UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, DC 20549





FORM 10-Q





(Mark One)





x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended September 30, 2010





OR





 ̈
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





Commission File Number: 001-34468





VITACOST.COM, INC.

(Exact Name of Registrant as Specified in Its Charter)





Delaware

37-1333024(State or Other Jurisdiction of

Incorporation or Organization)

(I.R.S. Employer

Identification No.)5400 Broken Sound Blvd. - NW, Suite 500, Boca Raton, FL

33487(Address of Principal Executive Offices)

(Zip Code)





(561) 982-4180


(Registrant’s Telephone Number, Including Area Code)





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





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes  ̈ No o





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





Large accelerated filer  ̈
Accelerated filer  ̈Non-accelerated filer x
Smaller reporting company  ̈


(Do not check if a smaller reporting company)





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes   ̈    No x





As of June 16, 2011, the registrant has 27,790,453 shares of common stock outstanding.







Vitacost.com, Inc. Form 10-Q





Table of Contents





PagePART I.
FINANCIAL INFORMATION

1ITEM 1.
FINANCIAL STATEMENTS

1ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

13ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

18ITEM 4.
CONTROLS AND PROCEDURES

18PART II.
OTHER INFORMATION

19ITEM 1.
LEGAL PROCEEDINGS

19ITEM 1A.
RISK FACTORS

19ITEM 2.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

19ITEM 3.
DEFAULTS UPON SENIOR SECURITIES

19ITEM 4.
[REMOVED AND RESERVED]

19ITEM 5.
OTHER INFORMATION

19ITEM 6.
EXHIBITS

20SIGNATURES


21







EXPLANATORY NOTE




Along with this delayed Quarterly Report on Form 10-Q, Vitacost.com, Inc., or Vitacost is also filing with the Securities and Exchange Commission, or SEC, its delayed Annual Report on Form 10-K for the period ended December 31, 2010 and its delayed Quarterly Report on Form 10-Q for the quarter ended March 31, 2011.




Unless the context otherwise requires, references in this Annual Report on Form 10-K to "Vitacost.com, Inc.," "Vitacost," “Company,” "we," "us," or "our" refer to Vitacost.com, Inc., a Delaware corporation.




We have not amended any of our Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for periods prior to September 30, 2010.




Background




In October 2010, pursuant to a request from a member of our board, our audit committee initiated an internal review into the methodologies and procedures used by the Company to calculate the value, for financial reporting purposes, of certain stock-based compensation grants and awards and the classification of certain non-cash expense items previously reported in the Company’s financial statements in connection therewith.  The internal review was conducted by the audit committee with the assistance of outside independent professional advisors and consultants.




On November 15, 2010, in connection with the ongoing internal review, we issued a press release announcing that we had filed a Form 12b-25 with the SEC related to the delayed filing of our Quarterly Report on Form 10-Q for the quarter ended September 30, 2010.  We contacted The NASDAQ Stock Market (“NASDAQ”) and informed NASDAQ of the delayed filing.  On November 16, 2010, we received a letter from NASDAQ indicating that we were not in compliance with NASDAQ Listing Rule 5250(c) because we had not timely filed our Form 10-Q for the quarter ended September 30, 2010.




On December 7, 2010, we announced that, in connection with the ongoing internal review, our board had voted to postpone our 2010 Annual Meeting of Stockholders previously scheduled to be held on Thursday, December 9, 2010. On December 21, 2010, we received a letter from NASDAQ indicating that based on its review of the Company and pursuant to NASDAQ Listing Rule 5101, the NASDAQ staff had determined that continued listing of our securities on The NASDAQ Stock Market was no longer warranted.  On January 3, 2011, we received a letter from NASDAQ indicating that we had not held our annual meeting of stockholders within the required timeframe and this would serve as an additional basis for delisting our securities from NASDAQ.




In response to our appeal of the decision to delist, NASDAQ set a delisting hearing for February 3, 2011.  On February 3, 2011, we requested an exception through June 20, 2011 in which to resolve our corporate governance, share, organizational and formation issues and file our Quarterly Report on Form 10-Q for the quarter ended September 30, 2010.  In addition, we requested an exception through July 5, 2011 in which to solicit proxies for and hold our 2010 Annual Meeting of Stockholders.  On February 28, 2011, we received a letter from NASDAQ granting both requests.  The letter provided that we would not be delisted, subject to certain conditions.




On January 14, 2011, Michael Sheridan resigned as Director of the Company, and as the Chairman of the Company’s Audit Committee.  On that same day, Mark Jung also resigned as a Director of the Company and as a member of its Audit Committee.  On February 22, 2011, we received another letter from NASDAQ indicating that we were not in compliance with NASDAQ’s audit committee requirements as set forth in NASDAQ Listing Rule 5605 because our committee only comprised of two members.  This would be an additional basis for delisting our securities from NASDAQ.  On February 28, 2011, we announced the appointment of Edwin J. Kozlowski and Stuart Goldfarb to our Board.  Mr. Kozlowski was also named as the Chairman of the Audit Committee and Mr. Goldfarb as a member of the Audit Committee. On April 7, 2011 and May 18, 2011, respectively, we received letters from NASDAQ indicating that we were not in compliance with NASDAQ Listing Rule 5250(c) because (i) we had not timely filed our Annual Report on Form 10-K for the year ended December 31, 2010 and (ii) we had not timely filed our Quarterly Report on Form 10-Q for the quarter ended March 31, 2011. As a result of the appointment of the two board members, we regained compliance with NASDAQ’s audit committee requirements.




On April 7, 2011 and May 18, 2011, respectively, we received letters from NASDAQ indicating that we were not in compliance with NASDAQ Listing Rule 5250(c) because (i) we had not timely filed our Annual Report on Form 10-K for the year ended December 31, 2010 and (ii) we had not timely filed our Quarterly Report on Form 10-Q for the quarter ended March 31, 2011.




On June 16, 2011, we filed this Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2010 and our Quarterly Report on Form 10-Q for the quarter ended March 31, 2011.




Audit Committee Findings




During the course of the internal review, our audit committee and its advisors discovered certain defects in our corporate organizational and formation documents and certain corporate transactions that may not have been authorized in accordance with all requirements of applicable Delaware corporate law, including, without limitation, certain stock splits and stock option and other stock issuance transactions.  In order to address these issues and to quiet title to all outstanding shares of common stock and stock options, as part of the settlement of our pending derivative suit in the Circuit Court of the Fifteenth Judicial District, Palm Beach County, Florida (the “Court”), captioned Kloss v. Kerker et al., we requested that the Court enter a final order recognizing and quieting title to all outstanding Vitacost shares of stock and stock options for and as of the twelve (12) month period ending December 31, 2004 through the six (6) month period ending June 30, 2009. On May 27, 2011, the Court issued an order and final judgment (the “Order”) approving the settlement of the derivative lawsuit. The Order also quiets title to all our outstanding shares of stock and stock options for all audited periods since 2004 through June 30, 2009 pursuant to the inherent equitable powers of the Court and the Uniform Commercial Code. The Order further provides that our certificate of incorporation, as amended, is the valid and effective certificate of incorporation of the Company, until validly amended in accordance with applicable Delaware law and our certificate of incorporation and bylaws.




On June 6, 2011, our audit committee concluded its internal review and determined that no restatement of the Company’s previously issued financial statements was required.








PART I.         FINANCIAL INFORMATION





ITEM 1.         FINANCIAL STATEMENTS





Vitacost.com, Inc.


Consolidated Balance Sheets


(unaudited)




As ofAssets

September 30, 2010


December 31, 2009Current AssetsCash and cash equivalents

$
3,714,153


$
8,658,157Securities available-for-sale


36,700,749



35,787,227Accounts receivable, net


1,154,803



735,355Other receivables


1,265,213



1,055,372Inventory, net


30,054,597



28,096,884Prepaid expenses


2,043,693



1,988,538Deferred tax asset


3,714,061



1,167,724Other assets


2,151,235



-Total current assets


80,798,504



77,489,257Property and equipment, net


35,281,388



21,961,903Goodwill


2,200,000



2,200,000Intangible assets, net


6,186



9,446Deposits


115,643



4,656,128Deferred tax asset


1,357,398



1,361,817Total assets

$
119,759,119


$
107,678,551Liabilities and Stockholders' EquityCurrent LiabilitiesLine of credit

$
8,000,000



3,458,183Current maturities of notes payable


5,087,301



1,090,969Interest rate swap liability


532,290



-Current maturities of capital lease obligations


-



35,452Accounts payable


21,079,463



18,052,495Deferred revenue


2,918,399



1,919,352Accrued expenses


9,925,832



3,282,476Income taxes payable


-



51,221Total current liabilities


47,543,285



27,890,148Notes payable, less current maturities


-



4,820,042Interest rate swap liability


-



468,719Total liabilities

$
47,543,285


$
33,178,909Commitments and ContingenciesStockholders' EquityPreferred stock, par value $.00001 per share; authorized 25,000,000;no shares issued and outstanding at September 30, 2010 and December 31, 2009, respectively


-



-Common stock, par value $.00001 per share; authorized 100,000,000;27,755,453 and 27,488,353 shares issued and outstanding atSeptember 30, 2010 and December 31, 2009, respectively


278



275Additional paid-in capital


74,198,058



71,932,256Accumulated other comprehensive loss


(4,112
)


-(Accumulated deficit) retained earnings


(1,978,390
)


2,567,111Total stockholders' equity


72,215,834



74,499,642Total liabilities and stockholders' equity

$
119,759,119


$
107,678,551





The accompanying notes are an integral part of these consolidated financial statements.


1


Vitacost.com, Inc.


Consolidated Statements of Operations


(unaudited)




For the Three Months Ended


For the Nine Months EndedSeptember 30,


September 30,2010


2009


2010


2009Net sales

$
50,312,049


$
48,353,730


$
161,440,092


$
141,516,249Cost of goods sold


37,794,402



33,287,677



118,844,402



96,353,173Gross profit


12,517,647



15,066,053



42,595,690



45,163,076Operating expenses:Fulfillment


4,378,196



2,294,965



12,463,418



6,027,153Sales and marketing


5,218,037



3,694,433



14,095,511



9,970,962General and administrative


11,781,367



15,779,586



23,108,280



23,951,56121,377,600



21,768,984



49,667,209



39,949,676Operating (loss) income


(8,859,953
)


(6,702,931
)


(7,071,519
)


5,213,400Other income (expense):Interest income


32,984



20,790



93,853



63,044Interest expense


(104,474
)


(219,163
)


(381,731
)


(457,975
)Other income


8,190



2,520



24,271



26,392(63,300
)


(195,853
)


(263,607
)


(368,539
)(Loss) income before income taxes


(8,923,253
)


(6,898,784
)


(7,335,126
)


4,844,861Income tax benefit (expense)


3,293,688



3,048,808



2,789,625



(1,505,686
)Net (loss) income

$
(5,629,565
)

$
(3,849,976
)

$
(4,545,501
)

$
3,339,175Basic per share information:Net (loss) income available to common stockholders

$
(0.20
)

$
(0.17
)

$
(0.16
)

$
0.14Weighted average shares outstanding


27,755,453



23,231,356



27,680,870



23,130,239Diluted per share information:Net (loss) income available to common stockholders

$
(0.20
)

$
(0.17
)

$
(0.16
)

$
0.14Weighted average shares outstanding


27,755,453



23,231,356



27,680,870



23,648,641


The accompanying notes are an integral part of these consolidated financial statements.





2





Vitacost.com, Inc.


Consolidated Statement of Stockholders' Equity and Comprehensive Income


(unaudited)


Additional


Accumulated Other


Retained EarningsCommon Stock


Paid-In


Comprehensive


(AccumulatedShares


Amount


Capital


Income


Deficit)


TotalBalance, December 31, 2009


27,488,353


$
275


$
71,932,256


$
-


$
2,567,111


$
74,499,642Comprehensive income:Net loss


-



-



-



-



(4,545,501
)


(4,545,501
)Unrealized loss related tosecurities available-for-sale


-



-



-



(4,112
)


-



(4,112
)Comprehensive loss






















(4,549,613
)Stock options exercised


267,100



3



847,114



-



-



847,117Stock-based compensationexpense


-



-



885,964



-



-



885,964Income tax benefit from stockoptions exercised


-



-



532,724



-



-



532,724Balance, September 30, 2010


27,755,453


$
278


$
74,198,058


$
(4,112
)

$
(1,978,390
)

$
72,215,834


The accompanying notes are an integral part of these consolidated financial statements.


3




Vitacost.com, Inc.


Consolidated Statements of Cash Flows


(unaudited)




For the Nine Months Ended September 30,2010


2009Cash Flows From Operating ActivitiesNet (loss) income

$
(4,545,501
)

$
3,339,175Adjustments to reconcile net (loss) income to net cashprovided by operating activities:Depreciation


3,749,961



2,512,237Amortization of intangibles


3,260



3,376Amortization of premium on debt securities available-for-sale


521,767



-Change in fair value of interest rate swap


63,571



(173,390
)Stock-based compensation expense


885,964



11,238,809Deferred taxes


(2,541,918
)


(2,308,826
)Provision for inventory reserve


252,773



(82,377
)(Gain) Loss on disposition of propertyand equipment and other assets


(71,294
)


108,963Changes in assets and liabilities:(Increase) decrease in:Accounts receivable


(419,448
)


(229,288
)Other receivables


(209,841
)


(76,905
)Inventory


(2,210,486
)


(2,127,653
)Prepaid expenses and other assets


(2,206,390
)


(926,245
)Increase (decrease) in:Accounts payable


3,026,968



(251,861
)Deferred revenue


999,047



422,831Accrued expenses


6,643,356



2,361,117Income taxes payable


(51,221
)


528,924Net cash provided by operating activities


3,890,568



14,338,887Cash Flows From Investing ActivitiesProceeds from disposition of property, equipment


155,582



956,110Payments for the purchase of property and equipment


(12,772,860
)


(4,406,044
)Decrease (increase) in deposits


159,610



(1,828,720
)Proceeds from repayment of related party advance


-



215,241Purchases of securities available-for-sale


(26,567,020
)


-Proceeds from maturities of securities available-for-sale


25,127,620



-Net cash used in investing activities


(13,897,068
)


(5,063,413
)Cash Flows From Financing ActivitiesPrincipal payments on notes payable


(823,710
)


(818,946
)Net borrowings (repayments) on line of credit


4,541,817



(9,412,630
)Repayments on related party note payable


-



(500,000
)Repayments of note receivable from exercise of stock options


-



1,165,625Repayments on capital lease obligation


(35,452
)


(44,167
)Proceeds from the exercise of stock options


847,117



13,811Stock-based tax benefit


532,724



2,036,564Net proceeds from intial public offering


-



47,105,853Payments for redemption of common stock


-



(500,000
)Net cash provided by financing activities


5,062,496



39,046,110Net (decrease) increase


(4,944,004
)


48,321,584Cash and cash equivalents:Beginning of period


8,658,157



61,326Ending of period

$
3,714,153


$
48,382,910
    The accompanying notes are an integral part of these consolidated financial statements.
 4


Vitacost.com, Inc.
 Consolidated Statements of Cash Flows (continued)
 (unaudited)


For the Nine Months Ended September 30,2010


2009Supplemental Disclosures of Cash Flow InformationCash payments for:Interest, net of amount capitalized

$
291,287


$
631,365Income taxes

$
1,422,025


$
1,020,000Supplemental Schedule of Noncash Investing and Financing ActivitiesProperty and equipment purchased through notes payable

$
-


$
625,829Equipment purchased not yet paid

$
2,203,439


$
-Application of deposits towards purchases of equipment

$
4,380,875


$
-





The accompanying notes are an integral part of these consolidated financial statements.


5


Vitacost.com, Inc.


Notes to the Consolidated Financial Statements


(unaudited)





Note 1.  Nature of Business and Significant Accounting Policies





Nature of business:  Vitacost.com, Inc.  (“Vitacost” or the “Company”) is an internet-based retailer and distributor of nutritional supplements. Vitacost was incorporated in 1994 and began the internet-based retail activity in 1999.  Vitacost sells a proprietary and internally developed line of nutraceuticals as well as a selection of other manufacturers’ brand-name health and wellness products.  The Company distributes products from two primary locations in North Carolina and Nevada.





Basis of presentation:  The accompanying unaudited consolidated financial statements of Vitacost as of September 30, 2010, and for the three and nine months ended September 30, 2010, have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information along with the instructions to Form 10-Q and Article 10 of Securities and Exchange Commission (“SEC”) Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles (“GAAP”) for annual financial statements. In management’s opinion, Vitacost has made all adjustments (consisting of normal, recurring and non-recurring adjustments) during the quarter that were considered necessary for the fair presentation of the financial position and operating results of the Company. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts in the financial statements and accompanying notes. Actual results could differ from those estimates. In addition, the results of operations for the three months and nine months ended September 30, 2010 are not necessarily indicative of the results for the entire fiscal year ending December 31, 2010, or for any other period. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes, together with management’s discussion and analysis of financial position and results of operations contained in Vitacost’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009 (the “Form 10-K”) filed alongside this Quarterly Report on Form 10-Q.





Principles of consolidation:   The consolidated financial statements include the accounts of Vitacost and any wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.





Earnings per share:  The Company computes earnings per share by dividing net income by the weighted-average number of common shares outstanding during the period.  Diluted earnings per share is computed by giving effect to all potentially dilutive common shares, including stock options. The following table reconciles basic weighted-average shares outstanding to diluted weighted-average shares outstanding for the three and nine months ended September 30, 2010 and 2009:




Three Months Ended September 30,


Nine Months Ended September 30,2010

2009


2010


2009Weighted-average shares outstanding - basic


27,755,453



23,231,356



27,680,870



23,130,239Effect of diluted securities


-



-



-



518,402Weighted-average shares outstanding - diluted


27,755,453



23,231,356



27,680,870



23,648,641


For the periods where the Company reported losses, all common stock equivalents are excluded from the computation of diluted earnings per share, since the result would be antidilutive.  Securities that could potentially dilute earnings per share in the future, but which were not included in the calculation of diluted earnings per share because to do so would have been antidilutive for the periods presented, are as follows:





Three Months Ended September 30,


Nine Months Ended September 30,2010

2009


2010


2009Antidilutive common stock equivalents excludedfrom  diluted earnings per share


2,216,491



2,695,880



2,216,491



1,345,600


Securities available-for-sale: Available-for-sale securities consist of investment grade municipal debt securities not classified as trading or held-to-maturity.  Available-for-sale securities are stated at fair value and unrealized holding gains and losses, net of the related deferred tax effect, are reported as a separate component of stockholders' equity.  Premiums and discounts on investments in debt securities are amortized over the contractual lives of those securities.  The method of amortization results in a constant effective yield on those securities (the interest method).  Interest on debt securities is recognized in income as earned.  Realized gains and losses, including losses from declines in value of specific securities determined by management to be other-than-temporary, are included in income.  Realized gains and losses are determined on the basis of the average cost of the securities sold. The aggregate fair value of securities available-for-sale as of September 30, 2010 and December 31, 2009 was $36,700,749 and $35,787,227 respectively, which approximates cost.   The fair value of available-for-sale securities by contractual maturity as of September 30, 2010, was as follows:




September 30,2010Due within one year

$
13,049,405Due after one year through three years


9,209,574Due after three years


14,441,770$
36,700,749





6





Derivative financial instruments:  The Company’s risk management policy is to use derivative financial instruments, as appropriate, to manage the interest expense related to debt with variable interest rates.  These instruments are not designated as hedges for financial reporting purposes; accordingly, gains and losses related to fair value are reflected in the statement of operations at each reporting date.  During 2007, the Company entered into two interest rate swap agreements with initial notional amounts of $3,360,000 and $1,849,263, respectively.  These swaps require the Company to pay a fixed rate of 6.81% and 6.85%, respectively, and receive a floating interest payment based on LIBOR plus 1.40% and 1.75%, respectively.  During 2008, the Company entered into another interest rate swap agreement with an initial notional amount of $2,573,884, which requires the Company to pay a fixed rate of 6.03%, and receive a floating interest payment based on LIBOR plus 2.50%.  As of September 30, 2010 and December 31, 2009, these interest rate swaps had a fair value of ($532,290) and ($468,719), respectively.  Changes in fair value are included in interest expense in the accompanying statements of operations.  The fair value of the interest rate derivatives is based on valuation models that take into account items such as maturity dates, interest rate yield curves, the Company’s creditworthiness and that of the counterparty and other data. As described in Note 8, the Company terminated these swap agreements and repaid in full the obligations outstanding thereunder in connection with the extinguishment of the Company’s notes payable on December 13, 2010.





Fair value of financial instruments:  The Financial Accounting Standards Board (FASB) issued authoritative guidance that defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements.   The guidance applies to all assets and liabilities that are being measured and reported on a fair value basis.  It requires new disclosure that establishes a framework for measuring fair value in GAAP and expands disclosure about fair value measurements.  This guidance enables the reader of the financial statements to assess the inputs used to develop those measurements by establishing a hierarchy for ranking the quality and reliability of the information used to determine fair values. The guidance requires that assets and liabilities carried at fair value will be classified and disclosed in one of the following three categories:





Level 1:
Quoted market prices in active markets for identical assets or liabilities.





Level 2:
Observable market based inputs or unobservable inputs that are corroborated by market data.





Level 3:
Unobservable inputs that are not corroborated by market data.





The Company’s investments in securities available-for-sale are valued based on observable market based inputs that are corroborated by market data and are therefore considered a level 2 investment within the fair value hierarchy.





The Company’s interest rate swaps are pay-fixed, receive-variable interest rate swaps based on the LIBOR swap rate.  The LIBOR swap rate is observable at commonly quoted intervals for the full term of the swaps and therefore is considered a level 2 item.  For the nine month period ended September 30, 2010, the application of valuation techniques applied to similar assets and liabilities has been consistent and there have been no significant transfers within the first two levels of the hierarchy.





The carrying amounts of other financial instruments, including cash, cash equivalents, accounts receivable, other receivables, accounts payable and short-term borrowings approximate fair value due to the short maturity of these instruments.  The carrying amount of long-term debt approximates fair value because the interest rates fluctuate with market interest rates or the fixed rates are based on current rates offered to the Company for debt with similar terms and maturities.





Concentration of credit risk: The Company’s cash and cash equivalents are held by one major financial institution. These cash and cash equivalent balances could be impacted if the underlying financial institution fails or is subjected to other adverse conditions in the financial markets.  To date the Company has experienced no loss or lack of access to its cash and cash equivalents.





Recent accounting pronouncements: In January 2010, authoritative guidance was issued requiring enhanced disclosures for fair value measurements.  Entities are required to separately disclose the amounts and reasons of significant transfers in and out of the first two levels of the fair value hierarchy. Entities are also required to present information about purchases, sales, issuance and settlements of fair value measurements within the third level of the fair value hierarchy on a gross basis.  As this guidance is disclosure related only, the adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.


7




Note 2. Inventory





Inventory consists of the following as of September 30, 2010 and December 31, 2009:




September 30,


December 31,2010


2009Raw materials

$
4,351,844


$
4,734,772Work in process


3,250,027



3,687,426Finished goods


23,057,256



20,026,44330,659,127



28,448,641Less: Inventory reserve


604,530



351,757$
30,054,597


$
28,096,884


Note 3. Property and Equipment





Property and equipment consists of the following as of September 30, 2010 and December 31, 2009:




September 30,


December 31,2010


2009Buildings and building improvements

$
7,983,831


$
7,904,870Furniture, fixtures and equipment


20,173,525



12,912,917Computers


4,403,885



3,644,992Software


6,916,718



4,800,157Leasehold improvements


2,508,140



1,117,712Land


460,000



460,00042,446,099



30,840,648Less accumulated depreciation


(13,109,816
)


(9,374,019
)29,336,283



21,466,629Construction-in-progress


5,945,105



495,274$
35,281,388


$
21,961,903




The increases to furniture, fixtures and equipment were primarily related to the expansion of the Company’s Las Vegas, Nevada distribution facility that was completed in 2010.





Construction-in-progress was primarily related to the expansion of the Company’s Lexington, North Carolina distribution facility.  The project is expected to be completed in 2011.





Note 4. Notes Payable





In February 2007, and in connection with the purchase of a new distribution center in North Carolina, the Company entered into a promissory note in the amount of $3,360,000.  The promissory note was to be repaid in monthly payments of principal and interest at a rate equal to one-month LIBOR plus 1.40% (1.68 % and 1.63% as of September 30, 2010 and December 31, 2009, respectively) with final payment of $2,699,166 due on February 14, 2014.  The note contained certain restrictive covenants, which required minimum financial ratios, including funded debt to EBITDA and a fixed coverage ratio.  The loan was collateralized by the property purchased with a depreciated cost of $3,686,867 as of September 30, 2010.  Borrowings outstanding as of September 30, 2010 and December 31, 2009 were $3,051,323 and $3,121,903, respectively.





On April 23, 2007, the Company entered into a promissory note in the amount of $1,535,467 with a bank to finance the purchase of machinery and equipment. On October 11, 2007, the note was amended to increase borrowings by $313,796, totaling $1,849,263.  The note bore interest at one-month LIBOR plus 1.75% (2.01% and 1.98% as of September 30, 2010 and December 31, 2009, respectively) and was payable in 60 monthly principal and interest payments.  The note contained certain restrictive covenants, which required minimum financial ratios, including funded debt to EBITDA and a fixed coverage ratio. The note was collateralized by the equipment that was purchased with a depreciated cost of $942,547 as of September 30, 2010. Borrowings outstanding as of September 30, 2010 and December 31, 2009 were $770,527 and $1,047,916, respectively.





On November 13, 2007, the Company entered into a promissory note in the amount of $2,521,797 with a bank to finance the purchase of machinery and equipment.  The note was amended on December 19, 2007 to increase borrowings to $2,617,509. The note bore interest at one-month LIBOR plus 2.50% (2.76 % and 2.73% as of September 30, 2010 and December 31, 2009, respectively) and was payable in 60 monthly principal and interest payments.  The note contained certain restrictive covenants, which required minimum financial ratios, including funded debt to EBITDA and a fixed coverage ratio. The note was collateralized by the equipment that was purchased with a depreciated cost of $1,645,352 as of September 30, 2010.   Borrowings outstanding as of September 30, 2010 and December 31, 2009 were $1,177,880 and $1,570,506, respectively.


8




As a result of the amount accrued for the settlement discussed in Note 6, the Company was in violation with the funded debt to EBITDA covenant related to its promissory notes as of September 30, 2010. Consequently, the borrowings outstanding were classified as current maturities as of September 30, 2010. As described in Note 8, the Company repaid in full the outstanding borrowings under the promissory notes on December 13, 2010.




September 30,


December 31,2010


2009Note payable to a bank, payable in monthly installments of principal andinterest at 1-month LIBOR plus 1.4% (1.68% as of September 30,2010), collateralized by land and building.

$
3,051,323


$
3,121,903Note payable to a bank, bearing interest at 1-month LIBOR plus 1.75%,(2.01% as of September 30, 2010), payable in monthly installments ofprincipal and interest  through March 2012, collateralized by equipment


770,527



1,047,916Note payable to a bank, payable in monthly installments of principal andinterest at 1-month LIBOR plus 2.5% (2.76% as of September 30,2010), collateralized by equipment


1,177,880



1,570,506Note payable to a financial institution, payable in monthly installments ofprincipal and interest  through July 2011, at a fixed rate of 6.98%,unsecured


87,571



170,6865,087,301



5,911,011Less current maturities


5,087,301



1,090,969$
-


$
4,820,042





Aggregate future maturities required on long-term debt as of September 30, 2010 are as follows:





Year EndingDecember 31,2010

$
5,018,7972011


68,5042012


-2013


-2014


-$
5,087,301


Line of Credit: On August 3, 2007, the Company entered into a loan and security agreement with a financial institution with maximum borrowings equal to the lesser of $8,000,000 or the borrowing base amount which is based on a percentage of eligible inventories as outlined in the agreement.  The initial term of the agreement was through July 2010, which was subsequently extended 90 days through October 2010. Borrowings bore interest at a rate equal to one-month LIBOR plus 2.75% (3.01% and 2.98% as of September 30, 2010 and December 31, 2009, respectively).  The line of credit was collateralized by all personal property of the Company excluding equipment.  The line of credit contained certain restrictive covenants, which required minimum financial ratios, including funded debt to EBITDA and a fixed coverage ratio. Borrowings outstanding as of September 30, 2010 and December 31, 2009 were $8,000,000 and $3,458,183, respectively, which included $3,233,000 and $753,183, respectively, of checks issued which have not cleared the bank.  The amount available on the line of credit as of September 30, 2010 was $0.





In October 2010, the Company entered into an amendment to modify and restate the loan and security agreement with maximum borrowings not to exceed $12,000,000 or the borrowing base amount as outlined in the agreement. The termination date was July 31, 2011 unless earlier terminated by either party. The line of credit was collateralized by all property of the Company excluding equipment. Borrowings bore interest at a rate equal to one-month LIBOR plus 2.25%. Fees associated with the amendment were not significant.





As a result of the amount accrued for the settlement discussed in Note 6, the Company was in violation with the funded debt to EBITDA covenant related to the line of credit as of September 30, 2010. As described in Note 8, the Company repaid in full the outstanding borrowings under the line of credit on December 13, 2010.


9




Note 5.        Stock Option Plan





A summary of the Company’s stock option activity related to common stock for the nine months ended September 30, 2010 and 2009 is as follows:




2010


2009Weighted-





Weighted-Average





AverageExercise





ExerciseShares


Price


Shares


PriceOutstanding at beginning of period


2,745,880


$
5.67



2,722,400


$
4.07Granted


447,250



9.36



469,200



11.72Exercised


(267,100
)


2.95



(231,528
)


2.03Cancelled


-



-



(154,192
)


3.49Forfeited


(121,300
)


7.56



(110,000
)


4.77Outstanding at period end


2,804,730



6.41



2,695,880



5.58Exercisable at period end


2,216,490


$
5.76



2,608,246


$
5.60


The weighted average grant date fair value for options granted during the nine months ended September 30, 2010 and 2009 was $6.04 and $9.08, respectively.





As of September 30, 2010 and 2009, there was $2,803,513 and $1,171,227, respectively, of total unrecognized compensation cost, net of estimated forfeitures related to stock options granted under the Company’s stock incentive plan, which is expected to be recognized over a weighted average period of 2.02 and 3.54 years, respectively.





Note 6.    Contingencies




Securities Class Action




On May 24, 2010, a putative class action complaint was filed in the United States District Court for the Southern District of Florida against the Company and certain current and former officers and directors by a stockholder on behalf of herself and other stockholders who purchased Vitacost common stock between September 24, 2009 and April 20, 2010, captioned Miyahira v. Vitacost.com, Inc., Ira P. Kerker, Richard P. Smith, Stewart Gitler, Allen S. Josephs, David N. Ilfeld, Lawrence A. Pabst, Eran Ezra, and Robert G. Trapp, Case 9:10-cv-80644-KLR. The complaint asserts claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. The complaint alleges that defendants violated the federal securities laws during the period by, among other things, disseminating false and misleading statements and/or concealing material facts concerning the Company’s current and prospective business and financial results. The complaint also alleges that as a result of these actions the Company’s stock price was artificially inflated during the class period. The complaint seeks unspecified compensatory damages, costs, and expenses.




On October 19, 2010 the Southern District of Florida appointed a lead plaintiff to represent the purported class of shareholders. Lead plaintiffs filed their amended complaint on February 15, 2011. The amended complaint additionally named as defendants the Company’s underwriters for its initial public offering and the Company’s former registered independent public accounting firm, added additional claims of alleged false and misleading statements and/or omissions under both the Securities Act and the Exchange Act, and expanded the class period to extend as late as December 7, 2010. On April 28, 2011, lead plaintiffs filed a notice of dismissal without prejudice of the accountant defendants, and on May 4, 2011 the court dismissed the former registered independent public accounting firm without prejudice. The remaining defendants filed their motion to dismiss the amended complaint on April 28, 2011. Lead plaintiffs’ opposition to the motion to dismiss is due on June 13, 2011 and defendants’ reply is due on July 12, 2011.




The Company records provisions in its consolidated financial statements for pending litigation when it determines that an unfavorable outcome is probable and the amount of loss can be reasonably estimated. As of September 30, 2010, the Company has concluded that it is not probable that a loss has been incurred and is unable to estimate the possible loss or range of loss that could result from an unfavorable verdict. Therefore, the Company has not provided any amounts in the consolidated financial statements for an unfavorable outcome. The Company believes, and has been so advised by counsel, that it has meritorious defenses to the complaint pending against it and will vigorously defend against it. It is possible that the Company’s consolidated balance sheets, statements of operations, or cash flows could be materially adversely affected by an unfavorable outcome.


10




Derivative Action and Shareholder Demand




On July 16, 2010 the Company received a letter from a stockholder’s counsel demanding that our board of directors take action against certain current and former officers and directors. The factual allegations in the letter are similar to those in the class action lawsuit discussed above. On July 20, 2010, a complaint was filed by an alleged stockholder in the Circuit Court of the 15th Judicial Circuit for Palm Beach County, Florida, purportedly on the Company’s behalf. The suit named the Company’s then-directors and certain officers as defendants. The factual allegations in the lawsuit mirrored those in the class action lawsuit as well, and the claims were for breach of fiduciary duty, unjust enrichment, abuse of control, gross mismanagement, insider trading, and waste of corporate assets. The complaint sought disgorgement, restitution, costs, expenses and non-monetary equitable relief. The Company reached an agreement with the derivative plaintiff to stay proceedings until the Southern District of Florida rules on the Company’s motion to dismiss the class action complaint. After a review conducted by the Company’s audit committee, on December 7, 2010, the Company filed a Current Report on Form 8-K notifying the market that the Company’s financial statements could not be relied upon due to issues relating to the Company's corporate governance and capital structure. In April 2011, the parties in the case, including the plaintiff and the stockholder who made a demand on the Company reached an agreement to settle the matter, subject to court approval. As a result of the settlement, Vitacost has adopted or will adopt significant organizational reforms to strengthen Vitacost’s compliance and corporate governance. The settlement also provided that the Company would agree to pay plaintiffs’ counsels a total of $3.5 million in attorney’s fees which was provided for in the consolidated financial statements during the quarter ended September 30, 2010. On April 18, 2011, the Plaintiff filed an amended complaint, which encompassed the allegations described in the initial complaint as well as new allegations concerning corporate governance, organizational, and corporate formation issues at the Company. On April 26, 2011, the Court entered an order preliminarily approving the settlement. On May 27, 2011, the Court issued an order and final judgment (the “Order”) approving the settlement of the derivative lawsuit. The Order also quiets title to all outstanding Vitacost shares of stock and stock options for all audited periods since 2004 through June 30, 2009 pursuant to the inherent equitable powers of the Court and the Uniform Commercial Code. The Order further provides that the Company’s certificate of incorporation, as amended, is the valid and effective certificate of incorporation of the Company, until validly amended in accordance with applicable Delaware law and the Company’s certificate of incorporation and bylaws.





Other matters


In addition to the matters described above, the Company is involved in litigation and administrative proceedings primarily arising in the normal course of its business. In the opinion of the Company, except as set forth above, our liability, if any, under any other pending litigation or administrative proceedings, even if determined adversely, would not materially affect our financial condition, results of operations or cash flows. Furthermore, the Company has not been the subject of any product liability litigation.





Note 7. Income Taxes





The effective tax rate for the nine months ended September 30, 2010 was 37.0% compared to 33.8% for the nine months ended September 30, 2009.  The change is primarily related to the disqualifying dispositions of incentive stock options exercised during the nine months ended September 30, 2010 and the impact of the 2009 tax return to provision true-up.





The Company regularly reviews its deferred tax assets for recoverability based on its history of earnings and expectations for future earnings. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income to support the amount of deferred taxes.





Note 8. Subsequent Events





On October 8, 2010, the Company announced that, upon the recommendation of an Ad Hoc Committee of the Board and of the Audit Committee of the Board, it has entered into a Stockholder Agreement with Great Hill Investors, LLC, Great Hill Equity Partners III, L.P., and Great Hill Equity Partners IV, L.P. (collectively, "Great Hill"), whereby Great Hill has agreed to various restrictions with respect to the voting, transfer and sale of shares of the Company's common stock it currently owns and with respect to any shares it may own in the future in excess of 30% of the Company's outstanding common stock. In addition, upon the recommendation of the Ad Hoc Committee and the Audit Committee, the Company and Great Hill have entered into a Registration Rights Agreement, which provides Great Hill with certain demand, incidental and shelf registration rights subject to various exceptions and qualifications.





On December 13, 2010, Vitacost.com, Inc. terminated (a) the Modified and Restated Loan and Security Agreement, dated July 30, 2008 as amended from time to time, between Wells Fargo Bank, National Association, as successor by merger to Wachovia Bank, National Association (“Wells Fargo”) and the Company with an outstanding balance as of December 13, 2010 of $6,313,635; (b) the Promissory Note, dated as of February 14, 2007 , issued by the Company to Wells Fargo in the original principal amount of $3,360,000, executed in connection with the purchase of land in Lexington, North Carolina with an outstanding balance as of December 13, 2010 of $3,039,638; (c) the Loan and Security Agreement, dated April 23, 2007 (the “Equipment Loan Agreement”) between Wachovia Financial Services, Inc. and the Company; (d) that certain Amended and Restated Promissory Note in the original principal amount of $1,849,262.97, dated October 11, 2007, executed in connection with the Equipment Loan Agreement with an outstanding balance as of December 13, 2010 of $710,186; (e) that certain Amended and Restated Promissory Note in the original principal amount of $2,617,509, dated December 19, 2007, executed in connection with the Equipment Loan Agreement with an outstanding balance as of December 13, 2010 of $1,092,631; and (f) certain interest rate swap agreements requiring a payment as of December 13, 2010 of $463,179.  In connection with the termination of each of the agreements and notes above, the Company repaid in full all of its obligations then outstanding as of December 13, 2010.   No early termination penalties were incurred by the Company.


11




On December 21, 2010, the Company received a Staff Determination letter from The NASDAQ Stock Market (“NASDAQ”) indicating that based on its review of the Company and pursuant to NASDAQ Listing Rule 5101, the NASDAQ staff (the “Staff”) had determined that “continued listing of the Company’s securities on The NASDAQ Stock Market was no longer warranted.” The Company appealed the determination and was granted a hearing before the NASDAQ Listing Qualification Panel (the “Panel”).





On January 3, 2011, the Company received a Staff Determination letter from NASDAQ indicating that the Company had not held its annual meeting of stockholders within the timeframe allowed under the NASDAQ Listing Rules.  The Staff informed the Company that the failure to hold its annual meeting within the allowed timeframe serves as an additional basis for delisting the Company’s securities from The NASDAQ Stock Market and that the Panel would consider this matter when rendering a decision regarding the Company’s continued listing on The NASDAQ Global Market.





On February 22, 2011, the Company received a Staff Determination Letter from NASDAQ indicating that the Company was not in compliance with NASDAQ’s audit committee requirements set forth in Listing Rule 5605 because the Company’s Audit Committee was comprised of only two members. The NASDAQ staff informed the Company that this serves as an additional basis for delisting the Company’s securities from The NASDAQ Stock Market and that the Panel would consider this matter when rendering a decision regarding the Company’s continued listing on The NASDAQ Global Market.





On February 28, 2011, the Company received written notice that the Panel had determined to grant the request of the Company to remain listed on The NASDAQ Stock Market, subject to certain conditions.  These conditions include: (1) on or before March 15, 2011, the Company shall have met the audit committee requirements by appointing new committee members who meet all applicable requirements under the NASDAQ Listing Rules, (2) on or before June 20, 2011, the Company shall have become current in its filing obligations, and demonstrated compliance with all quantitative requirements for continued listing, (3) on or before July 5, 2011, the Company shall have solicited proxies and held its annual meeting.  The Company was further required to notify the Panel of any significant events occurring during the exception period, including, without limitation, any event that could call into question the Company’s historical financial information or that could impact the Company’s ability to maintain compliance with any NASDAQ listing requirement or the exception deadline.  The Panel reserved the right to reconsider their decision based on any event, condition or circumstance that exists or develops that would, in the opinion of the Panel, make continued listing of the Company’s common stock inadvisable or unwarranted.





On March 11, 2011, McGladrey & Pullen, LLP (“McGladrey”) resigned as the Company’s registered independent public accounting firm. McGladrey resigned after concluding their independence had been impaired as a result of being named a defendant in a class action complaint filed in the United States District Court, Southern District of Florida.  The complaint alleged violations of the federal securities laws in connection with McGladrey’s audits of the financial statements that were included in the Company’s Registration Statement on Form S-1 (No. 333-143926 ) which was filed with the Securities and Exchange Commission in connection with the Company’s initial public offering.  The decision of McGladrey to resign was not recommended or approved by the Company’s Board of Directors or the Audit Committee of the Board of Directors. On May 4, 2011, the court dismissed McGladrey as a defendant without prejudice.





On April 20, 2011, the Board of Directors of the Company adopted and approved the recommendation of the Audit Committee of the Board of Directors that the Company engage PricewaterhouseCoopers LLP (“PricewaterhouseCoopers”) as the Company’s registered independent public accounting firm, effective April 21, 2011.


12




ITEM 2.         MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS





The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q.





This Quarterly Report on Form 10-Q contains trend analyses and other forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended.  Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, future revenue or performance, capital expenditures, financing needs, expected outcomes of litigation, and other information that is not historical information.  In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "could," "expect," "plan," "anticipate," "believe," "estimate," "predict," "intend," "potential," "continue," "seek" or the negative of these terms or other comparable terminology or by discussions of strategy.





All forward-looking statements, including, without limitation, our examination of historical operating trends, are based upon our current expectations and various assumptions. We believe there is a reasonable basis for our expectations and beliefs, but they are inherently uncertain.  We may not realize our expectations and our beliefs may not prove correct. Actual results could differ materially from those described or implied by such forward-looking statements and are subject to change due to the inherent risks and uncertainties such as those disclosed or incorporated by reference to our filings with the SEC. Important factors that could cause our actual results, performance and achievements, or industry results to differ materially from the forward-looking statements are set forth in this Quarterly Report on Form 10-Q, under the heading "Risk Factors" and include, among others:





·
the current global economic downturn or recession;





·
difficulty expanding our manufacturing and distribution facilities;





·
significant competition in our industry;





·
unfavorable publicity or consumer perception of our products on the Internet;





·
the incurrence of material product liability and product recall costs;





·
costs of compliance and our failure to comply with government regulations;





·
our inability to successfully defend intellectual property claims;





·
our failure to keep pace with the changing demands and preferences of our customers for new products;





·
disruptions in our manufacturing system, including our information technology systems, or losses of manufacturing certifications; and





·
the lack of long-term experience with human consumption of some of our products with innovative ingredients.





Overview





We are a leading internet-based retailer, based on annual sales volume, of health and wellness products such as vitamins, dietary supplements, minerals, herbs, anti-oxidants, organic body and personal care products and sports nutrition and health foods. We sell these products directly to consumers through our website, www.vitacost.com, as well as through our catalogs. Our website and catalogs allow customers to easily browse and purchase products at prices, on average, 30% to 60% lower than manufacturers’ suggested retail prices. We strive to offer our customers the broadest product selection of healthy living products at the best value, while providing superior customer service and timely and accurate delivery.





We began operations in 1994 as a catalog retailer of third-party vitamins and supplements under the name Nature’s Wealth Company. In 1999, we launched Vitacost.com and introduced our proprietary vitamins and supplements under the NSI brand. In 2000, we began operations under the name Vitacost.com, Inc. During 2008, we began manufacturing certain proprietary products in-house and currently have the capacity to produce in excess of one billion tablets and capsules annually.





Trends and Other Factors Affecting Our Business





The Company’s litigation climate, in connection with our equity capitalization issue, and the potential de-listing of our common stock from the NASDAQ exchange, has resulted in our vendors accelerating payment terms. This has had a negative impact on our liquidity and cash flow.





We regularly review our deferred tax assets for recoverability based on our history of earnings and expectations for future earnings. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income to support the amount of deferred taxes. During 2011, subsequent to finalizing our budget for 2011, and in considering our actual results for the year ended December 31, 2010, we determined it necessary to establish a valuation allowance for all of the deferred tax asset balances as of December 31, 2010. Accordingly, a full valuation allowance of $5.8 million was provided for in our 2010 Annual Report on Form 10-K.


13




Competition has increased as the vitamin and supplements industry shifts towards a greater internet presence. This competitive environment continues to drive margin pressure as deep discounting results from aggressive customer acquisition and retention actions.





The dietary supplement industry and our performance are affected by demographic trends as well as trends affecting health and lifestyle preferences and consumer spending. Changes in these trends and other factors that we may not foresee may also impact our business, including potential regulatory actions by the FDA and the FTC that may affect the viability of a given product that we offer. Our business allows us to respond to changing trends by introducing new products and adjusting our product mix and pricing. We will continue to expand our product offering and diversify our product lines.





We intend to continue our focus on meeting the demands of an increasingly aging population, as well as a rapidly growing fitness conscious public, and the effects of increasing costs of traditional healthcare.








Sources of Revenue





We derive our revenue principally through the sale of product and freight billed to customers associated with the shipment of product. For the nine months ended September 30, 2010, product net sales accounted for approximately 93% of our total net sales with freight and advertising comprising the remainder. The ratio remained unchanged compared to the nine months ended September 30, 2009.





Cost of Goods Sold and Operating Expenses





Cost of Goods Sold. Cost of goods sold consists primarily of the cost of the product and the cost of shipping the product to the customer.





Fulfillment.  Fulfillment expenses include the costs of warehousing supplies, equipment, maintenance, employees and rent.





Sales and Marketing. Sales and marketing expenses include advertising and promotional expenditures, website referral expenditures, including third-party content license fees, traditional media advertising, print expenses and payroll related expenses for personnel engaged in marketing, sales, customer service, website development and maintenance. We expense advertising costs as incurred.





General and Administrative. General and administrative expenses consist of management and executive compensation, information technology expenses, credit card fees, professional services and general corporate expenses.





Results of Operations





The following table sets forth certain condensed consolidated statements of operations data as a percentage of net sales for the three and nine months ended September 30, 2010 and 2009, respectively:




Three Months Ended


Nine Months EndedSeptember 30,


September 30,(unaudited)


(unaudited)2010


2009


2010


2009Net sales


100.0
%


100.0
%


100.0
%


100.0
%Cost of goods sold


75.1



68.8



73.6



68.1Gross profit


24.9



31.2



26.4



31.9Operating expenses:Fulfillment


8.7



4.7



7.7



4.3Sales and marketing


10.4



7.6



8.7



7.0General and administrative


23.4



32.6



14.3



16.9Total operating expense


42.5



45.0



30.8



28.2Operating (loss) income


(17.6
)


(13.9
)


(4.4
)


3.7Net (loss) income


(11.2
)  %


(8.0
)  %


(2.8
)  %


2.4
%
  14




Comparison of Three Months Ended September 30, 2010 to Three Months Ended September 30, 2009




Three Months EndedSeptember 30,(unaudited)

$


%2010

2009

Increase

(decrease)


Increase

(decrease)Third-party products

$
34,296,477


$
30,192,647


$
4,103,830



13.6
%Proprietary products


13,415,863



14,693,315



(1,277,452
)


(8.7
)Freight


2,599,709



3,467,768



(868,059
)


(25.0
)Net sales


50,312,049



48,353,730



1,958,319



4.0Cost of goods sold


37,794,402



33,287,677



4,506,725



13.5Gross profit

$
12,517,647


$
15,066,053


$
(2,548,406
)


(16.9
)%Note: Advertising fees included in third party products

$
138,466


$
423,615


Net Sales.  Net sales increased $2.0 million, or 4.0 %, to $50.3 million for the three months ended September 30, 2010. Net sales of our third-party products increased $4.1 million, or 13.6% to $34.3 million for the three months ended September 30, 2010. Third-party products include advertising and fees earned from affiliate programs of approximately $0.1 million and $0.4 million for the three months ended September 30, 2010 and 2009, respectively. Net sales of our proprietary products decreased $1.3 million, or 8.7%, to $13.4 million for the three months ended September 30, 2010, and freight decreased $0.9 million, or 25.0%, to $2.6 million for the three months ended September 30, 2010.










Cost of Goods Sold. Cost of goods sold increased $4.5 million, or 13.5%, to $37.8 million for the three months ended September 30, 2010. As a percentage of net sales, cost of goods sold increased to 75.1% for the three months ended September 30, 2010 from 68.8% for the three months ended September 30, 2009 primarily due to a shift in product mix to higher cost third-party products.





Gross Profit.  As a result of the changes discussed in net sales and cost of goods sold, gross profit decreased $2.5 million, or 16.9%, to $12.5 million for the three months ended September 30, 2010 and gross profit as a percentage of net sales decreased to 24.9% for the three months ended September 30, 2010 from 31.2% for the three months ended September 30, 2009.





Fulfillment. Fulfillment expense increased $2.1 million, or 90.8%, to $4.4 million for the three months ended September 30, 2010. As a percentage of net sales, fulfillment expense increased to 8.7% for the three months ended September 30, 2010 from 4.7% for the three months ended September 30, 2009. The increase in fulfillment expense was primarily attributable to higher costs at both our expanded Las Vegas, Nevada and Lexington, North Carolina distribution centers as a result of operating inefficiencies. The operating inefficiencies were primarily attributable to temporary warehouse systems optimization problems and a significant unanticipated shift to products requiring special handling (e.g. liquids and glass packaging) resulting in higher labor costs. These inefficiencies continued through 2010 and into 2011. We understand the requirements to reduce these inefficiencies and have been making the appropriate modifications to address them.





Sales and Marketing. Sales and marketing expense increased $1.5 million, or 41.2%, to $5.2 million for the three months ended September 30, 2010. As a percentage of net sales, expenses increased to 10.4% for the three months ended September 30, 2010 from 7.6% for the three months ended September 30, 2009. The increase was primarily due to an increase in online advertising of approximately $0.7 million, payroll costs of approximately $0.4 million principally due to increased staffing in our call center to meet augmented call volume, and print advertising of approximately $0.4 million.





General and Administrative. General and administrative expenses decreased $4.0 million, or 25.3 %, to $11.8 million for the three months ended September 30, 2010. As a percentage of net sales, expenses decreased to 23.4% for the three months ended September 30, 2010 from 32.6% for the three months ended September 30, 2009. Included in the 2010 amount were $6.1 million in expenses consisting of the following: $3.5 million accrual for the settlement of the derivative lawsuit discussed in Part I, Item I, Note 6 Contingencies, of this Quarterly Report on Form 10-Q, $1.2 million in accrued severance to the former Chief Executive Officer, $0.8 million in fees associated with the legal proceedings discussed in Part I, Item I, Note 6 Contingencies, of this Quarterly Report on Form 10-Q, the proxy solicitation and other matters, and $0.7 million in proxy reimbursement fees to Great Hill. Included in the 2009 amount was $10.9 million in stock based compensation expense that was recognized in connection with the Company’s initial public offering. Excluding these items in both three month periods, general and administrative expenses increased $0.7 million period-over-period. The increase period-over-period was primarily attributable to an overall increase of $0.5 million in on-going expenses, including higher technology costs and other items, an additional $0.3 million in stock-based compensation expense, an increase of $0.2 million in costs associated with being a public company, and an increase of $0.1 million in credit card fees due to higher sales. This was partially offset by a decrease in depreciation expense of $0.4 million.


15




Interest Expense. Interest expense decreased $0.1 million, or 52.3%, to $0.1 million for the three months ended September 30, 2010. The decrease was primarily a result of the capitalization of interest expense primarily related to the expansion of our Lexington, North Carolina facility and additional repayment of our outstanding notes payable balance.





Income Tax Benefit. Income tax benefit increased $0.2 million to $3.3 million for the three months ended September 30, 2010. This was a result of recognizing a loss before income taxes of $8.9 million for the three months ended September 30, 2010 compared to a loss before income taxes of $6.9 million for the three months ended September 30, 2009.





Comparison of Nine Months Ended September 30, 2010 to Nine Months Ended September 30, 2009





Nine Months EndedSeptember 30,(Unaudited)


$


%2010


2009


Increase

(decrease)


Increase

(decrease)Third-party products

$
106,647,316


$
88,520,100


$
18,127,216



20.5
%Proprietary products


44,312,499



43,033,049



1,279,450



3.0Freight


10,480,277



9,963,100



517,177



5.2Net sales


161,440,092



141,516,249



19,923,843



14.1Cost of goods sold


118,844,402



96,353,173



22,491,229



23.3Gross profit

$
42,595,690


$
45,163,076


$
(2,567,386
)


(5.7
) %Note: Advertising fees included in third party products

$
667,791


$
1,464,890


Net Sales.  Net sales increased $19.9 million, or 14.1%, to $161.4 million for the nine months ended September 30, 2010. Net sales of third-party products increased $18.1 million, or 20.5% to $106.6 million for the nine months ended September 30, 2010. Third-party products include advertising and fees earned from affiliate programs of approximately $0.7 million and $1.5 million for the nine months ended September 30, 2010 and 2009, respectively. Net sales of our proprietary products increased $1.3 million, or 3.0% to $44.3 million for the nine months ended September 30, 2010, and freight increased $0.5 million, or 5.2%, to $10.5 million for the nine months ended September 30, 2010.





The increase in net sales was primarily the result of an increase in our customer base and the number of shipped orders compared to the nine months ended September 30, 2009.





Cost of Goods Sold. Cost of goods sold increased $22.5 million, or 23.3%, to $118.8 million for the nine months ended September 30, 2010. As a percentage of net sales, cost of goods sold increased to 73.6% for the nine months ended September 30, 2010 from 68.1% for the nine months ended September 30, 2009 primarily due to a shift in product mix to higher cost third-party products and higher shipping costs during the current year as a result of an increased level of split shipped orders.





Gross Profit. As a result of the changes discussed in net sales and cost of goods sold, gross profit decreased $2.6 million, or 5.7%, to $42.6 million for the nine months ended September 30, 2010 and gross profit as a percentage of net sales decreased to 26.4% for the nine months ended September 30, 2010 from 31.9% for the nine months ended September 30, 2009.





Fulfillment. Fulfillment expense increased $6.4 million, or 106.8%, to $12.5 million for the nine months ended September 30, 2010. As a percentage of net sales, fulfillment expense increased to 7.7% for the nine months ended September 30, 2010 from 4.3% for the nine months ended September 30, 2009. The increase in fulfillment expense was primarily attributable to operating duplicate distribution centers in Las Vegas, Nevada in order to ensure there were no disruptions to our service levels during the early part of the nine months ended September 30, 2010, and higher costs at both our expanded Las Vegas, Nevada and Lexington, North Carolina distribution centers as a result of operating inefficiencies. The operating inefficiencies were primarily attributable to temporary warehouse systems optimization problems and a significant unanticipated shift to products requiring special handling (e.g. liquids and glass packaging) resulting in higher labor costs. These inefficiencies continued through 2010 and into 2011. We understand the requirements to reduce these inefficiencies and have been making the appropriate modifications to address them.





Sales and Marketing. Sales and marketing expense increased $4.1 million, or 41.4%, to $14.1 million for the nine months ended September 30, 2010. As a percentage of net sales, expenses decreased to 8.7% for the nine months ended September 30, 2010 from 7.0% for the nine months ended September 30, 2009.  The increase was primarily due to an increase in online advertising of approximately $1.6 million, print advertising of approximately $1.5 million, and payroll costs of approximately $1.2 million, principally due to increased staffing in our call center to meet augmented call volume.


16




General and Administrative . General and administrative expenses decreased $0.8 million, or 3.5%, to $23.1 million for the nine months ended September 30, 2010. As a percentage of net sales, general and administrative expenses decreased to 14.3% for the nine months ended September 30, 2010 from 16.9% for the nine months ended September 30, 2009. Included in the 2010 amount were $7.5 million in expenses consisting of the following: $3.5 million accrual for the settlement of the derivative lawsuit discussed in Part I, Item I, Note 6 Contingencies, of this Quarterly Report on Form 10-Q, $2.1 million in fees associated with the legal proceedings discussed in Part I, Item I, Note 6 Contingencies, of this Quarterly Report on Form 10-Q, the proxy solicitation and other matters, $1.2 million in accrued severance to the former Chief Executive Officer, and $0.7 million in proxy reimbursement fees to Great Hill. Included in the 2009 amount was $10.9 million in stock based compensation expense that was recognized in connection with the Company’s initial public offering. Excluding these items in both nine month periods, general and administrative expenses increased $2.6 million period-over-period. The increase period-over-period was primarily attributable to an overall increase of $2.3 million in on-going expenses, including higher technology costs and other items, an increase of $0.8 million in costs associated with being a public company, an increase of $0.6 million in credit card fees due to higher sales, and an additional $0.3 million in stock-based compensation expense. This was partially offset by a decrease in depreciation expense of $1.4 million.





Interest Expense. Interest expense decreased $0.1 million, or 16.6%, to $0.4 million for the nine months ended September 30, 2010. The decrease was primarily a result of the capitalization of interest expense primarily related to the expansion of our Lexington, North Carolina facility and additional repayment of our outstanding notes payable balance.





Income Tax Benefit (Expense). For the nine months ended September 30, 2010, we recorded an income tax benefit of $2.8 million compared to an income tax expense of $1.5 million for the nine months ended September 30, 2009. This was a result of recognizing a loss before income taxes of $7.3 million for the nine months ended September 30, 2010 compared to income before taxes of $4.8 million for the nine months ended September 30, 2009.





Liquidity and Capital Resources The significant components of our working capital are cash and cash equivalents, securities available-for- sale, inventory and accounts receivable, primarily from credit cards processors, reduced by accounts payable, accrued expenses and our line of credit. Cash and cash equivalents consist of cash and money market accounts.  The working capital characteristics of our business allow us to collect cash from sales to customers within a few business days of the related sale, while we typically have extended payment terms with our suppliers. At September 30, 2010, we had approximately $3.7 million in cash and cash equivalents and approximately $36.7 million of securities available-for-sale and a working capital surplus of approximately $33.3 million compared to approximately $8.7 million in cash and cash equivalents and approximately $35.8 million of securities available-for-sale and a working capital surplus of approximately $49.6 million at December 31, 2009.





During the nine months ended September 30, 2010, we expended approximately $17.2 million on property and equipment related primarily to the expansion of our distribution facilities at Las Vegas, Nevada and Lexington, North Carolina.





As discussed in Note 8 Subsequent Events,of our consolidated financial statements included in Part I, Item I of this Quarterly Report on Form 10-Q, we repaid our line of credit, interest rate swap obligations, and certain notes payable on December 13, 2010. The repayment was funded by liquidating a portion of our securities available-for-sale. The repayment of these borrowings and obligations does not impact our ability to continue our operations for the next twelve months.





Amounts deposited with third-party financial institutions exceed the Federal Deposit Insurance Corporation (“FDIC’), and Securities Investor Protection Corporation (“SIPC”), insurance limits, as applicable.  These cash and cash equivalent balances could be impacted if the underlying financial institutions fail or are subjected to other adverse conditions in the financial markets.  To date we have experienced no loss or lack of access to our cash and cash equivalents; however, we can provide no assurances that access to our invested cash and cash equivalents will not be impacted by adverse conditions in the financial markets.





We believe that our cash and cash equivalents and cash flows from operations will be sufficient to continue our operations for the next twelve months. Our future capital requirements will depend on many factors, including:





·
the rate of our revenue growth;·
the timing and extent of expenditures to enhance our website, network infrastructure and transaction processing systems;·
the extent of our advertising and marketing programs;·
the levels of the inventory we maintain; and·
other factors relating to our business.





We may require additional financing in the future in order to execute our operating plan. We cannot predict whether future financing, if any, will be in the form of equity, debt or a combination of both. We may not be able to obtain additional funds on a timely basis, on acceptable terms or at all.


17




Off-Balance Sheet Arrangements





We have no off-balance sheet arrangements.





Critical Accounting Policies and Estimates





Our discussion and analysis of our financial condition and results of operations is based upon our unaudited consolidated financial statements, which have been prepared in accordance with GAAP.





The preparation of these financial statements requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenue and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. Critical accounting policies are those that are the most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective and complex judgments as a result of the need to make estimates about the effect of matters that are inherently uncertain. Our most critical accounting policies pertain to revenue recognition, stock based compensation, inventories, income taxes, goodwill and intangible assets. In applying such policies, we exercise our best judgment and best estimates. For a further discussion of these Critical Accounting Policies and Estimates, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission (the “SEC”) on March 30, 2010 for the year ended December 31, 2009.





Recently Issued Accounting Standards




Refer to Note 1 to our consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for further information regarding recently issued accounting standards applicable to us.





ITEM 3.         QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





Market risk represents the risk of changes in the value of market risk sensitive instruments caused by fluctuations in interest rates, foreign exchange rates and commodity prices. Changes in these factors could cause fluctuations in the results of our operations and cash flows. However, we do not believe that a change in market interest rates would have a material effect on our results of operations or financial condition. Although we derive a portion of our sales outside of the United States, all of our sales are denominated in U.S. dollars. We have limited exposure to financial market risks, including changes in interest rates and foreign currency exchange rates.  Inflation generally affects us by increasing costs of raw materials, labor and equipment. We do not believe that inflation had any material effect on our results of operations in the periods presented in our financial statements.





ITEM 4.         CONTROLS AND PROCEDURES




Evaluation of Disclosure Controls and Procedures




We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Interim Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.





As of the end of the period covered by this Form 10-Q, we evaluated, under the supervision and with the participation of our Chief Executive Officer and Interim Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e). Based upon this evaluation, the Chief Executive Officer and Interim Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2010.




Changes in Internal Control over Financial Reporting




There were no changes in our internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) during the quarter ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.










Inherent Limitations on Effectiveness of Controls




Our disclosure controls and procedures include components of our internal control over financial reporting. Our management, including our Chief Executive Officer and Interim Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will necessarily prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Vitacost have been detected.  18




PART II.       OTHER INFORMATION








ITEM 1.         LEGAL PROCEEDINGS





Refer to Note 6 Contingencies,of our consolidated financial statements included in Part I, Item I of this Quarterly Report on Form 10-Q for a discussion on the nature of the legal proceedings against us, which is incorporated herein by reference.





ITEM 1A.   RISK FACTORS





Refer to the Risk Factors section of our Annual Report on Form 10-K and our Quarterly Report on Form 10-Q, as filed with the SEC on March 30, 2010 and August 16, 2010, respectively, for a complete explanation for the risk factors affecting our business.  With the exception of the risk factor identified below, there have been no material changes from the risk factors previously disclosed on our Annual Report on Form 10-K and our Quarterly Report on Form 10-Q, as filed with the SEC on March 30, 2010 and August 16, 2010, respectively.





Our Common Stock may be delisted from NASDAQ.





On December 21, 2010, we received a letter from The NASDAQ Stock Market (“NASDAQ”) indicating that based on its review of the Company and pursuant to NASDAQ Listing Rule 5101, the NASDAQ staff had determined that continued listing of the Company’s securities on The NASDAQ Stock Market was no longer warranted. In accordance with the procedures set forth in the NASDAQ Listing Rules, we timely appealed the staff determination, and requested a hearing before a NASDAQ Hearings Panel (the “Panel”). The hearing was held on February 3, 2011. On February 28, 2011, we received a written notice from NASDAQ indicating that the Panel had determined to grant our request to remain listed on The NASDAQ Stock Market, subject to certain conditions, including (1) on or before June 20, 2011, we shall have become current in our filing obligations, and demonstrated compliance with all quantitative requirements for continued listing, and (2) on or before July 5, 2011, we shall have solicited proxies and held our annual meeting. While we believe we will be able to comply with the NASDAQ requirements in the applicable time periods, no assurances can be made that we will in fact be able to comply and that our common stock will remain listed on The NASDAQ Stock Market. If we are not able to comply with the NASDAQ requirements in the applicable time periods, our common stock will be delisted from NASDAQ. A delisting of our common stock could negatively impact us by reducing the liquidity and market price of our common stock and the number of investors willing to hold or acquire our common stock, which could negatively impact our stock price and ability to raise equity financing.





We wish to caution the reader that the risk factors discussed in “Item 1A. Risk Factors” in our 2010 Annual Report on Form 10-K and those described elsewhere in this report or other Securities and Exchange Commission filings, could cause actual results to differ materially from those stated in any forward-looking statements.





ITEM 2.         UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS





None.





ITEM 3.         DEFAULTS UPON SENIOR SECURITIES





Refer to Note 4 Notes Payable, of our consolidated financial statements included in Part I, Item I of this Quarterly Report on Form 10-Q for a discussion on the nature of the default, which is incorporated herein by reference.





ITEM 4.         [REMOVED AND RESERVED]





ITEM 5.         OTHER INFORMATION





None.


19




ITEM 6.         EXHIBITS





Exhibits4.1

Stockholder Agreement dated as of October 8, 2010 by and between the Registrant and Great Hill Investors, LLC, Great Hill Equity Partners III, L.P. and Great Hill Partners IV, L.P. (1)4.2

Registration Rights Agreement dated as of October 8, 2010 by and between the Registrant and Great Hill Investors, LLC, Great Hill Equity Partners III, L.P. and Great Hill Partners IV, L.P. (2)31.1

Certification of Chief Executive Officer Pursuant to Rule 13(a)-14(a) of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2

Certification of Interim Chief Financial Officer Pursuant to Rule 13(a)-14(a) of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2

Certification of Interim Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(1)Filed as Exhibit 10.37 to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 13, 2010.

(2)Filed as Exhibit 10.38 to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 13, 2010.





20








SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.





VITACOST.COM, INC.By:
/s/ Jeffrey J. HorowitzName:  Jeffrey J. HorowitzTitle:  Chief Executive OfficerBy:
/s/Stephen E. Markert, Jr.Name:  Stephen E. Markert, Jr.Title:  Interim Chief Financial and Accounting OfficerDate: June 16, 2011








21




INDEX TO EXHIBITS





Exhibits4.1

Stockholder Agreement dated as of October 8, 2010 by and between the Registrant and Great Hill Investors, LLC, Great Hill Equity Partners III, L.P. and Great Hill Partners IV, L.P. (1)4.2

Registration Rights Agreement dated as of October 8, 2010 by and between the Registrant and Great Hill Investors, LLC, Great Hill Equity Partners III, L.P. and Great Hill Partners IV, L.P. (2)31.1

Certification of Chief Executive Officer Pursuant to Rule 13(a)-14(a) of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2

Certification of Interim Chief Financial Officer Pursuant to Rule 13(a)-14(a) of the Securities Exchange Act of 1934 as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2

Certification of Interim Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(1)Filed as Exhibit 10.37 to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 13, 2010.

(2)Filed as Exhibit 10.38 to Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 13, 2010.