 115,000 |                                | $      | 272,290  |   | $                              | (198,690   | ) | $ | 188,600 |   |
| Allowance for customer credits                      |   | $                                                    | 240,072 |                                | — |          | $      | (156,533                       | )          | $ | 83,539 |   |
| Reserve for slow moving inventory                   |   | $                                                    | 315,059 |                                | $      | 385,369       |   | —                         |       | $ | 700,428 |   |
| Year ended July31, 2002                             |   |                                                 |    |                                |   |          |   |                           |       |
| Allowance for doubtful accounts                     |   | $                                                    | 188,600 |                                | $      | 227,811  |   | $                              | (290,239   | ) | $ | 126,172 |   |
| Allowance for customer credits                      |   | $                                                    | 83,539  |                                | — |          | $      | (1,960                         | )          | $ | 81,579 |   |
| Reserve for slow moving inventory                   |   | $                                                    | 700,428 |                                | $      | 399           |   | —                         |       | $ | 700,827 |   |
| Year ended July31, 2003                             |   |                                                 |    |                                |   |          |   |                           |       |
| Allowance for doubtful accounts                     |   | $                                                    | 126,172 |                                | $      | 186,811       |   | $                              | (220,965   | ) | $ | 92,018 |   |
| Allowance for customer credits                      |   | $                                                    | 81,579  |                                | 34,085 |          | $      | —                         |       | $ | 115,664 |   |
| Reserve for slow moving inventory  moving inventory |   | $                                                    | 700,827 |                                | $      | 2,192,005     |   | $                              | (1,749,122 | )  | $ | 1,143,710 |   |

 

35

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INDEPENDENTCERTIFIED PUBLIC ACCOUNTANTS’ REPORT

 

To the Board of Directorsand Stockholders

 

Sherwood Brands, Inc.

 

We have audited theaccompanying consolidated balance sheets of Sherwood Brands, Inc. andSubsidiaries as of July 31, 2003 and 2002 and the related consolidatedstatements of operations, stockholders’ equity and cash flows for each of thethree years in the period ended July 31, 2003. These financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes, examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principals used and significantestimates made by management, as well as evaluating the overall presentation ofthe financial statements. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Sherwood Brands, Inc. andSubsidiaries at July 31, 2003 and 2002 and the results of its operations andcash flows for each of the three years in the period ended July 31, 2003 inconformity with accounting principals generally accepted in the United Statesof America.

 
|               | BDO SEIDMAN, LLP |
|--------------------|------------------|
| Bethesda, Maryland |
| October 10, 2003   |

 

36

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SHERWOOD BRANDS, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS

 
| **For the years ended July 31,**                                                                                     |   | **2003**   |            | **2002**   |   |
|----------------------------------------------------------------------------------------------------------------------|--------|------------|-----------------|------------|--------|
| Assets                                                                                                               |   |       |            |       |   |
| Current assets                                                                                                       |   |       |            |       |   |
| Cash and cash equivalents                                                                                            |   | $          | 227,352         |       | $      | 709,247 |   |
| Accounts receivable, less allowance of $92,000 and $126,000                                                          |   | 899,230    |            | 2,547,452  |   |
| Inventory                                                                                                            |   | 13,719,294 |            | 15,956,145 |   |
| Income taxes receivable                                                                                              |   | 1,020,379  |            | 1,555,078  |   |
| Other current assets                                                                                                 |   | 578,155    |            | 450,375    |   |
| Deferred taxes on income                                                                                             |   | 614,000    |            | 512,000    |   |
| Total current assets                                                                                                 |   | 17,058,410 |            | 21,730,297 |   |
| Net property and equipment                                                                                           |   | 7,129,227  |            | 7,350,488  |   |
| Goodwill                                                                                                             |   | 2,001,330  |            | 2,001,330  |   |
| Other assets                                                                                                         |   | 313,504    |            | 308,839    |   |
| Total Assets                                                                                                         |   | $          | 26,502,471      |       | $      | 31,390,954 |   |
| Liabilities and  Stockholders’ Equity                                                                           |   |       |            |       |   |
| Current liabilities                                                                                                  |   |       |            |       |   |
| Line of credit                                                                                                       |   | $          | 6,260,264  |       | $      | 8,203,971 |   |
| Current portion of long-term debt                                                                                    |   | 530,377    |            | 90,000     |   |
| Current portion of subordinated debt                                                                                 |   | 2,000,000  |            | —     |   |
| Current portion of capital lease obligation                                                                          |   | 15,718     |            | 15,718     |   |
| Accounts payable                                                                                                     |   | 6,257,145  |            | 5,833,301  |   |
| Accrued expenses                                                                                                     |   | 1,325,891  |            | 1,368,928  |   |
| Income taxes payable                                                                                                 |   | —     |            | —     |   |
| Total current liabilities                                                                                            |   | 16,389,395 |            | 15,511,918 |   |
| Long-term debt                                                                                                       |   | 1,150,513  |            | 1,722,000  |   |
| Capital lease obligation                                                                                             |   | 423,892    |            | 438,696    |   |
| Deferred taxes on income                                                                                             |   | 464,000    |            | 331,000    |   |
| Total Liabilities                                                                                                    |   | 18,427,800 |            | 18,003,614 |   |
| Commitments and Contingencies                                                                                        |   |       |            |       |   |
| 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,  3,003,476 and 2,986,809 issued and outstanding |   | 30,035     |            | 29,869     |   |
| 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                                                                                           |   | 9,843,774  |            | 9,816,856  |   |
| Retained (deficit)earnings                                                                                           |   | (1,809,138 | )               | 3,561,754  |   |
| Accumulated other comprehensive income (loss)                                                                        |   | —     |            | (31,139    | )      |
| Total Stockholders’ Equity                                                                                      |   | 8,074,671  |            | 13,387,340 |   |
| Total Liabilities and Stockholders’ Equity                                                                      |   | $          | 26,502,471      |       | $      | 31,390,954 |   |

 

See accompanyingsummary of accounting policies and notes to consolidated financial statements.

 

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SHERWOOD BRANDS, INC AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFOPERATIONS

 
|                                               |   | **For years  ended July 31,** |       |
|----------------------------------------------------|--------|-------------------------------|------------|
|                                               |   | **2003**                      |       | **2002** |   | **2001** |   |
| Net sales                                          |   | $                             | 49,162,787 |   | $ | 52,782,341 |   | $ | 58,316,716 |   |
| Cost of sales                                      |   | 37,680,097                    |       | 37,714,680 |   | 41,796,184 |   |
| Write down of inventory                            |   | 2,192,005                     |       | — |   | — |   |
| Gross profit                                       |   | 9,290,685                     |       | 15,067,661 |   | 16,520,532 |   |
| Selling, general and administrative expenses       |   | 8,192,774                     |       | 8,313,603 |   | 8,006,416 |   |
| Salaries and related expenses                      |   | 5,057,115                     |       | 5,100,167 |   | 4,806,061 |   |
| Non-recurring costs                                |   | 1,932,075                     |       | 707,551 |   | — |   |
| Total operating expenses                           |   | 15,181,964                    |       | 14,121,321 |   | 12,812,477 |   |
| (Loss) income from operations                      |   | (5,891,279                    | )          | 946,340 |   | 3,708,055 |   |
| Other income (expense)                             |   |                          |       |   |   |   |   |
| Interest income                                    |   | 2,636                         |       | 4,881 |   | 11,182 |   |
| Interest expense                                   |   | (623,201                      | )          | (468,687 | ) | (539,971 | ) |
| Other income (expense)                             |   | 274,728                       |       | 90,535 |   | 132,209 |   |
| Total other (expense) income                       |   | (345,837                      | )          | (373,271 | ) | (396,580 | ) |
| (Loss) income before provision for taxes on income |   | (6,237,116                    | )          | 573,069 |   | 3,311,475 |   |
| (Benefit) provision for taxes on income            |   | (866,224                      | )          | 248,039 |   | 1,093,100 |   |
| Net (loss) income                                  |   | $                             | (5,370,892 | ) | $ | 325,030 |   | $ | 2,218,375 |   |
| Net (loss) income per share                        |   |                          |       |   |   |   |   |
| —basic                                        |   | $                             | (1.34      | ) | $ | 0.09 |   | $ | 0.60 |   |
| —diluted                                      |   | (1.34                         | )          | 0.08 |   | 0.56 |   |
| Weighted average common shares outstanding         |   |                          |       |   |   |   |   |
| —basic                                        |   | 3,996,199                     |       | 3,778,375 |   | 3,700,000 |   |
| —diluted                                      |   | 3,996,199                     |       | 4,312,762 |   | 3,954,428 |   |

 

See accompanyingsummary of accounting policies and notes to consolidated financial statements.

 

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SHERWOOD BRANDS, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY

 
|                        |   | **Common  Stock** |   | **Accumulated  Additional  Paid-In  Capital** |   | **Other  Retained  Earnings** |      | **Comprehensive  Income (Loss)** |   | **Total** |   |
|-----------------------------|--------|-------------------|--------|-----------------------------------------------|--------|-------------------------------|-----------|----------------------------------|--------|-----------|--------|
|                        |   | **Class A**       |   | **Class B**                                   |   |                          |      |                             |   |
|                        |   | **Shares**        |   | **Amount**                                    |   | **Shares**                    |      | **Amount**                       |   |      |   |   |   |
| Balance, at July 31, 2000   |   | 2,700,000         |   | 27,000                                        |   | 1,000,000                     |      | 10,000                           |   | 7,973,538 |   | 1,018,349 |   | — |   | 9,028,887 |   |
| Foreign currency (loss)     |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | — |   | (18,270 | ) | — |   |
| Net income                  |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | 2,218,375 |   | — |   | — |   |
| Comprehensive income        |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | — |   | — |   | 2,200,105 |   |
| Balance, at July 31 ,2001   |   | 2,700,000         |   | 27,000                                        |   | 1,000,000                     |      | 10,000                           |   | 7,973,538 |   | 3,236,724 |   | (18,270 | ) | 1,228,992 |   |
| Foreign currency (loss)     |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | — |   | (12,869 | ) | — |   |
| Exercise of stock options   |   | 16,250            |   | 163                                           |   | —                        |      | —                           |   | 40,931    |   | — |   | — |   | — |   |
| Vesting restricted stock    |   | —            |   | —                                        |   | —                        |      | —                           |   | 19,401    |   | — |   | — |   | — |   |
| Issued stock Acquisition    |   | 270,559           |   | 2,706                                         |   | —                        |      | —                           |   | 1,674,760 |   | — |   | — |   | — |   |
| Warrants issued Acquisition |   | —            |   | —                                        |   | —                        |      | —                           |   | 108,226   |   | — |   | — |   | — |   |
| Net income                  |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | 325,030 |   | — |   | — |   |
| Comprehensive income        |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | — |   | — |   | 2,158,348 |   |
| Balance, at July 31, 2002   |   | 2,986,809         |   | $                                             | 29,869 |                          | 1,000,000 |                             | $      | 10,000    |   | $ | 9,816,856 |   | $ | 3,561,754 |   | $ | (31,139  | ) | $ | 13,387,340 |   |
| Foreign currency (loss)     |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | — |   | 31,139 |   | — |   |
| Exercise of stock options   |   | 16,667            |   | 166                                           |   | —                        |      | —                           |   | 26,918    |   | — |   | — |   | — |   |
| Net income                  |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | (5,370,892 | ) | — |   | — |   |
| Comprehensive income        |   | —            |   | —                                        |   | —                        |      | —                           |   | —    |   | — |   | — |   | (5,312,669 | ) |
| Balance, at July 31, 2003   |   | 3,003,476         |   | $                                             | 30,035 |                          | 1,000,000 |                             | $      | 10,000    |   | $ | 9,843,774 |   | $ | (1,809,138 | )  | $ | — |   | $ | 8,074,671 |   |

 

See accompanyingsummary of accounting policies and notes to consolidated financial statements.

 

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SHERWOOD BRANDS,INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTSOF CASH FLOWS

 
|                                                                                                |   | **For the  years ended July 31,** |          |
|-----------------------------------------------------------------------------------------------------|--------|-----------------------------------|---------------|
|                                                                                                |   | **2003**                          |          | **2002** |   | **2001** |   |
| Cash flows from operating activities                                                                |   |                              |          |   |   |   |   |
| Net income (loss)                                                                                   |   | $                                 | (5,370,892    | ) | $ | 325,030 |   | $ | 2,218,375 |   |
| Adjustments to reconcile net income (loss) to net Cash provided by  (used in) operating activities: |   |                              |          |   |   |   |   |
| Depreciation expense                                                                                |   | 961,712                           |          | 680,013 |   | 403,756 |   |
| Deferred income taxes                                                                               |   | 31,000                            |          | — |   | (94,000 | ) |
| Restricted stock                                                                                    |   | —                            |          | 19,401 |   | — |   |
| Gain (loss) on disposal of equipment                                                                |   | —                            |          | (3,674 | ) | — |   |
| (Gain) loss on foreign currency exchange                                                            |   | —                            |          | 422 |   | (2,519 | ) |
| Provision for inventory allowance                                                                   |   | 2,192,005                         |          | 399 |   | 385,369 |   |
| Provision for doubtful accounts                                                                     |   | 186,811                           |          | 227,811 |   | 272,290 |   |
| (Increase) decrease in assets                                                                       |   |                              |          |   |   |   |   |
| Accounts receivable                                                                                 |   | 1,461,411                         |          | (798,168 | ) | (154,689 | ) |
| Inventory                                                                                           |   | 44,846                            |          | 1,346,920  |   | (2,411,309 | ) |
| Income taxes receivable                                                                             |   | 534,699                           |          | (674,520 | ) | 407,237 |   |
| Other current assets                                                                                |   | (127,780                          | )             | (87,672 | ) | (55,634 | ) |
| Other assets                                                                                        |   | (4,665                            | )             | (210,204 | ) | 4,715 |   |
| Increase (decrease) in liabilities                                                                  |   |                              |          |   |   |   |   |
| Accounts payable                                                                                    |   | 423,844                           |          | 213,014 |   | (537,054 | ) |
| Accrued expenses                                                                                    |   | (11,898                      | )             | (795,008 | ) | 509,656 |   |
| Income taxes payable                                                                                |   | —                            |          | (722,474 | ) | 672,474 |   |
| Net cash provided by (used in) operating activities                                                 |   | 321,093                           |          | (478,710  | ) | 1,618,667 |   |
| Cash flows from investing activities                                                                |   |                              |          |   |   |   |   |
| Acquisition costs of Asher Candy                                                                    |   | —                            |          | (58,628 | ) | — |   |
| Proceeds from sale of property, plant & equipment                                               |   | —                            |          | 26,058 |   | — |   |
| Capital expenditures                                                                                |   | (740,451                          | )             | (2,128,435 | ) | (1,064,258 | ) |
| Net cash used in investing activities                                                               |   | (740,451                          | )             | (2,161,005 | ) | (1,064,258 | ) |
| Cash flows from financing activities                                                                |   |                              |          |   |   |   |   |
| Net borrowings on line of credit                                                                    |   | (1,943,707                   | )             | 3,177,584 |   | (276,703 | ) |
| Proceeds from LT debt                                                                               |   | 350,000                           |          | — |   | — |   |
| Proceeds from Subordinated debt                                                                     |   | 2,000,000                         |          | — |   | — |   |
| Payments on debt                                                                                    |   | (495,914                          | )             | (254,748 | ) | (534,008 | ) |
| Exercise of Stock options                                                                           |   | 27,084                            |          | 40,931 |   | — |   |
| Net cash (used in) provided by financing activities                                                 |   | (62,537                      | )             | 2,963,767 |   | (810,711 | ) |
| Net (decrease) increase in cash and cash equivalents                                                |   | (481,895                          | )             | 324,052 |   | (256,302 | ) |
| Cash and cash equivalents, at beginning of period                                                   |   | 709,247                           |          | 385,195 |   | 641,497 |   |
| Cash and cash equivalents, at end of period                                                         |   | $                                 | 227,352  |   | $ | 709,247 |   | $ | 385,195 |   |
| Interest Paid                                                                                       |   | $                                 | 623,201  |   | $ | 468,687 |   | $ | 539,971 |   |
| Income Taxes Paid                                                                                   |   | $                                 | —   |   | $ | 1,623,448 |   | $ | 443,440 |   |

 

See accompanyingsummary of accounting policies and notes to consolidated financial statements.

 

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SHERWOOD BRANDS, INC. AND SUBSIDIARIESSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation,Organization and Description of Business

 

The consolidatedfinancial statements include the accounts of Sherwood Brands, Inc. and itswholly-owned subsidiaries, Sherwood Brands, LLC, Sherwood Brands Overseas, Inc.(“Overseas”), Sherwood Brands of RI, Inc. and Asher Candy, Inc. (collectively,the “Company”). All material inter-company transactions and balances have beeneliminated in consolidation.

 

Sherwood Brands, Inc. wasincorporated in December 1982 in the state of North Carolina. Sherwood Brands,Inc. is engaged in the manufacture, marketing and distribution of a diverseline of candies, cookies and chocolates. The Company also manufactures jellybeans, lollipops, biscuits, soft and hard candies and assembles seasonal giftitems including gift baskets. The Company operates in the confectionaryindustry and aligns its operations into three business segments for managementto measure financial performance by product type.  The Company’s business segments are (i) Manufactured Candy andCookies, (ii) Purchased Candy and Cookies and (iii) Purchased Gift Items andAssembled Gift Items.

 

Sherwood Brands, Inc. isthe owner of Sherwood Brands, LLC, a Maryland limited liability company.Sherwood Brands, LLC markets and distributes its own line of confectioneryproducts in the United States.

 

Overseas (a wholly-ownedsubsidiary of Sherwood Brands, LLC) was incorporated in July 1993 in theBahamas to market and distribute the Sherwood lines of confectionery productsinternationally.

 

Sherwood Brands of RI,Inc. was incorporated in September, 1998 in the state of Rhode Island. SherwoodBrands of RI, Inc. d/b/a E. Rosen Company is a manufacturer of hard candies,jelly beans and packer of gift items and baskets. On September 24, 1998 theCompany completed the acquisition of certain assets of the E. RosenCompany—d/b/a School House Candy Co. (“Rosen”). Rosen was a Rhode Islandmanufacturer of hard candy, jelly beans and lollipops and assembled a varietyof holiday gift items including gift baskets. Rosen sold its holiday gift itemsto such chains as Wal-Mart, Kmart and CVS. The Company paid $4.0 million incash for the machinery and equipment, inventory and trade names, trademarks andcustomer lists of Rosen. For financial accounting purposes, the entire purchaseprice of $4.0 million was allocated to the inventories of raw material,components and finished product.

 

Sherwood AcquisitionCorporation (a wholly-owned subsidiary of the Company) was incorporated inApril 2002 in the state of Wyoming. Sherwood Acquisition merged with and intoAsher Candy Acquisition Corporation, a Wyoming corporation. On May 1, 2002, theCompany acquired all of the outstanding common stock of Asher Candy AcquisitionCorporation, a Wyoming corporation with operations located in New Hyde Park,New York. Asher Candy Acquisition Corporation is a manufacturer of candy canesand other hard candies under the “Asher” name. The surviving corporation of themerger is Asher Candy Acquisition Corporation, which has changed its name toAsher Candy, Inc. (See Note 3).

 

Cash Equivalents

 

For purposes of thestatement of cash flows, the Company considers highly liquid investments withmaturities at original date of acquisition of three months or less to be cashequivalents.

 

Accounts Receivable andAllowance for Doubtful Accounts.

 

Accounts receivable arecustomer obligations due under normal trade terms. We sell our products tothose involved in the retail industry. Accounts receivable are reviewed to determine if any receivables willpotentially be uncollectible.  TheCompany records an allowance for doubtful accounts based on specificallyidentified amounts that they believe to be uncollectible along with a generalreserve.  If the actual collectionsexperience changes, revisions to the allowance may be required.  Any unanticipated change in the customer’scredit worthiness or other matters affecting the collectibility of amounts duefrom such customers, could have a material affect on the results of operationsin the period in which such changes or events occur.  After all attempts to collect a receivable have failed, thereceivable is written off against the allowance.  Based on the information available, the Company believes theallowance for doubtful accounts as of July 31, 2003 and 2002 is adequate.  However, actual write-offs might exceed therecorded allowance.

 

Inventory

 

Inventory consists of rawmaterials, packaging materials, components used in assembly, work-in-processand finished goods and is stated at the lower of cost or market. Cost isdetermined by the FIFO (first-in, first-out) method.

 

Property and Equipment

 

Property and equipmentare stated at cost. Depreciation is computed using accelerated andstraight-line methods over the estimated useful lives of the individual assetswhich range from five to seven years for machinery and equipment to thirty-nineyears for the building.

 

Asset Impairment

 

The Company periodicallyevaluates the carrying value of long-lived assets when events and circumstanceswarrant such a review. The carrying value of a long-lived asset is considered

 

41

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impaired when theanticipated undiscounted cash flow from such asset is separately identifiableand is less than the carrying value. In that event, a loss is recognized basedon the amount by which the carrying value exceeds the fair market value of thelong-lived asset. Fair market value is determined primarily using theanticipated cash flows discounted at a rate commensurate with the riskinvolved.

 

Revenue Recognition

 

Sales are recognized uponshipment of products. Sales discounts and any other price adjustments are accountedfor as a reduction in revenue at the later of (1) the date at which the relatedrevenue is recognized by the Company or (2) the date at which the salesincentive is offered.

 

In September 2000, theEmerging Issues Task Force issued EITF 00-10, Accounting for Shipping andHandling Fees and Costs (EITF 00-10). EITF 00-10 requires that shipping andhandling fees billed to customers be classified as revenue and shipping andhandling costs be either classified as cost of sales or disclosed in the notesto the financial statements. The Company includes shipping and handling feesbilled to customers in net sales. Shipping and handling costs associated withinbound freight are included in cost of sales. Shipping and handling costsassociated with outbound freight are included in selling, general andadministrative expenses and totaled approximately $3,529,000, $2,973,000 and$3,437,000 in fiscal 2003, 2002 and 2001, respectively.

 

Income Taxes

 

Income taxes arecalculated using the liability method specified by Statement of FinancialAccounting Standards No. 109, “Accounting for Income Taxes (SFAS 109).” UnderSFAS 109, deferred taxes are determined using the liability method whichrequires the recognition of deferred tax assets and liability based on differencesbetween the financial statement and the income tax basis using presentlyenacted tax rates.

 

Use of Estimates

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosures of contingent assets and liabilities at the date of the financialstatements and reported amounts of revenues and expenses during the reportingperiod. Actual results could differ from those estimates.

 

Financial Instruments

 

Financial instruments ofthe Company include long-term debt. Based upon current borrowing ratesavailable to the Company, estimated fair values of these financial instrumentsapproximate their recorded amounts.

 

Derivative FinancialInstruments

 

The Company formerlyutilized derivative financial instruments to reduce foreign currency risks. TheCompany did not hold or issue derivative financial instruments for tradingpurposes. In June 1998, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” which was amended in June 2000 by SFAS No. 138, SFAS No. 133, asamended, establishes accounting and reporting standards for derivativeinstruments and hedging activities. They require that a company recognize allderivatives as either assets or liabilities in the statement of financialcondition and measure those instruments at fair value. Changes in the fairvalue of those instruments will be reported in earnings or other comprehensiveincome depending on the use of the derivative and whether it qualifies forhedge accounting. The accounting for gains and losses associated with changesin the fair value or the derivative, and the effect on the consolidatedfinancial statements will depend on its hedge designation and whether the hedgeis highly effective in achieving offsetting changes in the fair value of cashflows of the asset or liability hedged. The Company adopted SFAS 133, asamended in the fourth quarter of fiscal 2001. See Note 16.

 

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Comprehensive Income

 

Comprehensive income(loss) is reported on the Consolidated Statements of Stockholders’ Equity andaccumulated other comprehensive (loss) is reported on the Consolidated BalanceSheets. For the Company, other comprehensive income (loss) consists of changesin the fair market value of derivatives. Prior to the fourth quarter of 2001,the Company had no derivative financial instruments or items of othercomprehensive income. During the fiscal year ended July 31, 2002 the Companyexecuted a foreign exchange forward contract to purchase 766,000 Euros. Inaccordance with SFAS 133, as amended, the Company marked the contract to marketas of July 31, 2002 and recorded a loss of $31,139 in other comprehensiveincome since the Company designated the contract as a cash flow hedge. Duringthe fiscal year ended July 31, 2003 the Company had no derivative financialinstruments.

 

Earnings Per Share

 

The Company accounts forearnings per share in accordance with Statement of Financial AccountingStandards No. 128, Earnings Per Share (SFAS 128). SFAS 128 requires twopresentations of earnings per share-”basic” and “diluted”. Basic earnings pershare is computed by dividing net income available to common stockholders forthe period by the weighted average number of common shares outstanding for theperiod. The computation of diluted earnings per share is similar to basicearnings per share, except the denominator is increased to include the numberof additional common shares that would have been outstanding if the potentiallydilutive common shares had been issued. Basic and dilutive earnings per shareare the same during 2003 because the impact of dilutive securities isanti-dilutive.

 
|                                    |   | **For the  year ended July 31,  2002** |            |
|-----------------------------------------|--------|----------------------------------------|-----------------|
|                                    |   | **Income**                             |            | **Shares** |   | **Per Share  Amount** |   |
| Basic earnings per share                |   |                                   |            |   |   |   |   |
| Income available to common stockholders |   | $                                      | 325,030         |   | 3,778,375 |   | $ | 0.09 |   |
| Effect of dilutive stock options        |   |                                   |            | 534,386 |   |   |   |
| Diluted earnings per share              |   | $                                      | 325,030    |   | 4,312,761 |   | $ | 0.08 |   |
|                                    |   |                                   |            |   |   |   |   |
|                                    |   | **For the  year ended July 31,  2001** |            |
|                                    |   | **Income**                             |            | **Shares** |   | **Per Share  Amount** |   |
| Basic earnings per share                |   |                                   |            |   |   |   |   |
| Income available to common stockholders |   | $                                      | 2,218,375       |   | 3,700,000 |   | $ | 0.60 |   |
| Effect of dilutive stock options        |   |                                   |            | 254,428 |   |   |   |
| Diluted earnings per share              |   | $                                      | 2,218,375  |   | 3,954,428 |   | $ | 0.56 |   |

 

Stock compensation of stock options

 

The Company has adopted the disclosure only provisions of Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation” (SFAS 123”), but it continues to measure compensation cost forthe stock options using the intrinsic value method prescribed by APB Opinion No.25. As allowable under SFAS 123, the Company used the Black-Sholes method tomeasure the compensation cost of stock options granted in 2002 and 2001 withthe following assumptions: risk-free interest rate of 4.66% and 6.00%, adividend payout rate of zero, and an expected option life of ten years,respectively. The volatility is 66%. Using these assumptions, the fair value ofstock options granted during fiscal 2002 and 2001 was $3.76 and $2.56,respectively.

 

There were no adjustmentsmade in calculating the fair value to account for vesting provisions, fornon-transferability or risk of forfeiture. Because the Company’s employee stockoptions have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value of itsemployee stock options.

 

43

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If the Company hadelected to recognize compensation cost based on the value at the grant dateswith the method prescribed by SFAS 123, net income and earnings per share wouldhave been changed to the pro forma amounts indicated in the following table:

 
|                                                                                                                                         |   | **For years  ended July 31,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                                                                                         |   | **2003**                      |       | **2002** |   | **2001** |   |
| Net Income/(loss)                                                                                                                            |   |                          |       |   |   |   |   |
| As Reported                                                                                                                                  |   | $                             | (5,370,892 | ) | $ | 325,030 |   | $ | 2,218,375 |   |
|                                                                                                                                         |   |                          |       |   |   |   |   |
| Deduct: Total stock-based employee Compensation expense determined  under Fair value based method for all awards, Net of related tax effects |   | 149,000                       |       | 242,000 |   | 507,000 |   |
|                                                                                                                                         |   |                          |       |   |   |   |   |
| Pro Forma net income (loss)                                                                                                                  |   | (5,519,892                    | )          | 83,030  |   | 1,711,375 |   |
| Basic Income/(loss) per Common Share:                                                                                                        |   |                          |       |   |   |   |   |
| As Reported                                                                                                                                  |   | $                             | (1.34      | ) | $ | 0.09 |   | $ | 0.60 |   |
| Pro Forma                                                                                                                                    |   | (1.38                         | )          | 0.02 |   | 0.46 |   |
| Diluted income/(loss) per Common Share:                                                                                                      |   |                          |       |   |   |   |   |
| As reported                                                                                                                                  |   | $                             | (1.34      | ) | $ | 0.08 |   | $ | 0.56 |   |
| Pro Forma                                                                                                                                    |   | (1.38                         | )          | 0.02 |   | 0.43 |   |

 

The Company has issued38,562 warrants exercisable for shares of Class A common stock exercisable at$6.49 and expire on April 30, 2005.

 

The Company has issuedand outstanding 775,000 warrants to purchase shares of Class A common stock.The warrants are exercisable at $7.50 and expired on May 6, 2003.

 

Recent AccountingPronouncements

 

In October 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 144 (Accounting for the Impairment or Disposal of Long Lived Assets). This standard develops one accounting model for long-lived assets that are to be disposed of by sale, requiring such assets to be measured at the lower of book value or fair value less cost to sell. The standard also provides guidance on the recognition of liabilities for the obligations arising from disposal activities. We adopted the use of this accounting statement in August 2002. Adoption did not have a material effect on our financial position or results of operations.

 

In April 2002, the Financial Accounting Standards Board issued SFAS No. 145 (Rescission of FASB Statement No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical Corrections as of April 2002). Among other things, this statement addresses how to report gains or losses resulting from the early extinguishment of debt. Previously, any gains or losses were reported as an extraordinary item. Upon adoption of SFAS No. 145, an entity is required to evaluate whether the debt extinguishment is truly extraordinary in nature, in accordance with Accounting Principles Board Opinion No. 30. We adopted the use of this accounting statement in August 2002   Adoption did not have a material effect on our financial position or results of operations.

 

In July 2002, the Financial Accounting Standards Board issued SFAS No. 146 (Accounting for Costs Associated with Exit or Disposal Activities). This standard requires recognition of costs associated with exit or disposal activities when they are incurred rather than when management commits to an exit or disposal plan. Examples of costs covered by this guidance include lease termination costs, employee severance costs that are associated with restructuring, discontinued operations, plant closings, or other exit or disposal activities. We adopted the use of this accounting statement for all activities initiated after December 31, 2002. Adoption did not have a material effect on our financial position or results of operations.

 

In December 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements. FIN 45 expands required disclosures for certain types of guarantees and recognition of a liability at fair value of such guarantees at the time of issuance. The disclosure requirements are effective beginning with our second fiscal quarter financial

 

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statements, endingJanuary 31, 2002, while the fair value accounting requirements applyprospectively to guarantees issued or modified after December 31, 2002.Adoption of FIN 45 did not have a material effect on our financial position orresults of operations.

 

In January 2003, the FASB issued InterpretationNo. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 amendedARB 51, Consolidated Financial Statements, and established standards fordetermining under what circumstances a variable interest entity (VIE) should beconsolidated with its primary beneficiary. FIN 46 also requires disclosuresabout VIEs that the company is not required to consolidate, but in which it hasa significant variable interest. Adoption of FIN 46 did not have a materialeffect on our financial position or results of operations.

 

In January 2003, the FASB issued Statement No.148, Accounting for Stock-Based Compensation, to provide alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, this Statement amends thedisclosure requirements of Statement 123 to require prominent disclosures inboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults. We adopted the use of this accounting statement in January 2003by implementing the disclosure provisions. Adoption did not have a materialeffect on our financial position or results of operations as no accounting changewas required. We have no plans to voluntarily expense stock options or changeour current stock-based compensation program.

 

In April 2003, the FASB issued Statement No. 149,Amendment of Statement 133 on Derivative Instruments and Hedging Activities.This Statement amends and clarifies financial accounting and reporting forderivative instruments, including certain derivative instruments embedded inother contracts (collectively referred to as derivatives) and for hedgingactivities under FASB Statement No. 133, Accounting for Derivative Instrumentsand Hedging Activities. We adopted the use of this accounting statement inJune 2003. Adoption did not have a material effect on our financialposition or results of operations.

 

In May 2003, the FASB issued Statement No. 150,Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity. This Statement established standards on how an issuerclassifies and measures certain financial instruments with characteristics ofboth liabilities and equity and requires an issuer to classify a financialinstrument that is within its scope as a liability, or an asset in somecircumstances. We adopted the use of this accounting statement inMay 2003. Adoption did not have a material effect on our financialposition or results of operations.

 

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SHERWOOD BRANDS, INC. ANDSUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIALSTATEMENTS

 

1. INVENTORY

 

Inventories consist of the following:

 
|                                     |   | **For years ended  July 31,** |       |
|------------------------------------------|--------|------------------------------------|------------|
|                                     |   | **2003**                           |       | **2002** |   |
| Raw materials  and ingredients           |   | $                                  | 423,497    |   | $ | 868,319 |   |
| Components used  in assembly             |   | 1,496,166                          |       | 1,200,576 |   |
| Packaging  materials                     |   | 2,936,702                          |       | 3,025,912 |   |
| Work-in-process                          |   | 648,539                            |       | 667,694 |   |
| Finished product                         |   | 9,358,100                          |       | 11,069,471 |   |
|                                     |   | 14,863,004                         |       | 16,831,973 |   |
| Less reserve for  inventory obsolescence |   | (1,143,710                         | )          | (875,827 | ) |
| Total                                    |   | $                                  | 13,719,294 |   | $ | 15,956,145 |   |

 

2. PROPERTY, PLANT AND EQUIPMENT

 

Property, plant and equipment consist of the following:

 
|                              |   | **For years  ended July  31,** |      |
|-----------------------------------|--------|--------------------------------|-----------|
|                              |   | **2003**                       |      | **2002** |   |
| Land                              |   | $                              | 85,282    |   | $ | 85,282 |   |
| Buildings and  improvements       |   | 2,800,050                      |      | 2,543,550 |   |
| Machinery and  equipment          |   | 6,529,588                      |      | 6,031,033 |   |
| Furniture and  computer equipment |   | 335,911                        |      | 350,515 |   |
| Transportation  equipment         |   | 102,414                        |      | 102,414 |   |
|                              |   | 9,853,245                      |      | 9,112,794 |   |
| Accumulated  depreciation         |   | (2,724,018                     | )         | (1,087,332 | ) |
| Total                             |   | $                              | 7,129,227 |   | $ | 7,350,488 |   |

 

Depreciation expense for the years ended July 31, 2003, 2002 and2001 was $961,712, $674,973 and $403,756, respectively.

 

3. ACQUISITION

 

On May 1, 2002, the Company acquired all of the outstanding commonstock of Asher Candy Company (“Asher”). The results of Asher’s operations havebeen included in the consolidated financial statements since that date. Ashermanufactures and markets candy canes and sells primarily to mass merchandisersand supermarkets through out the United States. The Company acquired Asher tocontinue the diversification of its product mix. Also, the Company and Ashershare a similar customer base which it hopes will create marketing efficienciesand accelerated sales of Asher’s products to mass merchandisers.

 

The purchase price was approximately $1,783,000 consisting of 270,559shares of Class A common stock and warrants to purchase 38,562 shares of ClassA common stock. The Company valued the common shares issued at the closingmarket price on April 30, 2002 ($1,675,000) and valued the warrants usingthe Black-Scholes option pricing model ($108,000).

 

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The following table summarizes the estimated fair values of the assetsacquired and liabilities assumed as of May 1, 2002:

 
| Current assets          |   | $          | 3,424,000 |   |
|-------------------------|--------|------------|-----------|--------|
| Property and  equipment |   | 1,060,000  |      |
| Goodwill                |   | 1,775,000  |      |
| Total assets  acquired  |   | 6,259,000  |      |
| Current  liabilities    |   | (4,346,000 | )         |
| Net assets  acquired    |   | $          | 1,913,000 |   |

 

The Company expects all of the goodwill associated with the Asheracquisition to be tax deductible.

 

The following proforma consolidated results of operations assume theCompany acquired Asher on August 1, 2002:

 
|                                      |   | **2002** |       |
|-------------------------------------------|--------|----------|------------|
| Net sales                                 |   | $        | 63,153,000 |   |
| Income before  provision for income taxes |   | 324,000  |       |
| Net Income                                |   | 234,000  |       |
| Earnings per  share-basic                 |   | $        | 0.062      |   |
| Earnings per  share-diluted               |   | $        | 0.054      |   |

 

4. CREDIT FACILITY

 

In May 2001, the Company entered into a new agreement with FirstUnion National Bank. The new credit facility was a $20.0 million line of creditto provide additional working capital and issue letter of credits to supportthe Company’s additional sales. Advances under the line of credit are based ona borrowing formula equal to 85% of eligible domestic accounts receivable plus60% of eligible finished goods and 30% of eligible components inventory.Borrowings on inventory are capped based upon the Company’s seasonalrequirements and are limited to $9,000,000. The line of credit is secured bythe cash and cash equivalents, accounts receivable and inventories of SherwoodBrands, Inc. and its wholly-owned subsidiaries. The line of credit agreementcontains various business and financial covenants, including, among otherthings, a minimum tangible net worth, debt service coverage and unfundedcapital expenditure limits and expire in June 2004.

 

On April 30, 2002, the Company entered into the first amendmentand modification to the original loan and security agreement datedMay 2001. The modification was to increase the maximum principal amountavailable under the revolving line of credit to $25,000,000 from $20,000,000and the extension of two additional term loans in the principal amount of$650,000 each. Advances under the line of credit stayed the same. The businessand financial covenants were modified to require, a minimum tangible net worthof $12,500,000 at July 31, 2002, a fixed charge ratio of 1.75 to 1.0 as ofJuly 31, 2002 and a limit on capital expenditures of $2,000,000. Interestaccrues on such advances at LIBOR plus 2.35% (the rate at July 31, 2002was 4.16%) and is payable monthly. The loan agreement expires inJune 2004.

 

On September 5, 2002, the Company entered into the second amendmentand modification to the original loan and security agreement datedMay 2001.  The modificationincreased the permitted  out of formulaamount above the revolving loans during the following periods:$850,000 fromSeptember 5, 2002 through and including October 13, 2002; $650,000from October 14, 2002 through and including October 31, 2002; andcommencing on November 1, 2002 and at all times thereafter, no permittedout of formula amount shall be available.

 

On April 7, 2003, the Company entered into the third amendment andmodification to the original loan and security agreement dated May 2001.The modification increased the permitted out of formula amount above theRevolving loans during the following periods, $300,000 from April 7, 2003through and including May 31, 2003; and commencing on June 1, 2003and at all times thereafter, no permitted out of formula amount shall beavailable.  The Company agreed to obtainnew financing of $350,000 with all proceeds used to pay down a portion of theoutstanding revolving loan. The interest on the two loans with the bank will bemodified to

 

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incorporate a 340 basis point applicable term loan margin during thetime the fixed charge coverage ratio is equal or less than 1.75 to 1.0.  If the fixed charge coverage ratio is equalor greater than 1.75 to 1.0 the applicable loan margin will be 275 basispoints.

 

On May 30, 2003 the Company entered into the fourth amendment andmodification to the original loan and security agreement datedMay 2001.  The modificationextended the third amendment and modification to the out of formula advancefrom May 31, 2003 to June 9, 2003, so that the Company could explorefinancing alternatives and complete discussions on obtaining waivers forcovenant violations.

 

On July 30, 2003 the Company entered into the fifth amendment andmodification to the original loan and security agreement datedMay 2001.  The modificationdecreased the maximum revolving credit to $18,000,000 from $25,000,000.  The Company obtained subordinated debt fromLana, LLC in an amount equal to $2,000,000. The subordinated debt iscollateralized by a security interest in the Company’s accounts receivable andinventory.  The subordinated debt isfully subordinated to all obligations and all liens, security interests, rightsand remedies in favor of Lana, LLC, a related party to the board andofficers.  In addition to the sumsotherwise available to the Company as revolving loans, the Company may borrowthe following amounts for the following periods: $1,000,000 from July 30,2003 through and including October 31, 2003; $600,000 for November 1,2003 through and including November 15, 2003; and $350,000 fromNovember 16, 2003 through and including November 30, 2003. At alltimes after November 30, 2003, no permitted out of formula amount shall beavailable to the Company.  The bankwaived the Company’s noncompliance with the Fixed Charge Coverage Ratio andTangible Net Worth covenants for the fiscal periods ended October, 30, 2002,January 31, 2003 and April 30, 2003. The Fixed Charged Coverage Ratio and Tangible Net Worth covenants werechanged to Tangible Net Worth at July 31, 2003 $5,800,000, $6,800,000 asof October 31, 2003, $8,700,000 as of January 31, 2004 and of alltimes thereafter through April 29, 2004, $9,100,000 as of April 30, 2004 and $7,250,000 as of July 31,2004 and at all times thereafter. The Fixed Charged Coverage Ratio were changedas follows: (4.32) to 1.0 for the twelve month period ending July 31, 2003;(3.7) to 1.0 for the twelve month period ending October 31, 2003; (2.20)to 1.0 for the twelve month period ending January 3, 2004; 0.90 to 1.0 forthe twelve month period ending April 30, 2004; 1.75 to 1.0 for the twelvemonth period ending July 31, 2004; and 1.75 to 1.0 as of the end of eachof The Company’s fiscal quarters after July 31, 2004.  The Company was in violation of the FixedCharge covenant at July 31, 2003. The bank waived the noncompliance.

 

The loan agreement expires in June 2004. At July 31, 2003 and2002, the Company had borrowed $6,260,264 and $8,203,971, respectively underthe line of credit and had no letters of credit outstanding. During the yearsended July 31, 2003, 2002 and 2001, the Company incurred and paid approximately$527,047, $439,473 and $475,827 of interest expense on the line of credit,respectively.

 

Average short term borrowings and the related interest rates are asfollows:

 
|                                                   |   | **For years  ended July 31,** |       |
|--------------------------------------------------------|--------|------------------------------------|------------|
|                                                   |   | **2003**                           |       | **2002** |   |
| Borrowings under  revolving line of credit at year end |   | $                                  | 6,260,264  |   | $ | 8,203,971 |   |
| Weighted average  interest rate                        |   | 3.99                               | %          | 4.58 | % |
| Maximum  month-end balance during period               |   | $                                  | 11,663,335 |   | $ | 11,828,000 |   |
| Average balance  during the period                     |   | $                                  | 10,620,242 |   | $ | 7,318,510 |   |

 

On July 30, 2003, the Company entered into a subordinated debtagreement with Lana, LLC for $2,000,000. The shareholders of Lana, LLC include individuals who are related toboard members and officers of the Company. The subordinated debt bears interest at 16.575% with interest payable annually.  During the year ended July 31, 2003,the Company incurred approximately $49,216 of interest expense on thesubordinated debt.

 

5. LETTERS OF CREDIT

 

The Company has available an irrevocable letter of credit of $635,000with a bank, to be used for payments of principal portions of Virginia RevenueBonds in the event the Company defaults on payment. The letter iscollateralized by a first deed of trust and security interest in the Company’sland, building and equipment. The letter of credit expires in 2011. The letterof credit agreement

 

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has a debt to worth and a debt coverage requirement as well as alimitation on dividends paid and on borrowings. The letter of credit agreementcontains various business and financial covenants, including, among otherthings, a minimum debt coverage.

 

In addition, the Company has available another irrevocable letter ofcredit of $130,000 with a bank, to be used for payment of principal portions ofVirginia Revenue Bonds in the event the Company defaults on payment. The letteris collateralized by a first deed of trust in the Company’s commercial propertyas well as a lien on certain assets of the Company. This letter of creditexpired in June 2002.

 

6. LONG-TERM DEBT

 

Long-term debt consists of the following:

 
|                                                                                                                                                                                                                                                                                                                         |   | **For years  ended July  31,** |      |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|-----------|
|                                                                                                                                                                                                                                                                                                                         |   | **2003**                       |      | **2002** |   |
| Mecklenberg  County, Virginia Variable Rate Demand Revenue Bonds issued on June 1,  1996; collateralized by an irrevocable Letter of credit (see Note 5); payable  in varying annual amounts; To be redeemed in whole by June 1, 2011;  interest at variable Market tax exempt rates (4.40% at July 31, 2002) |   | $                              | 460,000   |   | $ | 550,000 |   |
| Wachovia term  loan on April 30, 2002; collateralized by assets of Asher Candy (see  Note 5); payable in monthly amounts of $19,000; to be paid whole by  February 1, 2005 interest at Libor Market rate (4.16% at July 31,  2002)                                                                            |   | 384,000                        |      | 612,000 |   |
| Wachovia term  loan on April 30, 2002; collateralized by assets of Asher Candy (see  Note 5); payable in monthly amounts of $18,056 starting in December 31,  2002; to be paid whole by December 1, 2006 interest at Libor Market rate  (4.16% at July 31, 2002)                                         |   | 523,611                        |      | 650,000 |   |
| Lake Country  Development on October 30, 2002; collateralized by assets of equipment;  payable in monthly amounts of $4,784 starting in October1, 2003; to be paid  whole by September 30, 2009 interest at 4.0%                                                                                                   |   | 313,279                        |      | — |   |
|                                                                                                                                                                                                                                                                                                                         |   | 1,680,890                      |      | 1,812,000 |   |
| Less current  maturities                                                                                                                                                                                                                                                                                                     |   | (530,377                       | )         | (90,000 | ) |
| Long-term  portion                                                                                                                                                                                                                                                                                                           |   | $                              | 1,150,513 |   | $ | 1,722,000 |   |

 

The scheduled maturities of long-term debt are as follows:

 
|                               |   | **Amount** |      |
|------------------------------------|--------|------------|-----------|
| Fiscal years  ending July 31, |   |       |      |
| 2004                               |   | $          | 530,377   |   |
| 2005                               |   | 447,184    |      |
| 2006                               |   | 207,843    |      |
| 2007                               |   | 106,527    |      |
| 2008                               |   | 113,627    |      |
| Thereafter                         |   | 274,332    |      |
| Total                              |   | $          | 1,680,890 |   |

 

8. CAPITAL LEASE OBLIGATION

 

In May 2000, the Company entered into a capital lease agreementwith the New Bedford Redevelopment Authority to lease a 430,000 square footbuilding in New Bedford, Massachusetts. The facility will be used for assemblyand storage of components. Under the terms of the lease the Company paid$400,000 up front and has commitments to pay rent of $25,000 per annum foryears one and two and $41,666.66 per annum for years three to twenty. TheCompany has the option to

 

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purchase the building at any time during the lease for $1,200,000 lessany amounts of rental payments made. Buildings and improvements includes$855,577, less amortization of $0 and $3,590 for the year ended July 31,2003 and 2002, respectively. Lease amortization is included in depreciationexpense.

 

Future minimum payments under the capital lease are as follows:

 
|                                         |   | **Amount** |    |
|----------------------------------------------|--------|------------|---------|
| Fiscal years  ending July 31,           |   |       |    |
| 2004                                         |   | 41,667     |    |
| 2005                                         |   | 41,667     |    |
| 2006                                         |   | 41,667     |    |
| 2007                                         |   | 41,667     |    |
| 2008                                         |   | 41,667     |    |
| Thereafter                                   |   | 489,581    |    |
| Total                                        |   | $          | 697,916 |   |
| Less amount  representing interest           |   | (258,306   | )       |
| Present value of  net minimum lease payments |   | $          | 439,610 |   |

 

9. STOCK TRANSACTIONS

 

In November 1997, the Company adopted the 1998 Stock Option Plan(the “Plan”).  Under the Plan, theCompany may grant qualified and nonqualified stock options to selectedemployees, consultants and directors. Options vest over a three year period andhave a ten year life. The Company had reserved 350,000 shares of common stockfor issuance under the Plan. In August 2000, the Board of Directorsapproved increasing the number of shares available by 750,000 for a total of1,100,000 as part of the Company’s ongoing Employee Incentive CompensationPlan.

 

The following table relates to options activity in 2001, 2002 and 2003under the Plan:

 
|                                       |   | **Number  of Shares** |   | **Weighted  average  Exercise price per  Share** |   |
|--------------------------------------------|--------|-----------------------|--------|--------------------------------------------------|--------|
| Options  outstanding at July 31, 2000 |   | 290,250               |   | $                                                | 4.46   |   |
| Granted                                    |   | 624,918               |   | $                                                | 1.67   |   |
| Cancelled                                  |   | —                |   | $                                                | — |   |
| Options  outstanding at July 31, 2001 |   | 915,168               |   | $                                                | 2.21   |   |
| Granted                                    |   | 142,200               |   | $                                                | 5.30   |   |
| Exercised                                  |   | (16,250               | )      | $                                                | 2.53   |   |
| Options  outstanding at July 31, 2002 |   | 1,041,118             |   | $                                                | 2.93   |   |
| Granted                                    |   | —                |   | $                                                | — |   |
| Exercised                                  |   | (16,667               | )      | $                                                | 1.63   |   |
| Options  outstanding at July 31, 2003 |   | 1,024,451             |   | $                                                | 2.95   |   |
| Options  exercisable at July 31, 2001 |   | 657,951               |   | $                                                | 5.95   |   |
| Options  exercisable at July 31, 2002 |   | 749,718               |   | $                                                | 2.64   |   |
| Options  exercisable at July 31, 2003 |   | 744,162               |   | $                                                | 2.64   |   |

 

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A summary of stock options outstanding and exercisable as ofJuly 31, 2003 is as follows:

 
| **Range of Exercise Price** |   | **Options  Outstanding**                        |   |                                   |   |
|-----------------------------|--------|-------------------------------------------------|--------|----------------------------------------|--------|
| **Number  Outstanding**     |   | **Weighted  Average  Remaining  Life  (years)** |   | **Weighted  Average  Exercise  Price** |   | **Options  Exercisable** |   |
| **Number  Exercisable**     |   | **Weighted  Average  Exercise  Price**          |
| $ 1.63 to $1.63             |   | 576,251                                         |   | 7.0                                    |   | $ | 1.63 |   | 495,329 |   | $ | 1.63 |   |
| $ 2.31 to $3.10             |   | 163,500                                         |   | 6.2                                    |   | $ | 2.98 |   | 106,333 |   | $ | 2.96 |   |
| $ 5.30 to $5.95             |   | 284,700                                         |   | 6.4                                    |   | $ | 5.63 |   | 142,500 |   | $ | 5.95 |   |

 

The options under the Plan granted in fiscal year 2001 expireAugust 2, 2010 and those granted in fiscal year 2002 expireApril 2011.

 

10. INCOME TAXES

 

The provisions for income taxes was as follows:

 
|                                                |   | **For the  years ended July 31,** |     |
|-----------------------------------------------------|--------|----------------------------------------|----------|
|                                                |   | **2003**                               |     | **2002** |   | **2001** |   |
| Current tax  provisions (benefit):                  |   |                                   |     |   |   |   |   |
| Federal                                             |   | $                                      | (837,181 | ) | $ | 220,039 |   | $ | 956,400 |   |
| State                                               |   | (60,043                                | )        | 28,000 |   | 230,700 |   |
| Current  (benefit) provision for income taxes  |   | (897,224                               | )        | 248,039  |   | 1,187,100 |   |
| Deferred Tax                                        |   |                                   |     |   |   |   |   |
| Federal                                             |   | 25,000                                 |     | — |   | (76,000 | ) |
| State                                               |   | 6,000                                  |     | — |   | (18,000 | ) |
| Total Deferred  Tax                                 |   | 31,000                                 |     | — |   | (94,000 | ) |
| Total (benefit)  provision on income taxes          |   | $                                      | (866,224 | ) | $ | 248,039 |   | $ | 1,093,100 |   |

 

During 1999, the IRS examined the tax returns for Sherwood Brands, Inc.and Sherwood Brands Overseas, Inc. for the tax years ended July 31, 1995to July 31, 1997. The IRS proposed an adjustment, which the Companycontests. The Company did not agree with the IRS position and had settled theadjustment for the tax year ended July 31, 1997. Under the settlement withthe IRS the Company paid $90,000 for the taxes due during the fiscal year endedJuly 31, 2002 and filed an amendment, which the Company was able to carryback an NOL which accounted for a refund due the company of approximately$83,000.

 

51

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The tax effects of the significant temporary differences, whichcomprised the deferred tax assets and liabilities, were as follows:

 
|                                                   |   | **For the  years ended  July 31,** |       |
|--------------------------------------------------------|--------|-----------------------------------------|------------|
|                                                   |   | **2003**                                |       | **2002** |   |
| Deferred tax  assets                                   |   |                                    |       |   |   |
| Net operating losses                                   |   | $                                       | 2,089,000  |   | $ | — |   |
| Officers salary  payable                               |   | 15,000                                  |       | 14,000 |   |
| Allowance for  doubtful accounts and customer credits. |   | 81,000                                  |       | 72,000 |   |
| Inventory  obsolescence reserve                        |   | 444,000                                 |       | 313,000 |   |
| Uniform  capitalization on inventories                 |   | 34,000                                  |       | 69,000 |   |
| Other                                                  |   | 40,000                                  |       | 44,000 |   |
| Total deferred  tax asset                              |   | 2,703,000                               |       | 512,000 |   |
| Deferred tax  liabilities                              |   |                                    |       |   |   |
| Accumulated  depreciation                              |   | (413,000                                | )          | (320,000 | ) |
| Goodwill                                               |   | (51,000                                 | )          | (11,000 | ) |
| Total deferred  tax liability                          |   | (464,000                                | )          | (331,000 | ) |
| Valuation allowance                                    |   | $                                       | (2,089,000 | ) | — |   |
| Net deferred tax  asset                                |   | $                                       | 150,000    |   | $ | 181,000 |   |
| Net current  deferred tax asset                        |   | $                                       | 614,000    |   | $ | 512,000 |   |
| Net long-term  deferred tax (liability)                |   | $                                       | (464,000   | ) | $ | (331,000 | ) |

 

The following summary reconciles taxes at the federal statutory ratewith recorded tax (benefit) expense:

 
|                                                       |   | **For the  years ended July 31,** |       |
|------------------------------------------------------------|--------|----------------------------------------|------------|
|                                                       |   | **2003**                               |       | **2002** |   | **2001** |   |
| Income tax  (benefit) expense at statutory rate            |   | $                                      | (2,120,619 | ) | $ | 194,839 |   | $ | 1,125,900 |   |
| Increase  (decrease) in taxes resulting from:              |   |                                   |       |   |   |   |   |
| Effect of  untaxed income from foreign subsidiary          |   | 9,800                                  |       | 54,700 |   | (22,500 | ) |
| Valuation  allowance on net operating losses               |   | 2,089,000                              |       | — |   | — |   |
| State and local  taxes, net of federal income tax benefits |   | (60,043                                | )          | 50,000 |   | 120,500 |   |
| Federal and  State, net operating losses and credits used  |   | (837,181                               | )          | (22,000 | ) | (136,700 | ) |
| Other                                                      |   | 52,819                                 |       | (29,500 | ) | 5,900 |   |
| Total (benefit)  provision for taxes                       |   | $                                      | (866,224   | ) | $ | 248,039  |   | $ | 1,093,100 |   |

 

11. COMMITMENTS AND CONTINGENCIES

 

The Company leases office space in Maryland, and office and warehousefacilities in Rhode Island and a manufacturing facility in New Hyde Park, NewYork. Rental expense under these leases aggregated approximately $809,618,$762,437 and $530,637 for the years ended July 31, 2003, 2002 and 2001,respectively. The lease for office space in Maryland is subject to annualincreases based upon both certain allocated operating costs and increases inthe Consumer Price Index.

 

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Future minimum rental commitments under operating leases as ofJuly 31, 2003 are summarized in the following table:

 
|                       |   | **Amount** |      |
|----------------------------|--------|------------|-----------|
| Years Ended  July 31, |   |       |      |
| 2004                       |   | $          | 712,748   |   |
| 2005                       |   | 162,445    |      |
| 2006                       |   | 119,393    |      |
| 2007                       |   | 122,975    |      |
| 2008                       |   | 126,664    |      |
| Thereafter                 |   | 108,179    |      |
| Total                      |   | $          | 1,352,404 |   |

 

The Company did not exercise the options on its office and assemblyfacility in Rhode Island and plans to vacate the location on March 31,2004.  After March 31, 2004, theCompany’s New Bedford, Massachusetts facility together with a planned WestCoast assembly and distribution facility will be utilized to improve itsshipping costs and assembly of its products.

 

The Company is, from time to time, involved in litigation incidental tothe conduct of its business. The Company is currently involved in severalactions.  In particular, the Company’slandlord at its Rhode Island facility has named the Company as a defendant inan action seeking security for claims relating to the lease agreement. TheCompany deposited $180,000 with the registry of the court relating to claimsfor payment of real estate taxes, water and sewer, rent of other occupied spaceand repair expenses. In September 2002, the landlord claimed otherbreaches of the lease agreement, alleging an obligation of $932,000 under thelease and demanded $750,000 to settle the disputes. The Company has claimsagainst the landlord it is pursuing and continues to occupy space at the leasedpremises. The Company has accrued amounts to cover current charges. Managementdoes not believe that the outcome of these actions, individually or in theaggregate, will have a material adverse effect on the financial condition ofthe Company.

 

The Company is currently involved as Plaintiff in asuit brought before the Circuit Court for Montgomery County, Maryland, presentingclaims in connection with the  mergeragreement under which Sherwood Brands acquired securities of Asher CandyAcquisition Corporation and agreed to sell securities in Sherwood Brands toprior shareholders of Asher Candy.  Thecomplaint alleges that the Company was fraudulently induced to enter into themerger agreement on the basis of, among other things, materialmisrepresentations and omissions by the shareholders of Asher Candy.   Sherwood Brands seeks declaratory andinjunctive relief and award of damages against the former shareholders of AsherCandy for violations of the merger agreement and for common law fraud andviolations of applicable securities laws. Pending resolution of the litigation, the Company has refused to honorthe demand of the former shareholders for the Company to repurchase half of theshares issued to them at a price of $4.50 per share. Certain of theshareholders have filed a counterclaim seeking $7.0 million in damages.  The Company believes that it has defenses tothe counterclaim. There can be no assurance that the Company will not be aparty to other litigation in the future.

 

The Company has entered into employment agreements with the ChiefExecutive Officer, Executive Vice President-Finance and Secretary, and the ExecutiveVice President—Marketing and Product Development and Treasurer. The agreementswere renewed and amended on August 1, 2001.

 

On August 1, 2001, the employment agreements for Uziel Frydman andAmir Frydman were extended for additional three year terms (until July 31,2004), each on substantially the same terms and conditions as in effect undertheir respective existing employment agreements. The annual base salariespayable to Uziel Frydman, Amir Frydman under the amended agreements wereincreased to $451,333 and $389,149, respectively, effective August 1, 2001and are subject to annual increases. Under the amendments to the employmentagreements, each of Uziel Frydman and Amir Frydman are entitled to participatein the Company’s 1998 Executive Compensation Incentive Plan. For fiscal yearsbeginning on or after August 1, 2001, the bonus pool will be increasedproportionately to the extent that earnings before interest, taxes, anddepreciation and amortization (EBITDA) in any year exceeds the EBITDA for thefiscal year ended July 31, 2001.

 

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12. EMPLOYEE BENEFIT PLANS

 

Effective January 15, 1987, the Company established aprofit-sharing plan and a money purchase pension plan covering all full-timeemployees meeting the minimum age and service requirements. Under the terms ofthe Money Purchase Pension Plan, the Company contributed 5.7% of total wages inthe year ended July 31, 1997.

 

The Money Purchase Pension Plan was terminated and the assets weremerged with the 401(k) Plan. All participants in the Money Purchase PensionPlan were fully vested in the 401(k) Plan as of August 1, 1997. There wereno contributions made in 2003, 2002 and 2001.

 

13. LICENSING AGREEMENTS

 

For the year ended July 31, 2003, the Company had a total offifteen licensing agreements,  nineduring the fiscal year ended July 31 ,2003 and six during the fiscal yearended July 31 ,2002, to incorporate its products into gift sets and to manufacturingof candies and wafers. The royalty rates for such licenses are from 2% to 12%of net sales and expire in range of 2 to 3 years. The products to beincorporated into the Company’s gift set items are primarily for the firstquarter and Easter selling season. The Company entered into a licensing agreementto produce everyday candies and wafers. The Company paid $232,000 in advancefees for the rights under the licensing agreements. These advance fees were beoffset against any amounts due on royalties. There was no other minimum licensefees under these agreements. The Company incurred $227,000, $0 and $0 inroyalties during the year ended July 31, 2003, 2002 and 2001,respectively. The Company is currently pursuing other licenses with similarterms and conditions. The Company expects the greatest impact from theagreements  will occur beginning in theyear ending July 31, 2004.

 

14. SUPPLEMENTAL CASH FLOWS DISCLOSURE

 
|                                   |   | **For the  years ended July  31,** |         |
|----------------------------------------|--------|------------------------------------|--------------|
|                                   |   | **2003**                           |         | **2002** |   | **2001** |   |
| Stock issued for  Asher acquisition    |   | $                                  | —  |   | $ | 1,675,000 |   | $ | — |   |
| Warrants issued  for Asher acquisition |   | —                             |         | 108,000 |   | — |   |
|                                        |        |                                    |              |  |  |  |  |  |  |  |

 

15. CONCENTRATION OF CREDIT RISK AND EXPORT SALES

 

The Company has a variety of customers, including mass merchandisers,drug stores and grocery stores throughout the United States and abroad. For theyear ended July 31, 2003 three customers accounted for approximately 16%,10% and 9% of the Company’s net sales. For the year ended July 31, 2002the same three customers accounted for approximately 29%, 8% and 14% of theCompany’s total net sales.  For the yearended July 31, 2001 the same three customers accounted for approximately 27%,8% and 14% of the Company’s total net sales. These net sales are included in the three business segments.  The Company had sales to customers in Canadawhich represent 0.4%, 0.4% and 0.7% of net sales in fiscal 2003, 2002 and 2001,respectively.

 

16. FOREIGN EXCHANGE CONTRACTS

 

In the fourth quarter of fiscal 2001, the Company adopted Statement ofFinancial Accounting Standards No. 133 “Accounting for Derivative Instrumentsand Hedging Activities” (SFAS 133) During the fiscal year ended July 31,2002 the Company executed a foreign exchange forward contract to purchase766,000 Euros. In accordance with SFAS 133, as amended, the Company marked thecontract to market as of July 31, 2002 and recorded a loss of $31,139 inother comprehensive income since the Company designated the contract as a cashflow hedge. During the fiscal year ended July 31, 2003 the Company had noderivative financial instruments.

 

17. NON-RECURRING COSTS

 

During the year ended July 31, 2003, the Company incurred$1,932,075 of start-up costs associated with the consolidation of itsmanufacturing facility in Rhode Island into its Chase City facility. Thesecosts primarily consist of training and production inefficiency on machineryand equipment in the Chase City facility.

 

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During the year ended July 31 ,2002 the Company incurred $707,551of moving and start-up costs associated with the consolidation of its manufacturingfacility in Rhode Island into its Chase City facility.  These costs primarily consist of freight anddismantling of machinery and equipment in Rhode Island and courier costs inrelocating the machinery and equipment to its Chase City facility.

 

The Company wrote down $1,200,000 of packaging materials and $1,000,000of inventory of hard candy product lines that will no longer be manufactured atthe Company’s Chase City facility. These product lines will be manufactured bythe Company’s overseas third party suppliers.

 

18. ADVERTISING COSTS

 

Advertising costs, included in selling, general and administrativeexpenses, are expensed as incurred and were $928,000, $1,127,000 and $979,691for the years ended July 31, 2003, 2002 and 2001, respectively.

 

19. ACCRUED EXPENSES

 

Accrued expenses consist of the following:

 
|                                  |   | **July 31,** |    |
|---------------------------------------|--------|-------------------|---------|
|                                  |   | **2003**          |    | **2002** |   |
| Payroll and  benefits                 |   | $                 | 226,117 |   | $ | 624,014 |   |
| Compensation  expense-Options Granted |   | 184,930           |    | — |   |
| Professional  fees                    |   | 169,080           |    | 75,906 |   |
| Commissions                           |   | 35,576            |    | 102,030 |   |
| Inventory costs                       |   | 60,228            |    | 68,584 |   |
| Personal  property taxes              |   | 351,586           |    | 294,779 |   |
| Water and sewer                       |   | 85,452            |    | 76,389 |   |
| Accrued travel  expenses              |   | 55,000            |    | — |   |
| Sales and use  tax                    |   | 68,585            |    | — |   |
| Other                                 |   | 89,337            |    | 127,226 |   |
| Total                                 |   | 1,325,891         |    | 1,368,928 |   |
|                                       |        |                   |         |  |  |  |  |

 

20. QUARTERLY DATA

 

Summary quarterly results were as follows:

 
|                               |   | **Quarter** |       |
|------------------------------------|--------|-------------|------------|
| **Year 2003**                      |   | **First**   |       | **Second** |   | **Third** |   | **Fourth** |   |
| Net Sales                          |   | $           | 18,462,212 |   | $ | 19,390,601 |   | $ | 9,482,412 |   | $ | 1,827,562 |   |
| Gross profit                       |   | 5,506,469   |       | 5,047,301 |   | (629,368 | ) | (633,717 | ) |
| Net income  (loss)                 |   | 708,949     |       | (77,865 | ) | (2,750,026 | ) | (3,251,950 | ) |
| Basic earnings  (loss) per share   |   | $           | 0.18       |   | $ | (0.02 | ) | $ | (0.69 | ) | $ | (0.81 | ) |
| Diluted earnings  (loss) per share |   | $           | 0.16       |   | $ | (0.02 | ) | $ | (0.69 | ) | $ | (0.81 | ) |

 
|                               |   | **Quarter** |       |
|------------------------------------|--------|-------------|------------|
| **Year 2002**                      |   | **First**   |       | **Second** |   | **Third** |   | **Fourth** |   |
| Net Sales                          |   | $           | 21,046,884 |   | $ | 15,931,434 |   | $ | 11,312,814 |   | $ | 4,491,839 |   |
| Gross profit                       |   | 6,762,325   |       | 4,876,904 |   | 2,248,762 |   | 1,179,670 |   |
| Net income  (loss)                 |   | 1,728,519   |       | 611,490 |   | (693,505 | ) | (1,321,474 | ) |
| Basic earnings  (loss) per share   |   | $           | 0.47       |   | $ | 0.17 |   | $ | (0.19 | ) | $ | (0.14 | ) |
| Diluted earnings  (loss) per share |   | $           | 0.41       |   | $ | 0.14 |   | $ | (0.19 | ) | $ | (0.14 | ) |

 

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The Company’s sales and net income historically are greater during thefirst and second quarters of the fiscal year relative to the third and fourthquarters due to sales associated with major holidays celebrated during theseperiods.

 

21. OPERATING SEGMENTS

 

The Company operates in the confectionary industry and aligns itsoperations 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. The Company’s business segmentsare (i) Manufactured Candy, (ii) Purchased Candy and (iii) Gift Items. TheCompany reports these as reportable segments in accordance with SFAS 131,“Disclosures about Segments of an Enterprise and Related Information.” Theaccounting policies of the operating segments are the same as those describedin the summary of significant accounting policies.

 

The Company’s Chief Operating Decision Maker, who is its Chairman andChief Executive Officer, evaluates performance based upon a measure of segmentoperating profit or loss that includes an allocation of common expenses, butexcludes certain unallocated expenses. Unallocated expenses represent corporateexpenditures that are not specifically allocated to the segments.

 

The Company’s reportable segments are strategic business units thatoffer different products in different geographic areas.  The Company has no assets outside of theUnited States.  There is noconcentration of net sales in any one area within the United States.  Net sales outside of the United States areminimal (see Note 15).

 
|                           |   | **Year ended  July 31, 2003** |       |
|--------------------------------|--------|------------------------------------|------------|
|                           |   | **Manufactured  Candy**            |       | **Purchased  Candy** |   | **Gift  Items** |   | **Other** |   | **Consolidated  Total** |   |
| Total revenue                  |   | $                                  | 17,164,078 |   | $ | 15,934,155 |   | $ | 16,064,554 |   | $ | — |   | $ | 49,162,787 |   |
| Gross margin                   |   | (2,599,646                         | )          | 6,934,383 |   | 4,955,948 |   | — |   | 9,290,685 |   |
| Interest expense               |   | 154,992                            |       | 295,160 |   | 173,049 |   | — |   | 623,201 |   |
| Segment assets                 |   | 15,492,718                         |       | 3,625,358 |   | 5,949,931 |   | 1,434,464 |   | 26,502,471 |   |
| Depreciation and  amortization |   | 802,353                            |       | — |   | 106,206 |   | 53,153 |   | 961,712 |   |
|                                |        |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                           |   | **Year ended  July 31, 2002** |       |
|--------------------------------|--------|------------------------------------|------------|
|                           |   | **Manufactured  Candy**            |       | **Purchased  Candy** |   | **Gift  Items** |   | **Other** |   | **Consolidated  Total** |   |
| Total revenue                  |   | $                                  | 13,638,031 |   | $ | 11,891,627 |   | $ | 27,252,683 |   | $ | — |   | $ | 52,782,341 |   |
| Gross margin                   |   | (316,308                           | )          | 4,630,738 |   | 10,753,231 |   | — |   | 15,067,661 |   |
| Interest expense               |   | 224,970                            |       | 170,685 |   | 73,032 |   | — |   | 468,687 |   |
| Segment assets                 |   | 16,561,958                         |       | 4,002,755 |   | 10,210,136 |   | 805,235 |   | 31,390,954 |   |
| Depreciation and  amortization |   | 567,383                            |       | — |   | 75,063 |   | 37,567 |   | 680,013 |   |
|                                |        |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                           |   | **Year ended  July 31, 2001** |       |
|--------------------------------|--------|------------------------------------|------------|
|                           |   | **Manufactured  Candy**            |       | **Purchased  Candy** |   | **Gift  Items** |   | **Other** |   | **Consolidated  Total** |   |
| Total revenue                  |   | $                                  | 16,284,193 |   | $ | 13,371,704 |   | $ | 28,660,819 |   | $ | — |   | $ | 58,316,716 |   |
| Gross margin                   |   | 298,389                            |       | 4,549,199 |   | 11,672,944 |   | — |   | 16,520,532 |   |
| Interest expense               |   | 317,252                            |       | 106,581 |   | 116,137 |   | — |   | 539,970 |   |
| Segment assets                 |   | 10,607,305                         |       | 3,336,244 |   | 8,366,351 |   | 494,212 |   | 22,804,112 |   |
| Depreciation and  amortization |   | 336,882                            |       | — |   | 44,568 |   | 22,306 |   | 403,756 |   |
|                                |        |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                           |   | **Year ended  July 31, 2000** |       |
|--------------------------------|--------|------------------------------------|------------|
|                           |   | **Manufactured  Candy**            |       | **Purchased  Candy** |   | **Gift  Items** |   | **Other** |   | **Consolidated  Total** |   |
| Total revenue                  |   | $                                  | 12,873,299 |   | $ | 13,127,263 |   | $ | 16,104,083 |   | $ | — |   | $ | 42,104,645 |   |
| Gross margin                   |   | 405,722                            |       | 4,014,793 |   | 5,500,245 |   | — |   | 9,920,760 |   |
| Interest expense               |   | 198,238                            |       | 143,433 |   | 93,307 |   | — |   | 434,978 |   |
| Segment assets                 |   | 8,212,010                          |       | 3,886,944 |   | 7,737,017 |   | 782,920 |   | 20,618,891 |   |
| Depreciation and  amortization |   | 189,295                            |       | — |   | 25,043 |   | 12,533 |   | 226,871 |   |
|                                |        |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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***Exhibit Index***

 
| **Exhibit  Number** |   | **Description**                                                                             |
|---------------------|--------|---------------------------------------------------------------------------------------------|
| 10.25               |   | Fifth Amendment to Loan agreements with Wachovia  dated July 30, 2003                  |
| 10.26               |   | Loan agreements, Promissory Note with Lake Country  Development dated August 15, 2003. |
| 23.1                |   | Consent of BDO, LLP                                                                         |
| 31.1                |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a)/15d-14(a).             |
| 31.2                |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a)/15d-14(a).             |
| 32.1                |   | Certification of Chief Executive Officer pursuant to  Section 1350.                    |
| 32.2                |   | Certification of Chief Financial Officer pursuant to  Section 1350.                    |

 

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