**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

**FOR ANNUAL ANDTRANSITIONAL REPORTSPURSUANT TO SECTIONS 13 AND 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**(Mark One)**

| **x**                                                | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| **For The Fiscal Year Ended December 31, 2005** |
| **OR**                                               |
| **o**                                                | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                           to                           **

**Commission File No:000-24567**

**NATROL, INC.**

(Exact name of registrant as specified in its charter)

| **Delaware**             | **95-3560780**                       |
|--------------------------|--------------------------------------|
| (State of Incorporation) | (I.R.S. Employer Identification No.) |

 

**21411 Prairie StreetChatsworth, California 91311**

(Address of principal executive offices)

**(818) 739-6000**

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) ofthe Act: **None**

Securitiesregistered pursuant to section 12(g) of the Act: **CommonStock, par value $.01 per share**

Indicate by a check markwhether the registrant: (1) has filed all reports required to be filed bysection 13 or 15 (d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes x   No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Registration S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K.   Yes o   No x

Indicate by check markwhether the registrant is a large accelerated filer o,an accelerated filer o  oran non-accelerated filer x (as defined in Exchange Act Rule 126-2).

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

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.   Yes o   No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.   Yes o   No x

The aggregate market valueof the shares of the registrant’s Common Stock held by non-affiliates of theregistrant on June 30, 2005 was approximately $19.9 million based upon theclosing price per share of the registrant’s Common Stock as reported on theNASDAQ National Market on such date. The calculation of holdings bynon-affiliates is based upon the assumption, for these purposes only, thatexecutive officers, directors, and persons holding 10% or more of theoutstanding Common Stock are affiliates. This determination of affiliate statusis not necessarily a conclusive determination for other purposes. As of March 8,2006, the registrant had 13,559,648 shares of Common Stock outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portions of theRegistrant’s Proxy Statement to be used in connection with the solicitation ofproxies for the Regis­trant’s 2006 Annual Meeting of Stockholders areincorporated by reference in Part III of this Annual Report on Form 10-K.

 

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**NATROL, INC.**

**2005ANNUAL REPORT on Form 10-K**

**TABLE OF CONTENTS**

|               | ** ** | ** **                                                                                                     | ** ** | **Page** |
|---------------|------------|----------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       | 2                                                                                                              |
| Item 1.       |       | Business                                                                                                       |       | 2        |
| Item 1A.      |       | Risk  Factors                                                                                                  |       | 13       |
| Item 2.       |       | Properties                                                                                                     |       | 23       |
| Item 3.       |       | Legal  Matters                                                                                                 |       | 24       |
| Item 4.       |       | Submission of Matters to a Vote of Security Holders                                                            |       | 24       |
| PART II  |       | 25                                                                                                             |
| Item 5.       |       | Market for Registrant’s Common Equity and Related  Stockholder Matters and Issuer Purchases of Securities |       | 25       |
| Item 6.       |       | Selected Consolidated Financial Data                                                                           |       | 26       |
| Item 7.       |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                    |       | 28       |
| Item 7A.      |       | Quantitative and Qualitative Disclosures About Market  Risk                                                    |       | 39       |
| Item 8.       |       | Financial Statements and Supplementary Data                                                                    |       | 40       |
| Item 9.       |       | Changes and Disagreements with Accountants on  Accounting and Financial Disclosure                             |       | 60       |
| PART III |       | Items 10, 11, 12,  13 and 14                                                                                   |       | 61       |
| PART IV  |       | 62                                                                                                             |
| Item 15.      |       | Exhibits and Financial Statement Schedules                                                                     |       | 62       |

 

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**CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS**

*This Annual Reporton Form 10-K, including “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in Item 7 of this report, andother materials accompanying this Annual Report on Form 10-K containforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934. These statements relate to our future plans, objectives, expectations,intentions and financial performance and the assumptions that underlie thesestatements. Examples of forward looking statements include, but are not limitedto, the use of forward-looking terminology such as “believes,” “expects,” “may,”“will,” “should,” “intend,” “estimate,” “assume,” “plan,” or “anticipates” orthe negative thereof, other variations thereon, or comparable terminology, orby discussions of strategy that predict or indicate future events or trends orthat are not historical facts* Similarly, discussions of strategy, although believed to bereasonable, are also forward-looking statements and are inherently uncertain.

*Theseforward-looking statements include, but are not limited to, statementsconcerning the following:*

·       *Industry trends and competition within the vitamin, mineral andsupplement (VMS) industry;*

·       *The effects of favorable and adverse publicity about our brands,products and the VMS industry;*

·       *Exposure to product liability and other legal claims and the cost ofdefense;*

·       *The effectiveness of our product development program and our need todevelop new products that receive a high degree of consumer acceptance;*

·       *The effectiveness of our manufacturing, quality control, and inventorycontrol measures;*

·       *The effectiveness of our marketing and sales efforts;*

·       *The cost of our marketing and sales efforts including the amount ofpayments which must be made to customers for slotting fees, coop advertisingand other fees;*

·       *The regulatory environment and the possibility that laws such as TheDietary Supplement Health and Education Act of 1994 (DSHEA) which benefit theindustry are amended in a way that hurts the industry;*

·       *Our dependence upon certain large customers;*

·       *Our ability to attract talented management and staff;*

·       *Our ability to execute and modify our business plan as the businessenvironment changes;*

·       *Our ability to successfully consummate and integrate futureacquisitions;*

·       *Our ability to obtain sufficient raw materials at competitive prices;*

·       *Our ability to protect our intellectual property;*

·       *Our ability to raise capital at reasonable rates;*

·       *The effectiveness of our disclosure controls and procedures and ourinternal control over financial reporting;*

·       *The cost of insurance and the limited scope of our self-insuranceprogram; and,*

*These statementsinvolve known and unknown risks, uncertainties and other factors that may causeindustry trends or our actual results, level of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by these statements.For a detailed discussion of these risks and uncertainties, see “Risk Factors”in Item 1A of this Annual Report on Form 10-K. We undertake noobligation to update forward-looking statements to reflect events orcircumstances occurring after the date of this Annual Report on Form 10-K.*

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**PART I**

**ITEM 1.**                BUSINESS

Our executive offices arelocated at 21411 Prairie Street, Chatsworth, California 91311 and our telephonenumber is 818-739-6000. Company information may be accessed via ourweb site at http://www.natrol.com. Unless the context otherwise requires theterms the “Company,” “Natrol,” “our,” and “us” refer to Natrol, Inc. and,as applicable, its subsidiaries.

**GENERAL**

We manufactureand market branded, high-quality dietary supplements, herbal teas, and sportsnutrition products under three labels: the Natrol®brand, the Laci Le Beau® brand of herbal teas, and the Prolab®sports nutrition brand. To a limited degree, we also market a few nutraceuticalingredients to other manufacturers of supplements or fortified foods throughour Essentially Pure Ingredients® (EPI) raw material supply division, whichalso sells contract-manufacturing services to companies within thenutraceutical industry.

Our core Natrol brand focuses on supplements that arein high demand as well as specialty niche and proprietary formulations thathave potentially strong margins. We position Natrol as a premium brand ofsupplements rather than as a value brand.

The majority of the dietary supplements we sell aresold under the Natrol brand. These supplements include vitamins, minerals,hormonal supplements, herbal products and specialty combination formulas thatcontribute to an individual’s physical and mental well being. We sell ourproducts through multiple distribution channels throughout the United States.These channels include domestic health food stores and mass-market drug, clubs,retail and grocery store chains. We also sell our products through independentcatalogs, Internet shopping sites, and within approximately 40 foreigncountries through international distributors. Our Natrol brand strategyemphasizes building strong recognition of the Natrol brand across multipledistribution channels through a marketing strategy that includes print,television, radio and coop advertising and public relations campaigns that aredesigned to build consumer awareness and increase the purchase of our productsby consumers.

Herbal teas are sold under the Laci Le Beau brand.Laci Le Beau teas are flavored herbal teas. The primary tea category is our *Super**Dieter’s**Tea*®.We use the same sales people and brokers to sell herbal teas as supplements.And, as with our supplement business, our Laci Le Beau strategy emphasizesbuilding strong recognition of the Laci Le Beau brand across multipledistribution channels.

The Prolab sports nutrition line of products istargeted to body builders and health minded individuals seeking a high degreeof physical fitness. Prolab’s products include supplements designed to helpthese individuals gain and lose weight as well as improve muscle mass and muscledefinition. Prolab products are sold primarily through sports nutrition retailstores, fitness centers, websites, health-food stores and, internationally,through designated distributors. Prior to October 2003, Prolab wasoperated as a separate operating segment with its own management andadministration. This operating segment was managed in Bloomfield, Connecticut.During 2003, we integrated Prolab into the core Natrol business with Prolabbecoming a sub-brand within Natrol similar to Laci Le Beau. This consolidationwas completed at the end of the third quarter of 2003 and, as of the fourthquarter of 2003, we no longer reported Prolab as a separate operating entity.As of the completion of the consolidation, the management and administration ofProlab was consolidated into our headquarters in Chatsworth, California and theonly functions remaining in Bloomfield, Connecticut were warehousing anddistribution. These last two functions were transferred to our shipping andwarehousing facility in Chatsworth, California in September 2005. Prolab’sBloomfield, Connecticut warehouse was sold in January 2006.

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We also sell nutraceutical grade ingredients such asgarlic and arabinogalactan to other manufacturers through our EPI division. TheEPI division also markets Natrol’s manufacturing capabilities to othernutraceutical businesses that need contract manufacturing support. EPI sharesall of Natrol’s resources including Natrol’s headquarters facility, itsmanufacturing and research and development personnel and expertise, itsfinancial resources, as well as accounting and management resources.

Natrol’s consumer products fall into the generaldefinition of vitamin, minerals, herbs and dietary supplements. Each year, westrive to broaden our product offerings so as to increase revenue and grossprofits while lessening dependence upon any one product. We divide ourbusiness, other than the EPI business, into approximately 50 productcategories. The products in these categories are packaged into approximately500 stock keeping units (SKUs).

Only one product category, Ester-C®,has represented more than 10% of revenue in each of the last three years. Inaddition, the Carb Intercept® category represented morethan 10% of revenue in 2004.

We actively participate in and financially support anumber of scientific and educational industry organizations that promoteconsumer well being. These include Citizens for Health, the NationalNutritional Foods Association (NNFA), the American Herbal Products Association,the American Herbal Pharmacopoeia, and the American Botanical Council. We are afounding member of the Dietary Supplement Education Alliance (DSEA) of whichour Chairman and Founder, Mr. Elliott Balbert, is the past CEO andcurrently a board member. We are also an active supporter of the VitaminAngel Alliance where Mr. Balbert also serves as a Board member. TheDSEA is a not-for-profit organization consisting of more than 60 companieswhose role is to improve public health by communicating the benefits of dietarysupplements. The Vitamin Angel Alliance contributes vitamins to needyrecipients around the world.

**BUSINESS STRATEGY**

*Quality Supplier*

Our primary business strategy is to position ourselvesas a quality supplier of nutraceutical products that can be trusted byconsumers and retailers alike. The Natrol and Laci Le Beau brands are soldacross multiple channels of distribution including health food stores,mass-market retail outlets including club stores, catalogs and Internet salesorganizations. The Prolab brand is also sold across multiple channels ofdistribution but sales through the mass-market channel of distribution arelimited because this is not a channel where sports nutrition products areprimarily sold.

As a quality supplier, we place a strong emphasis onquality control because we believe that quality standards play a criticalfactor in consumer purchasing decisions and in differentiating the Natrolbrand. Our products are manufactured in accordance with all applicable federalregulations as well as current Good Manufacturing Practices (GMPs) standardsset by the NNFA. We carefully review our products to ensure regulatorycompliance, safety and efficacy.

*Product Innovation*

A core part of our business strategy is to be aproduct leader. As such our Research and Development (R&D) department isconstantly working to identify and develop new products and technologiesrelated to the supplement business. Products can be internally developed oracquired from third parties and we are open to acquiring intellectual property,specific products and even entire businesses that can help us succeed in ourmission to improve the physical and mental well being of people everywhere.

New products, even with large resources, are difficultto develop or acquire. Even so, an important part of our business strategy isto work to develop products that are innovative.

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*Customer Relations*

As a quality supplier of nutraceutical products, ourstrategy includes developing and maintaining strong working relationships withour customers.

Our sales and marketing teams work with mass-marketretailers to ensure that our most profitable and rapidly selling items remainon retailers’ shelves while constantly seeking to obtain more shelf space foradditional, potentially profitable, items.

We believe that within the health food store channelof distribution, our products are under-represented and our strategy withinthat channel of trade is to ensure that retail outlets carry a higherpercentage of what we consider to be our core line of products.

*MaintainInfrastructure for Growth*

We have a state-of-the-artSAP enterprise resource planning software system to manage production, salesand accounting. Our quality control laboratories meet GMP standards. Wecontinually invest in manufacturing and we seek to employ talented personnel atall levels of the organization. We have a history of investing in ourinfrastructure to ensure that we can meet the needs of our customers. Weregularly evaluate our operations and as a business strategy make investmentsin building and maintaining our infrastructure as necessary.

*ExperiencedManagement Team*

Our management team hasextensive experience in the nutritional supplement industry and has developedlong-standing relationships with our suppliers and customers. We believe thatthe quality of our management team at all levels is important and we seek toemploy managers with experience in each respective position.

**SALES**

*BRANDED PRODUCTS*

We distribute Natrol supplements and Laci Le Beauherbal teas primarily to domestic, independent, health food stores andmass-market club, drug, retail and food stores. Although we sell the sameNatrol or Laci Le Beau products to both the health food and mass-marketchannels of distribution, we have built different sales organizations to meetthe differing requirements of each channel of trade.

Natrol and Laci Le Beau products are sold to healthfood stores primarily through leading national distributors, including *United Natural Foods, Nature’s Best* and *Tree of Life*. These products are also soldby health food store chains such as *WildOats Markets*, *Whole Foods Market*,*GNC*, *Fred Meyer Nutrition Centers* and *The Vitamin Shoppes*, as well as by most independent healthfood stores.

Within the health food channel of trade, we maintain asales staff of regional representatives across the country managed by anational manager who reports to the Vice President of Sales. These salesrepresentatives call on individual storeowners and distributors promoting theNatrol and Laci Le Beau lines.

The mass-market distribution channel is also managedby the Vice President of Sales. We employ three sales managers who manage anindependent broker network of more than 40 groups throughout the country. Ouremployees directly service some of our larger mass-market accounts whileindependent brokers service others in conjunction with the sales people andmanagement. We sell our products to mass-market merchandisers either directlyor through distributors of vitamins, minerals and other supplement products suchas: *Amerisource Bergen*, *McKesson*, and *Cardinal*.

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Our major drug,club and mass-market retail and grocery customers include:

| *• Albertsons*                |   | *• Dominick’s* |   | *• Rite Aid*   |
|-----------------------------------------|--------|-------------------------------|--------|--------------------------|
| *• BJ’s  Wholesale Club* |   | *• Hannaford*       |   | *• Sam’s* |
| *• Brooks/Eckerd*             |   | *• HEB*             |   | *• Vons*       |
| *• Costco*                    |   | *• Kroger*          |   | *• Walgreens*  |
| *• CVS*                       |   | *• Longs Drug*      |   | *• Wal-Mart*   |

 

Sales of vitamins and other supplements within themass-market channel of trade are extremely competitive with all vendorscompeting vigorously to defend their positions within each mass-market account.Many mass-market retailers emphasize their own in-house private label brand,which creates additional competition. Vendors to the mass-market class of tradecontinually analyze their own shelf space as well as that of their competitorsin an effort to maximize profits for themselves and the mass-market retailer.The result is a natural cycle in which companies such as ours prune slowermoving items from store shelves, replacing them with faster selling products.Our central strategy is to ensure that our most profitable and rapidly sellingitems remain on retailers’ shelves while we try to obtain more shelf space foradditional, potentially profitable, items.

Throughout the last decade there has been substantialconsolidation within the mass-market channel of trade. In late 2004, the Eckerddrug store chain was sold by its parent company, J.C. Penney, to the CVS andthe Brooks drugstore chains. When one chain is bought by another, the vendorsto the acquired retailer will gain or lose business depending upon the intentof the acquiring company. In the case of the Eckerd acquisition, Eckerd carriedmore of our products than did CVS and Brooks at the time of the acquisition. Theresult was that during 2005, CVS and Brooks returned $0.9 million more of ourproducts than in 2004. The number of our items carried in the old Eckerd storeswas reduced. We are working to expand our shelf space at these chains but thereis no guarantee that our shelf space will expand in the immediate future. How aconsolidation will affect a vendor is difficult to quantify immediately afterthe announced consolidating event because representatives of the acquirer andthe acquired business are most often difficult to reach and IT systems in eachcompany typically do not work well with each other. The result is that smallervendors have to wait for months before being able to obtain an accuratedescription of the acquirer’s plans. The returns were posted as a reduction ofgross sales thereby reducing net revenue.

Within the health food store channel of distribution,we believe that our product line is under-represented and our strategy withinthis channel of trade is to ensure that retail outlets carry a higherpercentage of what we consider to be our core line of products.

We provide retailers in both the health food store andthe mass-market distribution channels with a wide array of comprehensiveservices tailored to meet their individual needs. In the health food storechannel, our dedicated sales force maintains direct and regular contact withkey store personnel informing them of new product developments and industrytrends, aiding them in the design of store sets and creating merchandisingprograms that promote brand and category awareness. In the mass-marketdistribution channel our regional managers and independent brokers work withcorporate buyers focusing on new products, special promotional activities andbrand and category awareness in order to improve the consumer purchases of ourproducts and increase the movement of items through each outlet. The objectiveof these activities is to build strong relationships with our marketingpartners, to increase the number of stores carrying our products and improvethe profitability of the items sold within each of our trading partners.

Prolab products are sold primarily through sportsnutrition retail stores, fitness centers, web sites, health food stores andinternationally through designated distributors. Approximately 34.3% of Prolab’ssales are to distributors who sell products to European, Canadian and othernon-domestic accounts. Approximately 22% of this or 7.5% of Prolab’s grossshipments were to a Canadian distributor in 2005. 

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The Prolab business fellnearly $3.0 million in 2005. A key factor was our Canadian distributor whosesales in 2005 declined $1.5 million when compared to 2004. During the year, weworked to resolve issues with this distributor as they relate to contractualminimum purchases, pricing, and strategies for building the Prolab brand. Theissues were not resolved to what we believe are our best interests and as aresult, during the first quarter of 2006, we stopped shipping this distributorproduct. We are contractually prevented from using a different distributor inCanada (outside of Quebec) until 2007. We believe that despite the immediateproblems this presents in terms of gross sales and net income, our long termprospects in Canada are better if we sell directly in Canada or find anotherdistributor who is willing to build the Prolab brand in a manner we believe isappropriate.

Prolab’s domestic sales are primarily to wholesalerswho in turn service retail accounts. Prolab’s wholesaler network focuses onhealth food stores, health clubs and fitness facilities that cater to bodybuilders and other individuals seeking a high level of fitness.

Only one of our customers,Walgreens, which accounted for 12.8% of net sales, represented more than 10% ofnet sales for the year ended December 31, 2005. No customer representedmore than 10% of net sales in 2004 or 2003.

*CONTRACTMANUFACTURING AND INGREDIENT SUPPLY SALES: EPI*

Our contract manufacturing services are marketedthrough EPI. We manufacture a number of products for customers who distributethe products under their own private labels. As a contract manufacturer, wewill often assist our customers in the formulation of their products. Contractmanufacturing accounted for approximately 4.3% of our net sales in 2005.

In our bulk ingredient business, EPI sellsnutraceutical grade garlic, arabinogalactan and miscellaneous ingredients toother manufacturers of nutritional products. Bulk ingredient sales accountedfor 1.6% of our net sales in 2005.

During 2005, we continued to de-emphasize the EPIdivision, a process that began in 2004. During 2004, we ended our supplyrelationship with ConAgra Foods, Inc., which had been supplying us garlicand vegetable powders, and, in early 2005, with Larex Inc., which had beensupplying us with arabinogalactan. Furthermore, in 2005, we re-examined theprofitability of all contract-manufacturing customers and made the decision tostop producing items that did not deliver minimum profit levels.

Net shipments of the EPI division fell from $6.5million in 2004 to $4.7 million in 2005. Although revenue has declined, the netcontribution of the EPI division has improved due to higher margins on theremaining business and lower expenses to maintain the business that we nowhave.

Our strategy with respectto contract manufacturing business is to selectively bid on profitable contractmanufacturing business that can help us improve the utilization of ourmanufacturing plant.

**MARKETING**

*BRANDED PRODUCTS*

Management believes that our strategy of selling theNatrol, Laci Le Beau and Prolab brands through all appropriate channels ofdistribution including the health, mass-market, convenience store, fitness andhealth clubs and Internet channels distinguishes us from our competition. Mostcompetitors sell products into each channel using different brand names withineach channel.

Our core strategy has been to build the Natrol, LaciLe Beau and Prolab brand names within multiple channels of distribution inorder to develop increased brand awareness and strong brand recognition amongconsumers seeking products with a reputation for quality.

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We have utilized public relations campaigns, coupons,and outdoor billboard, print, radio and television advertising as well ascooperative and other incentive programs to build consumer awareness andgenerate sales revenue.

Our Marketing and Salesgroups periodically review our media mix for its effectiveness in creatingconsumer demand. As such, our use of certain media in past operating periods isnot necessarily an indicator of media choices to be made in future operatingperiods.

*INGREDIENT SUPPLYSALES AND CONTRACT MANUFACTURING SALES*

Our EPI division reliesprimarily on visibility developed through trade shows, word-of-mouth and theestablished relationships of the Natrol and Prolab sales forces to developawareness of our services.

**RESEARCH & DEVELOPMENT**

We are committed to developing or acquiring newproducts that meet changing consumer demand. Product innovation is part of ourcore strategy. Our R&D department is staffed with technical experts whomonitor developments within the dietary supplement industry. The R&D staffreviews the relevant scientific and medical literature and meets with vendorsto evaluate new ingredients and product concepts. The department is constantlyseeking to acquire new products, product rights, and technologies that can beprofitably marketed to our customers. In the early stages of research, theR&D department works with the Sales and Marketing departments to identifywhich of the *emergent* scientificor technical developments best addresses an unmet consumer need. R&D thendevelops the concept into a commercially viable product.

Product developmentundergoes a formal process where products are screened through physical,chemical and regulatory challenges. Before a product is introduced, theR&D, Quality Assurance and Legal departments review the safety and efficacyof ingredients, set specifications for raw materials and finished products,establish label claims and assess potential patent, trademark, legal orregulatory issues. The R&D department ensures product manufacturability andassists in ensuring that all of our products meet label claims and that allformulations are safe and efficacious to the standards that have beendeveloped.

**MANUFACTURING AND PRODUCT QUALITY**

*DIETARY SUPPLEMENTS*

Our commitment to consumers is to produce highlyefficacious products that can be trusted for their quality. Our products aremanufactured in full compliance with the GMP standards set by the NNFA.

We manufacture most of our tablets and capsules in our90,000 square foot manufacturing facility/headquarters located in Chatsworth,California. At this facility, we manufacture tablets and capsules, whichaccount for the vast majority of our supplement sales. Our liquid products,powders, softgels and herbal teas are outsourced to third party manufacturers.

We are capable of producing four million tablets andcapsules per eight-hour shift and 420,000 bottled goods per week. We make everyeffort to fulfill and ship all orders within 48 hours.

We place a strong emphasis on our quality controlpractices because we believe that quality standards play a critical factor inconsumer safety, purchasing decisions and in differentiating our brands.

Our procedures requirethat all raw materials be tested from the receiving stage and stored inquarantine area until they are approved for use by our Quality Controldepartment. Bulk materials are tested for physical characteristics, activeingredient content, and for contamination such as heavy metals and microbes.

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*Raw MaterialSupply:*

We obtain our raw materials from third-partysuppliers. Many of the raw materials used in our products are harvestedinternationally. We do not have substantial multi-year contracts with supplierscommitting such suppliers to provide the materials required for the productionof our products. During the last decade, coenzyme Q10, natural vitamin E,beta-carotene, melatonin, kava, and a select number of other raw materials havehad significant price fluctuations as a result of short supply and/or increasesin demand. As a result, we have experienced occasional shortages of rawmaterials for a limited number of our products or, alternately, supply forthese raw materials has only been available at sharply higher prices. Two ofour suppliers each accounted for more than 10% of our purchases in 2005 andthree of our suppliers each accounted for more than 10% of our inventorypurchases in 2004. The loss of any of these suppliers could have a materialadverse effect on our ability to produce and sell goods. We do not havematerial long-term supply agreements with these suppliers.

Raw materials arequarantined and tested by our quality control department before they arereleased for production.

*SpecialtySuppliers:*

We sell a limited number of products under a supplier’strademark. In 2005, the most significant of these was our Ester-C line ofproducts, which accounted for approximately 12.2% of our gross sales. When wemarket products under a supplier’s trademark, we are limited to that singlesupplier as a source of raw materials for that product. As a result, anyshortage of raw materials from that supplier would adversely affect our abilityto manufacture that product. Price increases from these suppliers couldseverely impact the profitability of these items. Our inability to obtainadequate supplies of raw materials for our products at favorable prices couldhave a material adverse effect on our business, financial condition and resultsof operations.

Our only source ofarabinogalactan is a single suppler, Larex, Inc. We do not believe thatother sources of nutraceutical grade arabinogalactan are readily available fromother suppliers.

*ShippingFacilities:*

We ship all of ourproducts from our 132,000 square feet warehouse facility located less thanone-quarter mile from our headquarters/manufacturing facility. Approximately52,000 square feet of this warehouse facility is subleased. Rental income wasapproximately $300,000, $389,000, and $473,000 for the years ended December 31,2005, 2004 and 2003, respectively. The remaining 80,000 square feet is beingused to ship finished goods to our customers. Finished goods are transferredfrom our packaging lines to the distribution facility for storage prior toshipment to customers.

*HERBAL TEAS*

We rely upon a singlethird party for the milling and processing of our Laci Le Beau herbal teas.

*PROLAB*

We produce the majority ofProlab supplements that are sold in tablet or capsule form. However, we rely onthird party vendors to process and package most of Prolab’s products, whichconsist of powders such as whey.

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**TRADEMARKS AND PATENTS**

We regard our trademarks, patents and otherproprietary rights as valuable assets and we believe that protecting our keytrademarks is crucial to our business strategy of building strong brand namerecognition and that such trademarks have significant value in the marketing ofour products.

Our policy is to pursue registrations for all of thetrademarks associated with our key products. Federally registered trademarkshave a perpetual life, provided that they are maintained and renewed on atimely basis and used correctly as trademarks, subject to the rights of thirdparties to attempt to cancel a trademark if priority is claimed or confusion ofusage. We rely on common law trademark rights to protect our unregisteredtrademarks as well as our trade dress rights. Common law trademark rightsgenerally are limited to the geographic area in which the trademark is actuallyused, while a United States federal registration of a trademark enables theregistrant to stop the unauthorized use of the trademark by any third partyanywhere in the United States. Furthermore, the protection available, if any,in foreign jurisdictions may not be as extensive as the protection available tous in the United States.

We have received one United States patent for ourKavatrol product and we  have receivedtwo United States patents related to two amino acid products, SAF and SAF forKids. When appropriate, we will seek to protect our research and developmentefforts by filing patent applications for proprietary products. To the extentthat we do not have patents on our products, another company may replicate oneor more of them.

Although we seek to ensurethat we do not infringe on the intellectual property rights of others, therecan be no assurance that third parties will not assert intellectual propertyinfringement claims against us.

**COMPETITION**

The dietary supplement industry is highly competitive.Competition is based primarily on price, quality and assortment of products,customer service, marketing support, and the availability of new products. Wecompete by positioning ourselves as a supplier of quality products, oftentimeswith unique compositions, as opposed to positioning ourselves as a value brand,which competes primarily through low pricing.

Our direct competition is made up of publicly andprivately owned companies, many of which are fragmented in terms of bothgeographical market coverage and product categories. Many companies with whichwe compete are larger in size and have greater financial, personnel,distribution and other resources. Numerous competitors sell broader productlines than we do.

Our principal competitionin the health food store distribution channel comes from a limited number oflarge nationally known manufacturers and many smaller manufacturers of dietarysupplements. In the mass-market distribution channel, our principal competitioncomes from broadline manufacturers, major private label manufacturers and othercompanies. In addition, several large pharmaceutical companies compete with thenutritional supplement companies. Competition from such companies is difficultbecause these companies have greater financial and other resources available tothem and possess manufacturing, distribution and marketing capabilities fargreater than what we have. We also face strong competition in both the healthfood store and mass-market distribution channels from private label dietarysupplements offered by health and natural food store chains, drugstore chains,mass merchandisers and supermarket chains.

**REGULATORY MATTERS**

The manufacture, packaging, labeling, advertising,promotion, distribution and sale of our products are subject to regulation bynumerous governmental agencies. Our products are subject to regulation by,among other regulatory entities, the Consumer Product Safety Commission (CPSC),the U.S. Department 

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of Agriculture (USDA), theEnvironmental Protection Agency (EPA) and the U.S. Food and Drug Administration(FDA). Advertising and other forms of promotion and methods of marketing aresubject to regulation primarily by the U.S. Federal Trade Commission (FTC),which regulates these activities under the Federal Trade Commission Act (FTCA).The manufacture, labeling and advertising of our products are also regulated byvarious state and local agencies as well as those of each foreign country towhich we distribute our products.

The Dietary Supplement Health and Education Act of1994 (DSHEA) revised the provisions of the Federal Food, Drug, and Cosmetic Act(FFDC Act) concerning the regulation of dietary supplements. The substantialmajority of the products we market are regulated as dietary supplements underthe FFDC Act.

Under the current provisions of the FFDC Act, thereare four categories of claims that pertain to the regulation of dietarysupplements. Health claims are claims that describe the relationship between anutrient or dietary ingredient and a disease or health related condition andcan be made on the labeling of dietary supplements if supported by significantscientific agreement and authorized by the FDA in advance via notice andcomment rulemaking. Nutrient content claims describe the nutritional value ofthe product and may be made if defined by the FDA through notice and commentrulemaking and if one serving of the product meets the definition. Statementsof nutritional support or product performance, which are permitted on labelingof dietary supplements without FDA pre-approval, are defined to includestatements that: (i) claim a benefit related to a classical nutrientdeficiency disease and disclose the prevalence of such disease in the UnitedStates; (ii) describe the role of a nutrient or dietary ingredientintended to affect the structure or function in humans; (iii) characterizethe documented mechanism by which a dietary ingredient acts to maintain suchstructure or function; or (iv) describe general well-being fromconsumption of a nutrient or dietary ingredient. In order to make a nutritionalsupport claim, the marketer must possess adequate substantiation to demonstratethat the claim is not false or misleading and if the claim is for a dietaryingredient that does not provide traditional nutritional value, prominentdisclosure of the lack of FDA review of the relevant statement and notificationto the FDA of the claim is required. Drug claims are representations that aproduct is intended to diagnose, mitigate, treat, cure or prevent a disease. Drugclaims are prohibited from use in the labeling of dietary supplements.

Claims made for our dietary supplement products mayinclude statements of nutritional support and health and nutrient contentclaims when authorized by the FDA or otherwise allowed by law. The FDA’sinterpretation of what constitutes an acceptable statement of nutritionalsupport may change in the future thereby requiring that we revise our labeling.In addition, a dietary supplement that contains a new dietary ingredient (i.e.,one not on the market before October 15, 1994) must have a history of useor other evidence of safety establishing that it is reasonably expected to besafe. The manufacturer must notify the FDA at least 75 days beforemarketing products containing new dietary ingredients and provide the FDA theinformation upon which the manufacturer based its conclusion that the producthas a reasonable expectation of safety. There is no assurance that the FDA willaccept the evidence of safety for any new dietary ingredients that we may wishto market, and the FDA’s refusal to accept that evidence could prevent themarketing of the new dietary ingredients and dietary supplements containing anew dietary ingredient. The FDA is in the process of developing guidance forthe industry to clarify the FDA’s interpretation of the new dietary ingredientnotification requirements, guidance that may result in new and significantregulatory barriers for new dietary ingredients.

The FDA in the first quarter of 2004 banned ephedrineproducts. We discontinued the sale of ephedrine-based products in the firstquarter of 2003.

The FDA has also announced its intention to promulgatenew GMPs specific to dietary supplements, to fully enforce DSHEA and monitorcompliance with the Bioterrorism Act of 2002.

Our failure to comply with applicable FDA regulatoryrequirements could result in, among other things, injunctions, productwithdrawals, recalls, product seizures, fines and criminal prosecutions. We 

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intend to comply with thenew GMPs once they are adopted. The new GMPs, predicted to be finalizedshortly, would be more detailed and stringent than the GMPs that currentlyapply to dietary supplements and may, among other things, require dietarysupplements to be prepared, packaged, produced and held in compliance withregulations similar to the GMP regulations for drugs. There can be no assurancethat, if the FDA adopts GMP regulations for dietary supplements, we will beable to comply with the new regulations without incurring a substantialexpense.

As a result of our efforts to comply with applicablestatutes and regulations, we have from time to time reformulated, eliminated orrelabeled certain of our products and revised certain advertising claims. Wecannot predict the nature of any future laws, regulations, interpretations orapplications, nor can we determine what effect additional governmentalregulations or administrative orders, when and if promulgated, would have onour business in the future. They could, however, require the reformulation ofcertain products to meet new standards, the recall or discontinuance of certainproducts not capable of reformulation, additional record keeping, expandeddocumentation of the properties of certain products, expanded or differentlabeling, and/or scientific substantiation. Any or all of such requirementscould have a material adverse effect on our business, financial condition andresults of operations.

Our advertising of dietary supplement products issubject to regulation by the FTC under the FTCA. Section 5 of the FTCAprohibits unfair methods of competition and unfair or deceptive acts orpractices in or affecting commerce. Section 12 of the FTCA provides thatthe dissemination or the causing to be disseminated of any false advertisementpertaining to drugs or foods, which would include dietary supplements, is anunfair or deceptive act or practice. Under the FTC’s Substantiation Doctrine,an advertiser is required to have a “reasonable basis” for all objectiveproduct claims before the claims are made. Failure to adequately substantiateclaims may be considered either deceptive or unfair practices. Pursuant to thisFTC requirement, we are required to have adequate substantiation for allmaterial advertising claims made for our products.

On November 18, 1998, the FTC issued “DietarySupplements: An Advertising Guide for Industry.” This guide provides marketersof dietary supplements with guidelines on applying FTC law to dietarysupplement advertising. It includes examples of the principles that should be usedwhen interpreting and substantiating dietary supplement advertising. Althoughthe guide provides additional explanation, it does not substantively change theFTC’s existing policy that all supplement marketers have an obligation toensure that claims are presented truthfully and to verify the adequacy of thesupport behind such claims. Our internal staff, in conjunction with outsidecounsel, reviews our advertising claims for compliance with FTC requirements.

The FTC has a variety of processes and remediesavailable to it for enforcement, both administratively and judicially,including compulsory process, cease and desist orders and injunctions. FTCenforcement can result in orders requiring, among other things, limits onadvertising, corrective advertising, consumer redress, divestiture of assets,rescission of contracts and such other relief as may be deemed necessary. Aviolation of such orders could have a material adverse effect on our business,financial condition and results of operations.

Advertising and labeling for dietary supplements andconventional foods are also regulated by state, county and other localgovernmental authorities. Some states also permit these laws to be enforced byPrivate Attorney Generals. These Private Attorney Generals may seek relief forconsumers, seek class action certifications, seek class-wide damages, seekclass-wide refunds and product recalls of products sold by us. In the ordinarycourse of business, we are named as a defendant in these types of stategovernmental agency and Private Attorney General Actions along with othervitamin and supplement companies. Until the courts rule that laws havebeen violated, that the actions can proceed by state governmental agencies orPrivate Attorney General Class Actions and that cognizable injuries haveoccurred, we do not believe such actions will have any material impact on ouroperations. There can be no assurance that state and local 

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authorities will notcommence regulatory action, which could restrict the permissible scope of ourproduct advertising claims, or products that can be sold in the future.

Governmental regulations in foreign countries where weplan to begin or expand sales may prevent or delay entry into the market orprevent or delay the introduction, or require the reformulation, of certain ofour products. Compliance with such foreign governmental regulations isgenerally the responsibility of our distributors for those countries. Thesedistributors are independent contractors over whom we have limited control.

We manufacture certain products pursuant to contractswith customers who distribute the products under their own or other trademarks.Such private label customers are subject to government regulations inconnection with their purchase, marketing, distribution and sale of suchproducts. We are subject to government regulations in connection with ourmanufacture, packaging and labeling of these products. However, our privatelabel customers are independent companies, and their labeling, marketing anddistribution of their products is beyond our control. The failure of thesecustomers to comply with applicable laws or regulations could have a materialadverse effect on our business, financial condition and results of operations.We may be named in legal proceedings directed at the independent companies’sales and liability creating activities.

We may be subject toadditional laws or regulations by the FDA or other federal, state, county,local or foreign regulatory authorities, the repeal of laws or regulationswhich the Company considers favorable, such as DSHEA, or more stringentinterpretations of current laws or regulations, from time to time in thefuture. We are unable to predict the nature of such future laws, regulations,interpretations or applications, nor can we predict what effect additionalgovernmental regulations, legal proceedings or administrative orders, when andif promulgated or initiated, would have on our business in the future. Theycould, however, require the reformulation of certain products to meet newstandards, the recall or discontinuance of certain products not able to bereformulated, imposition of additional record keeping requirements, expandeddocumentation of the properties of certain products, expanded or differentlabeling and scientific substantiation. Any or all of such requirements couldhave a material adverse affect on our business, financial condition and resultsof operations.

**EMPLOYEES**

As of December 31,2005, we had 256 employees. Of such employees, approximately 40 were engaged inmarketing and sales, 172 were devoted to production and distribution and 44were responsible for management and administration. Our employees are notcovered by a collective bargaining agreement. We consider our relations withour employees to be good.

**AVAILABLE INFORMATION**

The Securities and Exchange Commission (SEC) maintainsan Internet site (http://www.sec.gov),which contains reports, proxy and information statements, and other informationregarding us. Our Annual Report on Form 10-K filed with the SECincludes all exhibits required to be filed with the SEC. We make available,free of charge, on our website, our Annual Report on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-Kand all amendments to these reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”). Such reports are available as soon as is reasonably practicable after weelectronically file such materials with the SEC. Additionally, copies of thisAnnual Report on Form 10-K, not including any of the exhibits listedunder Item 15 of this Annual Report on Form 10-K, are availablewithout charge upon request.

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**ITEM 1A:**       RISKFACTORS

**ForwardLooking Statements and Certain Risks**

*The statementscontained in this report that are not purely historical are “forward-lookingstatements” within the meaning of Section 21E of the Securities ExchangeAct. These statements regard our expectations, hopes, beliefs, commitments,intentions, and strategies regarding the future. They may be identified by theuse of words or phrases, such as “believe,” “expect,” “anticipate,” “should,” “plan,”“estimate,” and “potential,” among others. Forward-looking statements include,but are not limited to, statements contained in “Business” and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”regarding our financial performance, revenue and expense levels in the future,and the sufficiency of our existing assets to fund future operations andcapital spending needs. Actual results could differ materially from theanticipated results or other expectations expressed in these forward-lookingstatements or for the reasons discussed below. The fact that some of the riskfactors may be the same or similar to past reports we have filed with the SECmeans only that the risks are present in multiple periods. We believe that manyof the risks detailed here are part of doing business in the industry in whichwe operate and compete and will likely be present in all periods reported. Thefact that certain risks are endemic to the industry does not lessen theirsignificance. The forward-looking statements contained in this report are madeas of the date of this report, and we assume no obligation to update them or toupdate the reasons why actual results could differ from those projected inthese forward-looking statements.*

*Our ability topredict results or the effect of certain events on our operating results isinherently uncertain. Therefore, we caution each reader of this report tocarefully consider the following factors and certain other factors discussedherein and in other past filings with the Securities and Exchange Commission.*

*Factors that could cause or contribute to our actualresults differing materially from those discussed herein and in any forwardlooking statement or adversely affect the price of our Common Stock include,but are not limited to, the following factors:*

*Specific Corporate Risks:*

*ReducedProduct Liability Insurance Coverage and Exposure to Product Liability Claims.**  *As with other retailers,distributors and manufacturers of products designed for human consumption, weface an inherent risk of exposure to product liability claims. We may besubjected to various product liability claims, including, among others, that ourproducts include inadequate instructions for use or inadequate warningsconcerning possible side effects and interactions with other substances. Inaddition, although we maintain strict quality controls and procedures,including the quarantine and testing of raw materials and qualitative andquantitative testing of selected finished products, there can be no assurancethat the our products will not contain contaminated substances. In addition, incertain cases, we rely on third party manufacturers for our products.

Natrol and its other brands, Laci Le Beau and Prolab,have each sold ephedrine-based products in past years. The volume of such saleshas not been large relative to the overall sales and, as of March 31,2003, we stopped selling or manufacturing ephedrine-based products. The sale ofephedrine-based products in the United Stated was banned by the U.S. Food andDrug Administration (FDA) in February 2004.

Since 2002, product liability insurance forephedrine-based products has been generally unavailable. Occurrence-basedproduct liability insurance became unavailable during the fourth quarter of2002. “Claims-made insurance,” was offered to us only with substantially lowerlimits than we had carried in prior years and at rates that were many times higherthan those paid in prior years. As of July, 2003, we chose to self-insureagainst product liability claims due to the high price of product liabilityinsurance, the inability to secure occurrence based coverage, as well as thelimited amount of coverage provided by insurers willing to provide insurance athigh prices. We deposited $5.0 million for a five-year policy term 

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with an insurance carrierwho provides certificates of insurance to our vendors. The $5.0 millionearns interest and is classified as a non-current asset entitled “RestrictedCash” on the accompanying consolidated balance sheet. The $5.0 million isfully refundable should we decide to end the self-insurance program at the endof the policy term.

There can be no assurance that insurance will, infuture years, be available at a reasonable cost or available with limits thatmeet the requirements of our customer base, or, if available, will be adequateto cover liabilities or that any insurance carrier will be willing to continueassisting us with our self insurance program in future years. Accordingly, ifinsurance coverage is inadequate or unavailable, we may face additional claimsnot covered by insurance, claims that exceed coverage limits or that are notcovered, which could have a material adverse effect on us.

In order to limit exposure to lawsuits, we generallyseek contractual indemnification from parties supplying raw materials for ourproducts or manufacturing or marketing our products, and request to be added asan additional insured under such parties’ insurance policies. Any suchindemnification or insurance is limited by its terms and any suchindemnification, as a practical matter, is limited to the creditworthiness ofthe indemnifying party. In the event that we do not have adequate insurance orcontractual indemnification, product liabilities relating to our products orcontract manufacturing activities could have a material adverse effect on ourbusiness, financial condition and results of operations.

There are many other reasons we can be sued other thanfor product liability. The cost of defending ourselves from legal claims, nomatter how spurious, can be high. The cost of defense can be substantiallyhigher than the cost of settlement even when claims are not factually based.The high cost of legal fees to defend or settle litigation could have amaterial adverse effect on our business, financial condition and results ofoperations.

*Dependenceon New Products.**  *Webelieve that to grow revenue year after year, we need to constantly develop oracquire new products. We attempt to introduce additional products each year.The success of new products is dependent upon a variety of factors, includingour ability to develop products that will appeal to consumers and respond tomarket trends in a timely manner. Obtaining distribution for new products isdifficult and often expensive due to slotting and other promotional chargesthat are mandated by retailers. New products often have to be promoted heavilyin the media in order to gain visibility and consumer acceptance. There can beno assurance that our efforts to develop new products will be successful orthat consumers will want to buy our new products. New products can often takesubstantial periods of time to develop consumer awareness, consumer acceptanceand sales volume. Some new products fail and as a result have to bediscontinued. In addition, products currently experiencing strong popularityand rapid growth may not maintain their sales volumes over time.

For example, our sales of Carb Intercept grewconsistently in 2003 and 2004 reaching $11.0 million in gross shipments in 2004.In 2005, gross shipments of Carb Intercept fell to $1.8 million. We believethat this downturn was due to negative publicity (*see: Effect of Unfavorable Publicity*) surrounding thelow-carbohydrate Atkins diet that was disseminated during the last quarter of2004.

*ProductReturns.**  *Productreturns are a part of our business. While customers generally do not have anabsolute right of return, products may be returned for various reasonsincluding expiration dates or lack of sufficient sales velocity. Another reasonfor returns is the loss of a significant account or the purchase of onecustomer by another. In late 2004, the Eckerd drug store chain was sold by itsparent company, J.C. Penney, to the CVS and the Brooks drugstore chains. Whenone chain is bought by another, the vendors to the acquired retailer will gainor lose business depending upon the intent of the acquiring company. In thecase of the Eckerd acquisition, Eckerd carried more of our products than didCVS and Brooks at the time of the acquisition. The result was that during 2005,CVS and Brooks returned $0.9 million more of our products than in 2004. Thenumber of our items carried in the old Eckerd stores was reduced. We areworking to expand our shelf space at these chains but there is no guaranteethat our shelf space will expand 

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in the immediate future.How a consolidation will affect a vendor is difficult to quantify in exactterms immediately after the announced consolidating event becauserepresentatives of the acquirer and the acquired business are most often difficultto reach and IT systems in each company typically do not work well with eachother. The result is that smaller vendors often have to wait for months beforebeing able to obtain an accurate description of the acquirer’s plans. Thereturns were posted as a reduction of gross sales thereby reducing net revenue.

We accrue allowances for returns based on historicaldata and future expectations. During 2005, returns and charges for damages andoutdated products amounted to approximately 6.2% of gross shipments, more thanthe 3.5% or 4.7% rates experienced in 2004 and 2003, respectively. Wecontinually work to lessen the impact of returns through the management of ourSKU count at retail establishments and the more effective use of sales andmarketing programs. Even so, there is no guarantee that future returns will notequal or exceed the levels experienced in years prior to 2003 when returnsamounted to as much as 14.5% of gross shipments.

It is our policy to review our retail base on acustomer-by-customer basis and to accrue for returns as soon as estimates canbe reasonably calculated.

*InventoryRisk.**  *Ourproducts are tested for stability and each product has an associated expirationdate after which the product cannot be sold. Expiration dates can be as shortas months or, in some cases, as long as four years. In order to provide thefreshest product possible, we make every attempt to manufacture product on ajust-in-time basis. However, as sales trends change, it is possible for us toover-produce finished goods inventory or have excess raw materials which arenot used before their expiration dates. We regularly dispose of overstockedfinished goods and expired raw material inventory. When sales trends change toorapidly or when manufacturing planning does not estimate future demandaccurately, we then have to write off inventory, which affects our results ofoperations during the period in which the write-downs of inventory occur.

In 2005, we wrote off $1.9 million of inventory,nearly 2.5 times the amount we wrote off in 2004 due in a large part to thesharp fall off of Carb Intercept sales in early 2005.

We closely monitor our inventory and we regularlyreview inventory levels, the velocity of sales, and raw material and componentusage relative to inventory. Our goal is to ensure that inventory on hand isfairly valued; is good and usable; and, that potentially unusable inventory isadequately reserved at the earliest possible time.

*DistributionGains.**  *Animportant element of our business strategy is to gain additional distributionin the various channels of trade that provide vitamins and other supplements toconsumers. Our salespeople are constantly looking for new avenues in which tosell our products and we are always making an effort to gain additionaldistribution for profitable and rapidly selling products in existing accounts.Our failure to make additional distribution gains or to maintain currentdistribution and expand sales of core products could have an adverse materialeffect on our business, financial condition and results of operations.

*Costof Retail Relationships.**  *Many large retailers require various forms ofincentive programs in order to develop branded sales with them. These programsinclude slotting fees, coop advertising programs, rebate incentives, price offpromotions, scandowns and other forms of support. We continually evaluatespecific programs to ascertain the profitability of potential business fromeach retailer. Because these programs are expensive, we may decide that wecannot profitably do business with a retailer. This may cause us to stop doingbusiness with existing customers or not allow us to enter into a businessrelationship with a potential new customer, each of which in turn could dampenfuture revenue growth. In 2005, approximately 13.6% of the revenue from grossshipments was allocated to such support programs.

*Dependenceon Significant Customers.**  *One major customer represented more than 10% of grosssales in 2005. This customer accounted for approximately 12.8% of net sales. Nomajor customer during 

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2004 represented 10% ofnet sales. Our top ten customers accounted for approximately 50.5% of ourbusiness. There is no assurance that our major customers will continue to bemajor customers. The loss of a significant number of major customers, or asignificant reduction in purchase volume by a major customer, and/or thefinancial difficulty of a major customer, for any reason, could have a materialadverse effect on our business, financial condition and results of operations.

*Abilityto Execute Our Business Plans.*   Our recentfinancial performance may limit our ability to execute our business plan. Inreaction to our financial performance, we have worked to manage expenses suchas payroll and advertising and we are striving to ensure our futureprofitability. But limited resources and restrictions on expenditures may havea long-term effect on revenue growth. Should industry and general economictrends for the nation as a whole be difficult, we may have to further reduce payrollas well as other forms of overhead and fixed expenses. Such cutbacks couldaffect, in a negative manner, our long-term growth.

Additionally, we may not be able to increase revenueand reduce expenses as rapidly as is necessary to become profitable quickly.

If corporate or industry trends strengthen in astrong, positive way resulting in the sudden growth of our revenues, ourmanagement, operations, sales and administrative personnel and other resourcesmay be strained in the short term. Attracting, training, motivating, managingand retaining qualified employees may be difficult in the short term. Noassurance can be given that our business will grow in the future or that wewill be able to effectively return to profitability. Our inability to manage growthor negative growth successfully could have a material adverse effect on ourbusiness, financial condition and results of operations.

Furthermore, we may have to substantially alter ourbusiness strategy and redeploy assets to grow the business. While suchdecisions would be made with the expectation that of long-term benefit to thecorporation, in the short-term, such decisions could have a negative impact onrevenue and net income. There is no guarantee that our efforts will succeed.

*RisksAssociated with Acquisitions.**  *In order to grow, we may have toalter our core business strategy to more aggressively pursue acquisitions thatwill help us grow our revenue and take advantage of the infrastructure we havein place. Acquisitions, however, do not come without risk. Acquisitions mayrequire an expenditure of cash, the issuance of stock or the assumption ofdifferent forms of debt, which may dilute current shareholders. Acquisitionsinevitably require the attention of senior management and an acquisition couldcause us to lose focus on our core business. Integrating an acquisition isoften difficult and a difficult integration could result in our spending morethan expected and could result in poorer results than anticipated at the timeof the acquisition’s announcement. And, even if we devote resources to findingsuitable acquisitions, such acquisitions may not materialize for many businessreasons. There is no guarantee that a suitable acquisition at terms we believeare appropriate can be consummated in the near future or at all.

*Absenceof Conclusive Clinical Studies.**  *Although many of the ingredients inour products are vitamins, minerals, herbs and other substances for which thereis a long history of human consumption, some of our products containingredients with a less developed history of use and effects. Accordingly, ourproducts are evaluated to identify any harmful side effects. However, very fewof our products have been tested through extensive clinical studies. Anyunintended and unconnected effects may result in adverse publicity or productliability claims, which could have a material adverse effect on our business,financial condition and results of operations.

*RisksAssociated with Supply of Raw Materials.**  *We obtain all of our raw materialsfrom third-party suppliers. Many of the raw materials are harvestedinternationally. We do not have significant long-term contracts with anysupplier committing the supplier to provide us with materials. During the last decade,

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coenzyme Q10, naturalvitamin E, beta-carotene and melatonin have had significant price fluctuationsas a result of short supply and/or increases in demand. We have experiencedoccasional shortages of raw materials for a limited number of products. Therecan be no assurance that suppliers will provide the raw materials we need inthe quantities we need at prices we are willing pay.

We also sell a limited number of products under thesupplier’s trademark. The most significant of these is our Ester-C line ofproducts, which accounts for approximately 12.2% of our gross sales in 2005.When we market products under the supplier’s trademark, we are limited to thatsingle supplier as a source of raw materials for that product. As a result, anyshortage of raw materials from that supplier would adversely affect our abilityto manufacture that product.

Because we do not control the actual production ofthese raw materials, we are also subject to delays caused by interruption inproduction of materials based on conditions not within our control. Suchconditions include job actions or strikes by employees of suppliers, weather,crop conditions, transportation interruptions and natural disasters or othercatastrophic events. As a result, any shortage of raw materials from thatsupplier would adversely affect our ability to manufacture that product. Priceincreases from such suppliers would directly affect our profitability when weare not able to pass price increases on to customers. Our inability to obtainadequate supplies of raw materials at favorable prices, or at all, could have amaterial adverse effect on our business, financial condition and results ofoperations.

We purchase goods from a variety of vendors. Twovendors each accounted for more than 10% of our purchases of raw material in2005. Three vendors each accounted for more than 10% of our purchases of rawmaterials in 2004. The loss of a large vendor could have a material impact onour ability to source raw material and manufacture finished product associatedwith the raw materials supplied by any one of these vendors. The result couldbe a material and adverse effect on our profitability.

*Salesand Earnings Volatility.**  *Our sales and earnings have been volatile andcontinue to be subject to volatility based upon, among other things: (i) trendsand general conditions in the dietary supplement industry and our ability torecognize such trends and effectively introduce and market new products inresponse to such trends; (ii) the introduction of new products by us orcompetitors; (iii) the loss of one or more significant customers; (iv) increasedmedia attention on the use and efficacy of dietary supplements; (v) consumers’perceptions of our products and those of competitors; (vi) theavailability of raw materials from suppliers; and, (vii) our ability toaccurately predict inventory needs so that we do not overstock items whicheventually must be written off due to low demand, or, that we fail to stockenough of an item so that sales are not lost due to lack of supply. Sales andearnings volatility as a result of the foregoing factors may affect ouroperating results from period to period, which may adversely affect the marketprice of the Common Stock.

*RisksAssociated with Manufacturing.**  *Our results are dependent upon thecontinued operation of our manufacturing facility in Chatsworth, California atits current levels. The operation of dietary supplement manufacturing plantsinvolves many risks, including the breakdown, failure or substandardperformance of equipment, natural and other disasters, and the need to complywith the requirements of directives of government agencies, including the FDA.In particular, our manufacturing facility is located in Southern California, ageographic area that has historically been prone to earthquakes, which in somecases have been catastrophic. Prior to our build-out of the building in whichour manufacturing facility is located, the building was severely damaged in amajor earthquake in 1994, the epicenter of which was within five miles of thebuilding. Although the building was rebuilt with an enhanced ability towithstand earthquakes and conforms to current local and state coderequirements, our manufacturing facility could be damaged or destroyed in theevent of an earthquake. Any such damage or destruction would have a materialadverse effect on our business, financial condition and results of operations.We do not carry earthquake insurance on our facilities. In addition, oursoftgel and liquid products, the Laci Le Beau tea products, as well as all ofProlab’s non-tablet and capsule products, which make up a majority of Prolab’sbusiness, are 

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manufactured by thirdparty contractors. Our profit margins on these products and our ability todeliver these products on a timely basis are dependent upon the ability of theoutside manufacturers to continue to supply products that meet our qualitystandards in a timely and cost-efficient manner. The occurrence of any of theforegoing or other material operational problems could have a material adverseeffect on our business, financial condition and results of operations duringthe period of such operational difficulties.

*Relianceon Independent Brokers.**  *We place a degree of reliance on a network ofindependent brokers to act as our first-line sales force to mass-marketretailers. Although we employ seasoned sales professionals to closely monitorthe brokers, such brokers are not employed or otherwise controlled by us andare generally free to conduct their business at their own discretion. Althoughthese brokers enter into contracts with us, such contracts typically can beterminated upon 30 days notice by the independent broker or us.

*IntellectualProperty Protection.**  *Ourpolicy is to pursue registrations for all of the trademarks associated with keyproducts. We rely on common law trademark rights to protect unregisteredtrademarks as well as trade dress rights. Common law trademark rights generallyare limited to the geographic area in which the trademark is actually used,while a United States federal registration of a trademark enables theregistrant to stop the unauthorized use of the trademark by any third partyanywhere in the United States. We intend to register our trademarks in certainforeign jurisdictions where the products are sold but we may not register allor even some or our trademarks in every country in which we sell our productsor intend to sell our products. However, the protection available, if any, insuch jurisdictions may not be as extensive as the protection available in theUnited States.

We have few patents on our products and no materialbusiness is derived from those items that are patented. To the extent we do nothave patents, another company may replicate one or more of our products.Additionally, we sell a number of products that includepatented ingredients, purchasing those patented ingredients as a directlicensee of the rights holder or from parties that we believe have the right tomanufacture and/or sell those ingredients to us. Furthermore, there are severalpatents that have been issued and/or applied for connected to dietarysupplements and their ingredients, possibly resulting in third parties seekingto compel us and our competitors to purchase patented ingredients, which areusually more costly than non-patented ingredients.

Although we try to ensure that we do not infringe theintellectual property rights of others, there can be no assurance that thirdparties will not assert intellectual property infringement claims against us;claims that may result in significant costs and diversion of other assets andcould have a material adverse effect on our financial condition or results ofoperations. If an infringement claim is asserted or litigation filed, we may berequired to pay for a license to certain rights, paying royalties on both aretrospective and prospective basis, and/or cease our manufacturing and sale ofcertain products that are alleged to be infringing. There can be no assurancethat future claims asserted by third parties will not adversely impact ourbusiness, our financial condition or results of operations.

*PossibleVolatility of Stock Price.**  *There can be no assurance that an active market inour stock will be sustained. The trading price of the Common Stock hashistorically been subject to wide fluctuations and daily trading volume isrelatively low.

The price of the Common Stock may fluctuate in thefuture in response to quarter-to-quarter variations in operating results,material announcements by us or competitors, governmental regulatory action,conditions in the dietary supplement industry, or other events or factors, manyof which are beyond our control. In addition, the stock market has historicallyexperienced significant price and volume fluctuations which have particularlyaffected the market prices of many dietary supplement companies and which have,in certain cases, not had a strong correlation to the operating performance ofsuch companies. In addition, our operating results in future quarters may bebelow the expectations of securities analysts and investors. In such event, theprice of the Common Stock would likely decline, perhaps substantially.

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*RiskAssociated with Large Controlling Shareholders.*   Ourpublic float is relatively small, consisting of less than 30% of our issuedshares. As of year-end 2005, our top five shareholders owned approximately 77%of our stock. The decision by any one of these shareholders to sell theirinterest could materially and adversely affect the share price.

In addition, on February 14, 2006, the Board ofDirectors of Natrol, Inc. (the “Company”) appointed Mr. Wayne Bos asa Director of the Company and appointed him Chief Executive Officer Designateand President Designate. In connection with his appointment, Mr. Bos wasawarded fully vested options to purchase 6,029,500 shares of the Company’scommon stock with a strike price of $2.282 per share. The strike price wasequal to the price of the last reported trade immediately prior to the time theBoard determined to grant this option and therefore reflects the fair marketvalue of our common stock at the time of the grant. For a period of threeyears, Mr. Bos’s ability to sell the majority of the shares he receivesupon exercise of these options is restricted, with the restrictions lapsingbased upon the stock price reaching defined hurdles. The grant is subject toshareholder approval. Should these shares be exercised and not subsequentlysold, the concentration of our stock amongst our top five shareholders wouldincrease.

*ContinuedAcceptance of Our Products.**  *We strive to continually burnish the brand image ofour products. Even so, negative events, negative publicity about supplements inparticular or in general, and other factors could lead to a future lack ofacceptance of our products. Such events or publicity may not be relateddirectly to us. Even so such events or other factors could reduce demand forour products.

*Availabilityof Capital.**  *Shouldwe need to borrow, the cost of capital may be high. Traditional debt financingmay be unavailable and we may have to seek alternative sources of financing,including the issuance of new shares of stock or preferential stock that coulddilute current shareholders.

*Riskof Litigation from Private Attorney Generals and Others.**  *Advertising and labeling fordietary supplements and conventional foods are, in addition to the federalgovernment, regulated by state, county and local authorities. Some states alsopermit these laws to be enforced by Private Attorney Generals. These PrivateAttorney Generals may seek relief for consumers, seek class actioncertifications, seek class wide damages and product recalls of products sold byus. In the ordinary course of business, we may be named as a defendant in thesetypes of State Attorneys and Private Attorney General Actions along with othervitamin and supplement companies. Until the courts rule that laws havebeen violated, that the actions can proceed as Private Attorney General Class Actionsand that the cognizable injury has occurred, we do not believe such actionswill have any material impact on our operations. There can be no assurance thatstate, county or local regulatory authorities will not commence regulatory orlegal proceedings, which could restrict the permissible scope of the ourproduct claims or the ability to sell our products in the future.

*InternalControls.**  *In2002, Congress passed the Sarbanes-Oxley Act. As directed by Section 404of the Sarbanes-Oxley Act, the SEC adopted rules requiring publiccompanies to include a report of management on internal control over financialreporting in their Annual Reports on Form 10-K. In addition, theindependent registered public accounting firm auditing a public company’sfinancial statements must attest to and report on management’s assessment ofthe effectiveness of internal control over financial reporting. The date bywhich companies with a market capitalization of less than $75.0 million mustreceive auditor attestation has been delayed until the fiscal year ended December 31,2007. Even so, we have been preparing for attestation and in 2005, we spentapproximately $300,000 with a consulting firm to document all of our processesas required by the Sarbanes-Oxley Act.

If we fail to maintainadequate and effective internal control over financial reporting, our abilityto manage our business, comply with Sarbanes-Oxley, obtain required auditorattestation and provide reliable financial reporting could be impaired and ourmanagement and auditors may be precluded from certifying effective internalcontrol over financial reporting, which could harm our business reputation andcause our 

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stockprice to decline. While we believe our controls meet all required standards, inthe future our independent registered public accounting firm may not besatisfied with our internal controls over financial reporting or the level atwhich these controls are documented, designed, operated or reviewed. Ourauditing firm may interpret the requirements, rules or regulationsdifferently from the way we interpret them, then they may decline to attest tomanagement’s assessment or may issue a report that is qualified or has a scopelimitation. From time-to-time, in our ongoing effort to improve business andoperational processes and our internal control over financial reporting, we orour auditors may determine that “significant deficiencies” or “materialweaknesses” (as such terms are defined under accounting standards establishedby the Public Company Accounting Oversight Board) exist or that our internalcontrol over financial reporting may otherwise require improvement. Significantdeficiencies or material weaknesses could impair our ability to providefinancial statements that can be relied upon. If this were to occur, ourbusiness reputation could be harmed and investors may lose confidence in thereliability of our financial statements and reports, either of which could havea significant negative impact on our stock price.

*Industry Risks*

*Industrytrends.**  *Oursuccess is linked to the size and growth rate of the vitamin, mineral andsupplement market and a weakness in the VMS marketplace could have a materialadverse effect on us.

The total United States retail market for nutritionalsupplements is highly fragmented. Highly documented industry data is notreadily available and, when available, it is generally historical in nature,reporting on periods 12 months or more in arrears. Information Resources, Inc. (IRI) tracks sales data within thefood, drug, and mass-market channels of distribution. This tracking does notinclude *Wal-Mart* sales, which area significant portion of this sector. *Wal-Mart*is one of our top 10 customers. Health food channel sales, which are nottracked by IRI, make up approximately 22% of our overall business and Prolabsales which, in 2005, made up approximately 20% of our overall business are nottracked by IRI. Even so, IRI is useful for tracking key parts of themass-market business. For the 52-week period ending December 31,2005, IRI reported that the general vitamin category saw sales fall 3% in 2005.IRI does not track sales at health stores, sales through the Internet, or salesto other types of retailers.

The private label business has been a significantgrowth element within the VMS industry. The growth of private label salesimpacts the sales of branded products such as those distributed by Natrol.Large mass-market retailers are to an ever-greater degree, emphasizing privatelabel sales. As such, the growth of brands such as Natrol, Laci Le Beau, andProlab within food, drug, and general mass-market merchants is highlycompetitive and uncertain.

In addition to the trends in the nutraceuticalindustry, the United States economy has experienced significant fluctuationsover the last few years, in part due to uncertainty over foreign events,terrorists’ activities, the war in Iraq, unemployment and job creation in theUnited States and swings in overall consumer confidence. A sluggish economyinevitably impacts Natrol as well as the entire vitamin, mineral and supplementsector.

*Competition.**  *The dietary supplement industry ishighly competitive and we face intense competition from competitors that arelarger, more established and that possess greater resources than we do. If weare unable to compete effectively, we may be unable to maintain sufficientmarket share to achieve and sustain profitability.**Numerous companies, many of which are larger in size andpossess greater financial, personnel, distribution and other resources, competewith us in the development, manufacture and marketing of dietary supplements.Our principal competition in the health food store distribution channel comesfrom a limited number of large nationally known manufacturers and many smallermanufacturers of dietary supplements. Some of these companies focus exclusivelyin the health food channel of trade and have more salespeople than we do, and,as a result, have developed very strong relationships in this single channel oftrade. In the mass-market distribution channel, our principal competition comesfrom broadline 

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manufacturers, majorprivate label manufacturers and other companies. In addition, largepharmaceutical companies compete with us and others in the dietary supplementindustry. Packaged food and beverage companies compete on a limited basis inthe dietary supplement market. Increased competition from such companies couldhave a material adverse effect on us because such companies have greaterfinancial and other resources available to them and possess manufacturing,distribution and marketing capabilities far greater than we possess. We alsoface competition in both the health food store and mass-market distributionchannels from private label dietary supplements and multivitamins offered byhealth and natural food store chains, drugstore chains, mass merchandisers andsupermarket chains. Private label brands at mass-market chains representsubstantial sources of income for these merchants and the mass-market merchantsoften support their own labels at the expense of other brands.

*Effectof Unfavorable Publicity.**  *Our reputation and the reputation of the industry areextremely important to developing and maintaining the confidence of consumers.We believe that if consumers perceive the industry is not producing products toa high standard or that VMS products are not as efficacious as they should be,then our sales and those of the industry will be damaged. For these reasons, wealso believe that the dietary supplement market is significantly affected bynational media attention regarding the consumption of dietary supplements.

Future scientific research or publicity may not befavorable to the dietary supplement industry or to any particular product oringredient and may not be consistent with earlier favorable research orpublicity. Because of our dependence on consumers’ perceptions, adversepublicity associated with illness or other adverse effects resulting from theconsumption of VMS products or ingredients or any similar products distributedby other companies and future reports of research that are perceived as lessfavorable or that question earlier research could have a material adverseeffect on our business, financial condition and results of operations. The merepublication of reports asserting that such products may be harmful orquestioning their efficacy could have a material adverse effect on ourbusiness, financial condition and results of operations, regardless of whethersuch reports are scientifically supported or whether the claimed harmfuleffects would be present at the dosages recommended for such products.

There is no guarantee that unfavorable publicity willnot have a similar negative effect on other products in the future. This may bethe case regardless of whether or not the negative publicity is warranted toany degree.

*GovernmentRegulation.**  *Oursis a very highly regulated industry. Changes in regulations could be harmful toour long-term growth and lawsuits could arise over the interpretation of themany rules and regulations we must follow.

We have regulations surrounding almost every part ofour business from how we manufacture product to how we package goods and label,advertise, promote and distribute products. We are subject to regulation by,among other regulatory entities, the CPSC, the USDA, the EPA and the FDA.Advertising and other forms of promotion and methods of marketing of ourproducts are subject to regulation primarily by the FTC which regulates theseactivities under the FTCA. The manufacture, labeling and advertising of ourproducts are also regulated by various state and local agencies as well asthose of each foreign country to which we distribute.

Our products are generally regulated as dietarysupplements under the FFDC Act, and are, therefore, not subject to pre-marketapproval by the FDA. However, these products are subject to extensiveregulation by the FDA relating to adulteration and misbranding. For instance,we are responsible for ensuring that all dietary ingredients in a supplementare safe, and must notify the FDA in advance of putting a product containing a newdietary ingredient (i.e., an ingredient not marketed for use as a supplementbefore October 15, 1994) on the market and furnish adequate information toprovide reasonable assurance of the ingredient’s safety. Furthermore, if wemake statements about the supplement’s effects on the structure or function ofthe body, we must, among other things, have 

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substantiation that thestatements are truthful and not misleading. In addition, our product labelsmust bear proper ingredient and nutritional labeling and our supplements mustbe manufactured in accordance with current GMPs for foods. The FDA has issuedan advanced notice of its intention to promulgate new GMPs which, when finallyadopted may be more expensive to follow than prior GMPs. A product can be removedfrom the market if it is shown to pose a significant or unreasonable risk ofillness or injury. Moreover, if the FDA determines that the “intended use” ofany of our products is for the diagnosis, cure, mitigation, treatment orprevention of disease, the product would meet the definition of a drug andcould not be sold as a dietary supplement without a modification of its “intendeduse” claims. Failure to comply with applicable FDA regulatory requirements mayresult in, among other things, injunctions, product withdrawals, recalls,product seizures, fines and criminal prosecutions.

Our advertising is subject to regulation by the FTCunder the FTCA. Section 5 of the FTCA prohibits unfair methods ofcompetition and unfair or deceptive acts or practices in or affecting commerce.Section 12 of the FTCA provides that the dissemination or the causing tobe disseminated of any false advertisement pertaining to, among other things,drugs or foods, which includes dietary supplements, is an unfair or deceptiveact or practice. Under the FTC’s “substantiation doctrine,” an advertiser isrequired to have a “reasonable basis” for all product claims at the time theclaims are first used in advertising or other promotions. Failure to adequatelysubstantiate claims may be considered either as a deceptive or unfair practice.Pursuant to this FTC requirement, we are required to have adequatesubstantiation for all advertising claims. The type of substantiation will bedependent upon the product claims made. For example, a health claim normallywould require competent and reliable scientific evidence, while a taste claimwould require only survey evidence.

In recent years the FTC has initiated numerousinvestigations of dietary supplement and weight loss products and companies. OnNovember 18, 1998, the FTC issued “Dietary Supplements: An AdvertisingGuide for Industry.” This guide provides marketers of dietary supplements withguidelines on applying FTC law to dietary supplement advertising. It includesexamples of the principles that should be used when interpreting andsubstantiating dietary supplement advertising. Although the guide providesadditional explanation, it does not substantively change the FTC’s existingpolicy that all supplement marketers have an obligation to ensure that claimsare presented truthfully and to verify the adequacy of the support behind suchclaims. Our  internal staff, inconjunction with outside counsel, reviews advertising claims.

We are not currently a party to any investigation,consent order or other decree of the FTC. We may be subject to investigation bythe FTC in the future. If the FTC has reason to believe the law is beingviolated (e.g., we do not possess adequate substantiation for product claims),it can initiate enforcement action. The FTC has a variety of processes andremedies available to it for enforcement, both administratively and judicially,including compulsory process authority, cease and desist orders andinjunctions. FTC enforcement could result in orders requiring, among otherthings, limits on advertising, consumer redress, divestiture of assets,rescission of contracts and such other relief as may be deemed necessary.Violation of such orders could result in substantial financial or otherpenalties. Any such action by the FTC could materially adversely affect ourability to successfully market our products.

We manufacture certain products pursuant to contractswith customers who distribute the products under their own or other trademarks.Such private label customers are subject to government regulations inconnection with their purchase, marketing, distribution and sale of such products,and we are subject to government regulations in connection with themanufacture, packaging and labeling of such products. However, our privatelabel customers are independent companies, and their labeling, marketing anddistribution of such products is beyond our control. The failure of thesecustomers to comply with applicable laws or regulations could have a materialadverse effect on our business, financial condition and results of operations.

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Governmental regulations in foreign countries where weplan to begin or expand sales may prevent or delay entry into the market orprevent or delay the introduction, or require the reformulation, of certainproducts. Compliance with such foreign governmental regulations is generallythe responsibility of our distributors in those countries. These distributorsare independent contractors over whom we have limited control.

We may be subject toadditional laws or regulations by the FDA or other federal, state or foreignregulatory authorities, the repeal of laws or regulations, which we considerfavorable, such as DSHEA, or more stringent interpretations of current laws orregulations, from time to time in the future. We are unable to predict thenature of such future laws, regulations, interpretations or applications, norcan we predict what effect additional governmental regulations oradministrative orders, when and if promulgated, would have on our business inthe future. They could, however, require the reformulation of certain productsto meet new standards, the recall or discontinuance of certain products thatcannot be reformulated, imposition of additional record keeping requirements,expanded documentation of the properties of certain products, or expanded ordifferent labeling or scientific substantiation. Any or all of theserequirements could have a material adverse effect on our business, financialcondition and results of operations.

*General BusinessRisk:*

*Risk Associated withNational Trends.**  *Wesell our products nationally in several channels of distribution. As such, weare not immune from trends in the national economy. Negative employment orother economic trends directly affects the average consumer’s purchasingability which in turn can affect our sales. Uncertainty due to the world eventssuch as the war in the Middle East can affect the general willingness ofconsumers to spend on any item, including our products, that the consumer mayfeel is not essential. National economic trends affect our customers. Shouldany one of our national customers fail due to national trends, their failurecould have a direct impact on the success of the our business.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS.

We do not have anyunresolved comments from the SEC staff.

**ITEM 2.**                PROPERTIES

We own our 90,000 square foot manufacturing,distribution and office facility in Chatsworth, California. We have occupiedthis facility since March 1997. The facility was designed and constructedto our specifications and includes areas for receiving, quarantine of newmaterials, manufacture, quality control and laboratory activities, research anddevelopment, packaging, warehousing and administrative offices.

We also own our 132,000 square foot warehousefacility. This facility is located within one-quarter mile of our headquartersfacility. We generally lease 52,000 square feet of this space to a third party.The tenant who has been leasing this space has been in default on its rentpayments since December 2005. In February 2006, this tenant formallynotified us of its intent to vacate the facility and we have commissioned abroker to find a new tenant. Although we are attempting to collect rent due us,there is no guarantee that the tenant will be able to pay us for rent owed evenif a formal legal settlement is reached. Rental income during 2005 was postedonly as cash payments were received. Although the notification by the tenantwas a subsequent event, in December 2005, the Company expensed deferredrent and prepaid commissions which were related to the lease with the tenant of$132,000.

At December 31, 2005,we owned a 25,000 square foot light manufacturing and warehouse facility inBloomfield, Connecticut. This property, which formerly housed Prolab’s shippingoperations, was sold in January 2006.

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**ITEM 3.**                LEGALMATTERS

From time to time, we aresubject to litigation incidental to our business, including product liabilityclaims, state agency actions, Attorney General Actions and class actions. Weare a party to a number of lawsuits that arise in the ordinary course ofbusiness and may become a party to additional lawsuits. Although none of thelawsuits in which we are involved in as of the date of this filing arereasonably estimated to be material, the possibility exists that futurelawsuits could arise or that developments could occur in existing legal actionsthat could have a material adverse effect on us. Such claims, if successful,could exceed the $5.0 million retention under our self-insurance program.We are not currently a party to any material legal proceedings.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

During the fourth quarter of 2005, no matters weresubmitted to a vote of the security holders of the Company.

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**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES

*PRICE RANGE OFCOMMON STOCK*

Our Common Stock is traded on the NASDAQ NationalMarket under the symbol “NTOL.” On March 9, 2006, the last reported salesprice of our Common Stock as reported on the NASDAQ National Market was $2.02.As of March 1, 2006 there were 25 holders of record of our Common Stock.

Thehigh and low sales closing prices for the Common Stock as reported by the NASDAQNational Market for the years ended December 31, 2005 and 2004 are setbelow:

| ** **                             | ** ** | **Fiscal year ended  December 31, 2005** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                             | ** ** | **High**                                                     | ** ** | **Low** | ** ** |
| Quarter ended  March 31, 2005     |       | $                                                            | 3.28       |   | $ | 2.65 |   |
| Quarter ended  June 30, 2005      |       | 3.05                                                         |       | 2.72 |   |
| Quarter ended  September 30, 2005 |       | 3.02                                                         |       | 2.30 |   |
| Quarter ended  December 31, 2005  |       | 2.62                                                         |       | 1.49 |   |
|                                        |            |                                                              |            |  |  |  |  |

 

| ** **                             | ** ** | **Fiscal year ended  December 31, 2004** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                             | ** ** | **High**                                                     | ** ** | **Low** | ** ** |
| Quarter ended  March 31, 2004     |       | $                                                            | 4.10       |   | $ | 2.77 |   |
| Quarter ended  June 30, 2004      |       | 3.78                                                         |       | 2.63 |   |
| Quarter ended  September 30, 2004 |       | 3.00                                                         |       | 2.47 |   |
| Quarter ended  December 31, 2004  |       | 3.54                                                         |       | 2.75 |   |
|                                        |            |                                                              |            |  |  |  |  |

 

*DIVIDEND POLICY*

We currently intend toretain earnings to finance our operations and future growth and do notanticipate paying dividends on our Common Stock in the foreseeable future.Under Delaware law, we are permitted to pay dividends only out of surplus, or,if there is no surplus, out of net profits.

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**ITEM 6.**                SELECTEDCONSOLIDATED FINANCIAL DATA

Thefollowing selected financial data is derived from the audited consolidatedfinancial statements of Natrol and its subsidiaries. The data set forth belowshould be read in conjunction with “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and the Consolidated FinancialStatements of the Company and Notes thereto included herein.

| ** **                                                                                  | ** ** | **Year Ended December 31,**                        | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                  | ** ** | **(in thousands except per share data)** | ** ** |
| **Consolidated  Statements of Operations Data:**                                            |       |                                                              |       |   |   |   |   |   |   |   |   |
| Net sales                                                                                   |       | $                                                                 | 67,530     |   | $ | 79,269 |   | $ | 72,658 |   | $ | 70,260 |   | $ | 71,821 |   |
| Cost of goods  sold                                                                         |       | 44,107                                                            |       | 46,820 |   | 44,246 |   | 41,715 |   | 42,989 |   |
| Gross profit                                                                                |       | 23,423                                                            |       | 32,449 |   | 28,412 |   | 28,545 |   | 28,832 |   |
| Selling and  marketing expenses                                                             |       | 18,000                                                            |       | 19,560 |   | 17,701 |   | 16,915 |   | 18,103 |   |
| General and  administrative expenses                                                        |       | 9,525                                                             |       | 9,348 |   | 10,063 |   | 8,744 |   | 9,746 |   |
| Impairment of goodwill                                                                      |       | —                                                            |       | — |   | — |   | — |   | 20,000 |   |
| Total operating  expenses                                                                   |       | 27,525                                                            |       | 28,908 |   | 27,764 |   | 25,659 |   | 47,849 |   |
| Operating income  (loss)                                                                    |       | (4,102                                                            | )          | 3,541 |   | 648 |   | 2,886 |   | (19,017 | ) |
| Interest income  (expense), net                                                             |       | (449                                                              | )          | (529 | ) | (595 | ) | (644 | ) | (736 | ) |
| Income (loss)  from continuing operations before income taxes                               |       | (4,551                                                            | )          | 3,012 |   | 53 |   | 2,242 |   | (19,753 | ) |
| Income tax  provision (benefit)                                                             |       | (1,918                                                            | )          | 1,144 |   | 34 |   | 861 |   | 587 |   |
| Income (loss)  from continuing operations before cumulative change in accounting principles |       | (2,633                                                            | )          | 1,868 |   | 19 |   | 1,381 |   | (20,340 | ) |
| Discontinued  operations(1):                                                                |       |                                                              |       |   |   |   |   |   |   |   |   |
| (Loss) from  operations of Annasa component                                                 |       | —                                                            |       | — |   | (1,766 | ) | (1,068 | ) | — |   |
| (Loss) from  operations of Tamsol component                                                 |       | —                                                            |       | — |   | (542 | ) | (41 | ) | — |   |
| Income tax  benefit                                                                         |       | —                                                            |       | — |   | 821 |   | 421 |   | — |   |
| Loss on  discontinued operations                                                            |       | —                                                            |       | — |   | (1,487 | ) | (688 | ) | — |   |
| Income (loss)  before cumulative effect of accounting change                                |       | (2,633                                                            | )          | 1,868 |   | (1,468 | ) | 693 |   | (20,340 | ) |
| Cumulative effect  of change in accounting principle(2)                                |       | —                                                            |       | — |   | — |   | (6,819 | ) | — |   |
| Net income (loss)                                                                           |       | $                                                                 | (2,633     | ) | $ | 1,868 |   | $ | (1,468 | ) | $ | (6,126 | ) | $ | (20,340 | ) |
| Income (loss) per share:                                                                    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Basic income (loss) from continuing operations                                              |       | $                                                                 | (0.20      | ) | $ | 0.14 |   | $ | 0.00 |   | $ | 0.11 |   | $ | (1.59 | ) |
| Diluted income (loss) from continuing operations                                            |       | $                                                                 | (0.20      | ) | $ | 0.13 |   | $ | 0.00 |   | $ | 0.11 |   | $ | (1.59 | ) |
| Basic and diluted income (loss) from discontinued  operations                               |       | —                                                            |       | — |   | $ | (0.11 | ) | (0.06 | ) | — |   |
| Basic and Diluted income (loss) from cumulative  effect of change in accounting principle   |       | —                                                            |       | — |   | — |   | $ | (0.53 | ) | — |   |
| Basic earnings (loss) per share                                                             |       | $                                                                 | (0.20      | ) | $ | 0.14 |   | $ | (0.11 | ) | $ | (0.48 | ) | $ | (1.59 | ) |
| Diluted earnings (loss) per share                                                           |       | $                                                                 | (0.20      | ) | $ | 0.13 |   | $ | (0.11 | ) | $ | (0.48 | ) | $ | (1.59 | ) |
| Weighted average shares outstanding—basic                                              |       | 13,474                                                            |       | 13,277 |   | 12,946 |   | 12,852 |   | 12,783 |   |
| Weighted average  shares outstanding—diluted                                           |       | 13,474                                                            |       | 14,113 |   | 13,452 |   | 12,992 |   | 12,783 |   |

 

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| ** **                               | ** ** | **December 31,**                                             | ** ** |
|------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                               | ** ** | **(in thousands except per share data)** | ** ** |
| **Consolidated Balance Sheet  Data:**    |       |                                                              |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents               |       | $                                                                 | 3,097      |   | $ | 6,022 |   | $ | 2,599 |   | $ | 10,077 |   | $ | 5,485 |   |
| Working capital                          |       | 15,910                                                            |       | 18,260 |   | 13,328 |   | 18,722 |   | 18,190 |   |
| Total assets                             |       | 51,462                                                            |       | 52,924 |   | 51,439 |   | 53,357 |   | 59,357 |   |
| Long-term debt,  less current maturities |       | 7,165                                                             |       | 7,685 |   | 7,451 |   | 7,778 |   | 8,083 |   |
| Total stockholders’  equity         |       | 35,404                                                            |       | 37,760 |   | 35,558 |   | 36,651 |   | 42,640 |   |
|                                          |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          During the fourthquarter of 2003, we discontinued our Annasa and Tamsol operations, see notes tothe consolidated financial statements.

(2)          In 2002, we adopted SFASNo. 142, “Goodwill and Other Intangible Assets.” In connection with theadoption of SFAS No. 142, we recorded an impairment loss on the goodwillof our Natrol reporting unit. The impairment loss was recorded as a cumulativeeffect of a change in accounting principle (net of an income tax benefit of$4,139) in the consolidated statement of operations for the year ended December 31,2002.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(MD&A)

*The following discussion of our results of operationsand financial condition should be read in conjunction with our “SelectedConsolidated Financial Data” and the audited Consolidated Financial Statementsand the notes thereto included elsewhere in this document.*

**OVERVIEW**

Since divesting ourselves of our unprofitablemulti-level marketing and direct marketing units in 2003 (see discontinuedoperations), our business plan has been to focus on our core brands. The Natroland Laci Le Beau brands are sold in health food stores, in mass-market drug,food and retail chains as well as club stores. Prolab products are sold throughdistributors who in turn service retail accounts. Prolab’s distributor networkfocuses on health food stores, health clubs and fitness facilities that caterto body builders and other individuals seeking a high level of fitness. Withthe integration of Prolab as a brand within Natrol, Natrol’s health foodoriented sales professionals have become responsible for presenting appropriateProlab products to health food retailers, who in turn, order from distributorswho carry Prolab product. In 2005, more than 37% of Prolab sales were todistributors who sell Prolab products outside the United States. We arecontinually trying to expand the distribution of our best selling items toadditional retail outlets and to create promotional opportunities for ourproducts within our existing customer base.

We also provide contract manufacturing services toother supplement companies and sell a limited number of raw materialingredients to other nutraceutical companies.

Key issues for management include product development,product introductions, inventory management, and controlling the cost of doingbusiness in our various channels of trade.

The nutritional supplement business is dependent uponnew product introductions for growth and to replace volume lost by productsreaching the end of their product life cycles. For these reasons, wecontinually research potential new products. Developing a single new productcan be a multi-year effort depending upon the complexity of the product and theamount of testing that must be completed to validate the product concept.

Product introductions do not come without risk.Product launches can require substantial marketing support. Oftentimesretailers demand slotting fees or other up front expenditures. If a productlaunch is not as successful as anticipated, additional promotional expendituresmay be needed to sustain sales and reduce possible returns. Most vendors retaincertain rights as they relate to product returns. A broad product launch, onein which a new product is introduced into thousands of retail outlets, cancause a strain on corporate resources since inventories must be produced anddelivered. The resulting sales increase also leads to an increase in accountsreceivable with customers.

Nutritional supplements must maintain potency levelsduring their selling life. As a result, products must be stamped with anexpiration date and retailers will not accept product with limited shelf lifeinto their warehouses. Shelf life issues require a high degree of supply chainmanagement of raw materials and finished goods to ensure that shelf life ismaximized and that the out-of-date inventory is minimized.

The competition for shelf space at retailers isintense. Our sales people have ongoing discussions with our retail customerswith regards to the allocation of shelf space and the level of promotionalsupport for products. Retailers look to their vendors for promotional supportfor the products on their shelves in order to maximize sales. Vendors such asNatrol look to retailers for advantageous placement of their products andpromotion of their products within stores and within a retailer’s promotionalmedia such as newspaper advertisements placed by retailers. The cost ofpromotions and support to the retailer on the part of vendors such as Natrolcan be very high and management must continually review promotional effortswith retailers to ensure that sales are profitable.

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During 2005, we were challenged by nearly all of theissues outlined above.

Our Carb Intercept product line was introduced in 2002and sales were built steadily in 2003 and 2004 and we shipped $11.0 million ofCarb Intercept products in 2004. But, toward the end of 2004, negativepublicity began to surface regarding the low-carbohydrate Atkins diet andlifestyle. The publicity caused consumers to change their attitude toward lowcarbohydrate products. The result was that sales of Carb Intercept declined in2005 to $1.8 million, which resulted in our losing more than $5.0 million ingross profit.

The sharp decline in Carb Intercept sales had theadditional impact of making previously good raw material and finished goodsinventory obsolete because the product would expire before it could be used orsold. This problem caused us to write down inventory by approximately $690,000.The write down reduced our gross profit.

We also faced unusual margin pressure due to therapidly increasing cost of two important raw materials, coenzyme Q10 (CoQ10)and whey. CoQ10 accounts for a little more than 6% of our sales volume and wheyproducts account for a little more than 11% of our sales volume. The averageraw material price of CoQ10 in 2005 was 68% higher than in 2004, which resultedin our spending approximately $1.2 million more than we would have if thepricing of CoQ10 had remained at 2004 levels. We were unable to pass much ofthis cost to consumers via price increases. Similarly, whey product pricingincreased 26% which cost us approximately $1.3 million relative to 2004 and aswith CoQ10, very little of the extra cost could be passed on to consumers. Fortunately,the trends for 2006 appear to be that pricing for both of these categories ison the decline. We cannot predict if the cost of these items will fully returnto their 2004 levels.

Another issue that we faced in 2005 was consolidationwithin the drug store channel of trade. In late 2004, the Eckerd drug storechain was sold by its parent company, J.C. Penney, to the CVS and the Brooksdrugstore chains. When one chain is bought by another, the vendors to theacquired retailer will often gain or lose business depending upon the intent ofthe acquiring company. In the case of the Eckerd acquisition, Eckerd carriedmore of our products than did CVS and Brooks at the time of the acquisition. Theresult was that during 2005, CVS and Brooks/Eckerd returned $0.9 million moreof our products than in 2004. The number of our items carried in the old Eckerdstores was reduced. We are working to expand our shelf space at these chainsbut there is no guarantee that our shelf space will expand in the immediatefuture. How a consolidation will affect a vendor is difficult to quantify inexact terms immediately after the announced consolidating event becauserepresentatives of the acquirer and the acquired business are most oftendifficult to reach and IT systems in each company typically do not work wellwith each other. The result is that smaller vendors often have to wait formonths before be able to obtain an accurate description of the acquirer’s plans.The returns are posted as a reduction of gross sales thereby reducing netrevenue.

In 2005, we also introduced brainSpeedTM, a new productline in the cognitive care category. The products were introduced in selectretailers at mid-year. As is the challenge with any new product, the brainSpeedproduct line needs to gain the attention of consumers and to this end we haveadvertised and used other means to build consumer awareness such as publicityto heighten the product line’s visibility. In 2006, we will continue to buildawareness and, hopefully, repeat business. But, garnering the support ofconsumers is not a quick process and there is no guarantee that brainSpeed willbe the long-term success we hope it to be.

Future challenges includeovercoming the issues we faced in 2005 and returning to profitability. We haveworked to better manage inventory and cut other costs. We continually seek todevelop new products that consumers will want. But, replacing the approximately$9 million of lost Carb Intercept volume is difficult in the best ofcircumstances. Seeking to be a product leader and innovator remains a core partof our business strategy and we continue to believe that additionalopportunities for growth exist. However, 

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capitalizingupon these opportunities may require us to modify our business strategy which,itself, poses risk.

**SUBSEQUENT EVENTS**

On February 14, 2006, the Board of Directors ofNatrol, Inc. (the “Company”) appointed Mr. Wayne Bos as a Director ofthe Company and appointed him Chief Executive Officer Designate and PresidentDesignate and he assumed all responsibilities relative to this position on March 13,2006.

In connection with his appointment, Mr. Bos wasawarded fully vested options to purchase 6,029,500 shares of the Company’scommon stock with a strike price of $2.282 per share. The strike price wasequal to the price of the last reported trade immediately prior to the time theBoard determined to grant this option and therefore reflects the fair marketvalue of our common stock at the time of the grant. For a period of threeyears, Mr. Bos’s ability to sell the majority of the shares he receivesupon exercise of these options is restricted, with the restrictions lapsingbased upon the stock price reaching defined hurdles. The grant is subject toshareholder approval.

In February 2006, thetenant who leases 52,000 square feet of space in our 132,000 square footshipping facility formally notified us of its intent to vacate the facility andwe have commissioned a broker to find a new tenant. This tenant was in arrearsof its rent obligations at December 31, 2005. Although this tenant iscontractually bound for the entire term of the lease, and although we areattempting to collect rent due us, there is no guarantee that the tenant willbe able to pay us for rent owed even if a formal legal settlement is reached. Rentalincome during 2005 was posted only as cash payments were received. Although thenotification by the tenant was a subsequent event, in December 2005, theCompany expensed deferred rent and prepaid commissions, which were related tothe lease with the tenant of $132,000.

**CRITICAL ACCOUNTING POLICIES**

Our consolidated financial statements are prepared inaccordance with accounting principles generally accepted in the United Statesof America, which requires us to make certain estimates and assumptionsaffecting the reported amounts in the consolidated financial statements andaccompanying notes. We base our estimates on historical experience and onvarious other assumptions believed to be reasonable, the results of which formthe basis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these estimates under different assumptions or conditions.

Management believes the following critical accountingpolicies, among others, affect our more significant judgments and estimatesused in the preparation of our consolidated financial statements.

*RevenueRecognition.**  *Wesell our products to retail outlets through a direct sales force and a nationaldistributor network. We recognize revenue from sales only after product isshipped and risk of loss is transferred. We have no consignment customers. Netsales represent product shipped less actual and estimated future returns,spoilage allowances, allowances for product deemed to be unsaleable bycustomers, and slotting fees, rebates and other expenditures which, usingGenerally Accepted Accounting Principles (GAAP) should be accounted for asreductions of revenue. Estimates and allowances are based upon known claims andan estimate of additional returns. We believe the amount of future returns canbe reasonably estimated.

Our recognition of revenue from sales to distributorsand retailers is impacted by agreements giving them rights to return damagedand outdated products as well as the fact that as a practical business matter,our sales force, along with our customers, is constantly working to ensure the profitability of ourproducts within retailers by rotating slow moving items out of stores andreplacing those products with what we and 

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the retailer expect willbe more profitable, faster selling items. Our obligation to accept returns ofslow moving items may or may not be contractually bound.

Ouraccounting and sales staffs regularly monitor historical patterns of returnsfrom individual customers as well as current and ongoing sales to customersand, when information is available, consumer purchases of our products from theour customers. We have determined that historical trends with respect toproduct sales of individual items are not a good barometer of future returns ofthose items. Excellent historical sales with few returns does not guaranteestrong future sales and a low level of future returns. This is due to a numberof factors including: changes in consumer demand for individual items;increasing or decreasing competition from industry participants; differentlevels of periodic support from retail partners; the amount of advertising withwhich we may be able to support products; and, favorable or unfavorablepublicity. Products that sell well at one account may not sell well at anotheraccount due to factors that are unique to the particular customer such as: poorvs. excellent product placement on the customer’s shelves, the fact thatcustomers do not carry the same products, the carrying by a customer of more orfewer competitive products, and pricing at the retail level which is controlledby the customer. In order to reduce the amount of subjectivity when analyzingsales trends and reserving for future returns, we perform a detailed analysesof trends at each of our major customers, i.e., those customers who havehistorically accounted for the bulk of returns. This analysis takes intoaccount sales patterns of individual products at each customer on acustomer-by-customer basis as well as inventory levels at the customer,scheduled promotional events, and the probability that items will bediscontinued. We believe that this analysis creates appropriate estimates ofnecessary future reserves. Our use of the term returns throughout this documentincludes estimates of our liability for damaged and outdated product within ourchannels of trade. Over the last three years, returns and estimates of returnliability were as follows (in thousands):

| **Description**                    | ** ** | ** ** | ** ** | **Balance at  Beginning  of Year** | ** ** | **Charged to  Cost and  Expense** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for Sales  Returns:      |       |       |       |                                         |       |                                        |       |           |       |                                       |       |   |   |   |   |   |   |
| Year ended December 31, 2003  |       |       | $          | 1,593                                        |       |                                        |       | $              | 4,014      |                                       |       |   | $ | 4,372 | (1) |   |   | $ | 1,235 |   |   |
| Year ended December 31, 2004  |       |       | $          | 1,235                                        |       |                                        |       | $              | 3,172      |                                       |       |   | $ | 3,340 | (1) |   |   | $ | 1,067 |   |   |
| Year ended  December 31, 2005 |       |       | $          | 1,067                                        |       |                                        |       | $              | 4,874      |                                       |       |   | $ | 3,664 | (1) |   |   | $ | 2,277 |   |   |

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(1)          Represents actualreturns

In recent years, as a result of a combination of thefactors described above, gross sales have been materially offset by theestimated amount of returns and other charges to arrive at net sales. It isalso possible that returns could increase rapidly and significantly in thefuture. Accordingly, although we attempt to eliminate as much subjectivity aswe believe possible, we note that estimating product returns requires a degreeof management judgment. For this reason, the accounting estimate related toproduct returns is a “critical accounting estimate.”

The total amount charged against sales for returns anddamages and outdates in 2005, 2004, and 2003 was $4.9 million,$3.2 million and $4.0 million, respectively.

*Impairmentof Goodwill.**  *OnJanuary 1, 2002, we adopted SFAS No. 142, “Goodwill and OtherIntangible Assets.” SFAS No. 142 requires that goodwill not be amortized.In accordance with the adoption, we identified all reporting units inconjunction with the provisions of SFAS No. 142 and allocated all goodwillaccordingly. Beginning in 2002, goodwill began to be evaluated for impairmentannually, or more frequently if changes in circumstances indicated that thecarrying amount of goodwill may not be recoverable. In 2002, we tested goodwillfor impairment using the two-step process prescribed in SFAS No.142. The firststep is a screen for potential impairment, while the second step measures theamount of the impairment, if any. We performed the impairment test anddetermined that there was potential impairment of the Natrol segment. Weperformed the second step as of January 1, 2002 for the 

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Natrol segment anddetermined that the goodwill balance of $10,958,000 was impaired. Theimpairment loss was recorded as a cumulative effect of a change in accountingprinciple, net of income tax benefit of approximately $4.1 million for theyear ended December 31, 2002.

The remaining goodwill balance at December 31,2002 and 2003 was approximately $4 million. In the fourth quarter of 2003,we completed our annual goodwill impairment testing and determined thatgoodwill was not impaired. Additionally, during March 2004, we settledlitigation with the former owners of Prolab Nutrition, Inc. We received$2.0 million in cash, which was reflected in the financial statements forthe quarter ending March 31, 2004 as a reduction of goodwill. Inaccordance with the provisions of SFAS No. 142, we performed our annualimpairment test of goodwill during the fourth quarter of 2004 and 2005 andconcluded that it was not impaired in either year. In 2004 and 2005, wereported only one operating unit and, as a result, the impairment test was donefor the Company as a whole.

In all years in which impairment was tested, weconsidered a number of variables including, but not limited to, the marketcapitalization of the Company, estimates of future earnings and discounted cashflows, third party assessments of the value of the Company and transactionsinvolving the purchase and sale of businesses similar to ours.

*IncomeTaxes.**  *Deferredincome tax assets have been established for future tax benefits related todeductible goodwill for which we have recorded an impairment charge and forcertain other temporary items, the aggregate benefit of which is approximately$5.9 million. Realization of this benefit is dependent on generatingsufficient taxable income in future periods. Although it is not assured,management believes it is more likely than not that the carrying value of thisbenefit will be realized. The amount of the benefit that is consideredrealizable, however, could change if estimates of future taxable income areadjusted in future periods.

*Inventory.**  *We monitor inventory and analyze iton a monthly basis. Cycle counts are taken daily to verify inventory levels. Inaddition, we analyze the movement of items within inventory in an effort todetermine the likelihood that inventory will be sold or used before expirationdates are reached. We provide an allowance against that portion of inventorythat we believe is unlikely to be sold or used before expiration dates arereached. At December 31, 2005, inventory allowances were approximately$2.5 million. The reserves are as high as they are because a large amountof inventory, such as Carb Intercept inventory that has been reserved for, hasnot been physically removed from our inventory. Until the inventory isphysically removed, reserves remain in place.

**RESULTS OF OPERATIONS**

***Year Ended December 31, 2005 Compared to YearEnded December 31, 2004***

*NetSales.**  *Werecognize revenue from sales only after product is shipped. We have noconsignment sales. Net sales represent product shipped less actual andestimated future returns, spoilage allowances, allowances for product deemed tobe unsaleable by customers, free goods shipped to customers for promotional orother purposes, rebates, slotting fees and other promotional expenditures.Estimates and allowances are based upon known claims and an estimate ofadditional returns when the amount of future returns from customers can bereasonably estimated.

Net sales in 2005 decreased 14.8%, or$11.7 million, to $67.5 million from $79.2 million in 2004. Netsales is calculated by subtracting from gross revenue certain expenses such asincentive rebates, shipping damages, and returns. Gross revenue decreased lessthan net sales because total deductions from gross revenue were $1.2 millionmore in 2005 than in 2004. Returns in 2005 were $1.7 more than in 2004. Thisexpense was offset in part by reducing other discounts. Off invoice promotionaldiscounts in particular were $0.4 million less in 2005 than in 2004.

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As discussed in the overview section of MD&A, thelargest relative change in returns came from the CVS, Brooks, Eckerd drug storechains after the purchase of Eckerd Drug by the CVS and Brooks drug storechains. The returns from this group were $0.9 million higher in 2005 thanin 2004.

Thenet revenue of Natrol (including Laci Le Beau), EPI, and Prolab changed asfollows from 2004 to 2005:

| ** **                      | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| ** **                      | ** ** | **(in thousands)**                 | ** ** |
| Net Revenue                     | ** ** | ** **                              | ** ** | ** ** | ** ** |
| Natrol (including Laci Le Beau) |       | $                                       | 47,720     |   | $ | 54,668 |   |
| EPI                             |       | 4,676                                   |       | 6,515 |   |
| Prolab                          |       | 15,134                                  |       | 18,086 |   |
| Total net Revenue               |       | $                                       | 67,530     |   | $ | 79,269 |   |

 

The overriding reason behind the fall off in Natrolsales was the decline in the Carb Intercept line of products. Gross shipmentsof Carb Intercept products fell from $11.0 million in 2004 to $1.8 million in2005. This decline was partially offset by growth in other areas, including theintroduction of the brainSpeed product line in June 2005.

Net sales of the EPI division fell $1.8 million in2005. During 2005, we continued to de-emphasize the EPI division, a process thatbegan in 2004. During 2004, we ended our supply relationships with ConAgra,which had been supplying us garlic and vegetable powders, and with Larex, whichhad been supplying us with arabinogalactan. Furthermore, in 2005, were-examined the profitability of all contract-manufacturing customers and madethe decision to stop producing items that did not deliver minimum profitlevels. Although revenue has declined, the net contribution of the EPI divisionhas improved due to higher margins on the remaining business and lower expensesto maintain the business that we now have.

The Prolab business fell nearly $3.0 million in 2005.A key factor was our Canadian distributor whose sales in 2005 declined $1.5million when compared to 2004. During the year, we worked to resolve issueswith this distributor as they relate to contractual minimum purchases, pricing,and strategies for building the Prolab brand. The issues were not resolved towhat we believe are our best interests and as a result, at the end of the firstquarter of 2006, we stopped shipping this distributor product. We arecontractually prevented from using a different distributor in Canada (outsideof Quebec) until 2007. We believe that despite the immediate problems thispresents in terms of gross sales and net income, our long term prospects inCanada are better if we sell directly in Canada or find another distributor whois willing to build the Prolab brand in a manner we believe is appropriate.

We believe that an additional reason for the decline inProlab sales has been the high cost of product to consumers. The price of wheyproducts increased 26% during 2005 forcing us to implement two price increases.The price increases did not make up for the lost margin to us. Even so,consumers purchased less from us in response to the price increases theyreceived.

During 2005, only the Ester-C product categoryaccounted for more than 10% of our net revenue. In 2004, both Ester-C and CarbIntercept each accounted for more than 10% revenue.

*GrossProfit.**  *Grossprofit decreased 27.8% or $9.0 million to $23.4 as compared to$32.4 million in 2004. Gross margin decreased to 34.7% from 40.9%. Grossmargin fluctuates depending upon product mix, the cost of raw materials, laborand overhead as well as the difference between gross revenue and net salesrevenue. As noted above under the caption *NetSales,* deductions from gross revenue were more in 2005 than in 2004,which negatively affected gross margins.

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Had the gross margin remained 40.9% in 2005, our grossprofit would have fallen $4.8 million due to the lower volume of sales.

A second important factor in the $9.0 milliondrop in gross profit is the high cost of two important raw materials in 2005,CoQ10 and whey. CoQ10 accounts a little more than 6% of our sales volume andwhey products account for a little more than 11% of our sales volume. Theaverage price of CoQ10 in 2005 was approximately 68% higher than it was in2004, which resulted in our spending approximately $1.2 million more thanwe would have if the pricing of CoQ10 had remained at 2004 levels. We wereunable to pass much of this cost to consumers via price increases. Similarly,whey product pricing increased 26% which cost us approximately $1.3 millionrelative to 2004 and as with CoQ10, very little of the extra cost could bepassed on to consumers. Fortunately, the trends for 2006 appear to be thatpricing for both of these categories is on the decline. We cannot predict ifthe cost of these items will fully return to their 2004 levels.

Another significant issue was the sharp decline inCarb Intercept sales, which had the additional impact of making previously goodraw material and finished goods inventory obsolete because the product would expirebefore it could be used or sold. This problem caused us to write down inventoryby approximately $690,000 reducing our gross profit.

The remainder of the difference in the gross profitwas due to product mix, some increase in overhead and other promotionalexpenditures that affected margins.

*Sellingand Marketing Expenses.**  *Selling and marketing expenses consist primarily ofadvertising and promotional expenses, costs of distribution, and relatedpayroll expenses and commissions. Selling and marketing expenses decreased by$1.6 million or 8.0% to $18.0 million from $19.6 million in2004. Of the $1.6 million net decrease in selling and marketing expenses,approximately $93,000 was due to a decrease in the cost of shipping productbecause of the lower sales volume experienced in 2005. Sales and marketingpayroll was $1.0 million less in 2005 than in 2004. The remainder of thedecrease in expenditures was due to an overall decline other sales andmarketing expenses.

*Generaland Administrative Expenses.**  *General and administrative expenses consist primarilyof personnel costs related to general management functions, research anddevelopment, finance, accounting and information systems, as well asprofessional fees. General and administrative expenses increased $177,000 or1.9% to $9.5 million from $9.3 million in 2004. We spent $238,000more on our Sarbanes-Oxley compliance efforts in 2005 than in 2004 and $212,000more on R&D. We documented our processes and controls in 2005, using anoutside consultant as part of our effort to meet the auditor attestationrequirements of the Sarbanes-Oxley law. Continuing to expand our R&Dcapabilities is a core element of our business strategy, and, in 2005, wecontinued this process. These additional expenses were partially offset by$88,000 of lower legal expenditures and $274,000 in lower administrativepayroll as well as minor reductions in other expense areas.

*InterestIncome (Expense), net.**  *Interestexpense was approximately $638,000 in 2005 versus $630,000 in 2004. Interestincome was approximately $189,000 in 2005 versus $101,000 in 2004. Interestexpense and interest income increased in 2005 as a result of rising interestrates in 2005.

*Income Tax Provision(Benefit).**  *Wehad an income tax benefit of $1.9 million in 2005 as opposed to an incometax expense of $1.1 million in 2004. Our effective tax rate was 42.1% in2005 versus 38.0% in 2004. The difference in our effective tax rate wasprimarily due to tax benefits we were able to claim as a result of an R&Dtax credit study performed during the fourth quarter of 2005.

***Year Ended December 31, 2004 Compared to YearEnded December 31, 2003***

*NetSales.**  *Netsales in 2004 increased 9.1%, or $6.6 million, to $79.3 million from$72.7 million in 2003. Net sales in 2004 were positively affected by alower level of returns than in 2003. The level of 

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returns, which includescharges from customers for damaged or outdated product, was approximately 3.5%of gross revenue in 2004 as compared to 4.7% of gross revenue in 2003. Otherdeductions from gross revenue fell from 9.0% in 2003 to 7.9% in 2004. Theseother deductions are due to: payment discounts given to customers for timelypayment, audit claims from customers for such items as shipping shortages, andpromotional support such as rebate incentives and pricing reductions which,according to GAAP rules, must be recorded as reductions of revenue. The levelof promotional support recorded as a reduction of revenue declined from 6.2% ofgross shipments in 2003 to 5.9% of gross shipments in 2004. The remainder ofthe savings was due to fewer payment discounts and a lower level of auditclaims from customers.

The level of gross revenue in any period is a resultof many factors including customer relations and the popularity of our productswith consumers. During 2004, we improved the level of sales with club storesand mass-market merchants and certain categories of products, weight-lossproducts in particular, proved to be popular with consumers. Sales gains inthese areas were partially offset by the loss of sales with other customers anddeclining sales of certain other product categories.

| ** **                      | ** ** | **Years Ended  December 31,** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|
| ** **                      | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| ** **                      | ** ** | **(in thousands)**                 | ** ** |
| Net Revenue                     | ** ** | ** **                              | ** ** | ** ** | ** ** |
| Natrol (including Laci-Le Beau) |       | $                                       | 54,668     |   | $ | 46,502 |   |
| EPI                             |       | 6,515                                   |       | 7,373 |   |
| Prolab                          |       | 15,135                                  |       | 18,086 |   |
| Total net Revenue               |       | $                                       | 79,269     |   | $ | 72,658 |   |

 

Natrol products (including Laci Le Beau) grewapproximately 11.8% relative to 2003.

The largest sales declines were due to slower saleswithin the EPI raw materials division. Bulk ingredient sales accounted for 2.3%of gross sales in 2004. Approximately 61% of these sales or $1.4 millionwere generated through the sales of garlic and other vegetable powders. Thebalance of sales was from the sale of arabinogalactan. Sales of garlic andvegetable powders fell approximately 40% in 2004. Reasons for the declineinclude market conditions and competition from domestic and internationalsuppliers. This decline was partially offset by sales of arabinogalactan.

During 2004, two product categories each accounted formore than 10% of gross shipments. During 2003, only one category accounted formore than 10% of gross shipments. No customer accounted for 10% or more ofgross sales in 2004 or 2003. Our top 10 customers accounted for approximately48% and 47% of our gross sales in 2004 and 2003, respectively.

*GrossProfit.**  *Grossprofit increased 14.1% or $4.0 million to $32.4 million in 2004 ascompared to $28.4 million in 2003. Gross margin increased to 40.9% in 2004from 39.1% in 2003. Gross margin fluctuates depending upon product mix, thecost of raw materials, labor and overhead as well as the difference betweengross revenue and net sales revenue. As noted above under the caption *Net Sales,* deductions from gross revenuewere less in percentage terms in 2004 than in 2003 and this positively affectedgross margins.

*Sellingand Marketing Expenses.**  *Selling and marketing expenses consist primarily ofadvertising and promotional expenses, costs of distribution, and relatedpayroll expenses and commissions. Selling and marketing expenses increased by10.5% or $1.9 million to $19.6 million in 2004 from $17.7 millionin 2003. Of the $1.9 million net increase in selling and marketingexpenses, approximately $280,000 was due to the increased cost of shippingproduct, approximately $780,000 was due to increased promotional expenditures,approximately $250,000 was due to increased public relations expenditures, andapproximately $460,000 was due to increases in payroll outside of the shippingdepartment and brokers’ commissions.

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*Generaland Administrative Expenses.**  *General and administrative expenses consist primarilyof personnel costs related to general management functions, research anddevelopment, finance, accounting and information systems, as well asprofessional fees. General and administrative expenses decreased 7.1% or $0.8 millionin 2004 from $10.1 million in 2003 to $9.3 million in 2004.

The largest savings in general and administrativeexpenses came from the closing of Prolab’s headquarters facility in October 2003and the consolidation of all administrative functions for Prolab into Natrol’sheadquarters facility. This consolidation reduced net payroll by approximately$850,000 when compared to 2003. We also saved approximately $750,000 whencompared to 2003 through the implementation of our self-insurance program forproduct liability insurance in July 2003. These savings were partiallyoffset by the establishment of a research and development department within theadministrative area in October 2003. We spent approximately $575,000 moreon this department in 2004 than in 2003. Also offsetting savings generated bythe Prolab closure and the self-insurance program was our bonus incentiveprogram. This program was established in 2004 and resulted in the granting ofapproximately $600,000 in incentive payments to qualified employees.

*InterestIncome (Expense), net.**  *Interestexpense was approximately $630,000 in 2004 versus interest expense ofapproximately $649,000 in 2003. Interest income in 2004 was approximately$101,000 versus approximately $54,000 in 2003. Interest expense decreased in2004 because we had less debt outstanding during the year. Interest incomeincreased due to the average level of cash on hand earning interest.

*Income Tax Provision(Benefit).**  *Incometaxes were $1.1 million in 2004 as compared to approximately $34,000 in2003. The difference in income tax expense was primarily due to the differencesin taxable income earned in 2004 versus 2003. Our tax rate was 38.0% in 2004versus 64.2% in 2003. The difference was due primarily to the fact that thesome of our expenses cannot be expensed for tax purposes. When earnings are ata low level, these permanent adjustments to taxable income have aproportionately greater effect on our tax rate than when total earnings are ata higher level.

**LIQUIDITY AND CAPITAL RESOURCES**

At December 31, 2005, we had working capital of$15.9 million, as compared to $18.3 million in working capital at December 31,2004.

In 2005, net cash used by operating activities was$2.2 million versus $1.7 million provided by operations in 2004 andnet cash used of $2.1 million in 2003. In 2005, our net loss of $2.6 millionand a $316,000 net change in non cash charges, both of which used cash, werepartially offset by a $777,000 net change in operating assets and liabilitieswhich provided cash. Changes in operating assets and liabilities provided cashdue a $1.7 million increase in accounts payable, an $881,000 decrease inaccounts receivable, a $517,000 decrease in income taxes receivable, a $405,000increase in accrued expenses and a $69,000 decrease in pre[aid expenses,  which were partially offset by a $2.1 millionincrease in accounts payable, and a $763,000 decrease in accrued payroll. Theincrease in accounts payable and inventory were primarily due to anopportunistic purchase of raw materials of approximately $2 million inlate December 2005. The decrease in accrued payroll was due to the factthat no bonus payments were awarded under our management incentive bonusprogram in 2005 due to our loss in 2005. Approximately $600,000 in bonuspayments were granted for the year ended December 31, 2004 and this amountwas accrued as a liability on our balance sheet at December 31, 2004.

At December 31, 2005, the number of days salesoutstanding in trade receivable was approximately 37 days versus 32 daysand 38 days in 2004 and 2003, respectively.

Net cash used in investing activities was $540,000versus net cash provided by investing activities of approximately $945,000 in2004 versus net cash used of $5.4 million in 2003. We investedapproximately $691,000 in plant and equipment in 2005 and other assetsdecreased $151,000. In 2004, we invested 

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$920,000 in plant andequipment and other assets grew by approximately $135,000 during the year.These uses of cash were offset by the receipt of $2 million due to thesettlement of litigation with the former owners of Prolab.

In 2003, we deposited $5.0 million with aninsurance company to fund our self-insurance program. Aside from thisinvestment which is fully refundable should we decide not to self-insure,nearly all of the cash used for investing activities from 2003 to 2005 has beenfor plant and equipment.

Net cash used by financing activities in 2005 amountedto $213,000 as opposed to cash provided by financing activities of $744,000 and$56,000 for the years ended December 31, 2004 and 2003, respectively. In2005, we repaid approximately $490,000 on our long-term debt. We also raisedapproximately $277,000 from the sale of stock to employees exercising stockoption or purchasing stock through the Employee Stock Purchasing Program (ESPP).In 2004, we borrowed $750,000 in a five-year note to purchase equipment, paidback $338,000 of debt and received $332,000 through the exercise of employeestock options and the sale of stock to employees through our ESPP. During 2003,we reduced debt by approximately $303,000. This use of cash was offset byapproximately $359,000 raised through the exercise of employee stock option orthe sale of stock to employees through our ESPP.

As of December 31, 2005, we had $7.7 millionin outstanding debt versus $8.2 million at the end of 2004. All but$600,000 related to the term note cited above is related to a mortgage on ourmanufacturing/headquarters facility and a mortgage on our shipping facility.

Our cash balance at the close of 2005 wasapproximately $3.1 (excluding $5.0 million in restricted cash) as opposedto approximately $6.0 million and $2.6 million (excluding $5.0 millionin restricted cash) at the end of 2004 and 2003, respectively.

We currently do not have a line of credit established.We are, however, attempting to secure a line of credit. Although we believethat a line of credit should be obtainable, there is no guarantee thatfinancial institutions will be willing to provide capital to us. Also, inproviding us with additional funds, potential lenders may seek to institutecovenants restricting us from certain activities and if we think it necessaryto borrow funds with these restrictions in place, we may find that our abilityto compete effectively in our market sector is hindered.

In order to meet our long-term liquidity needs, we maybe required to incur additional indebtedness or issue additional equity anddebt securities, subject to market and other conditions. There can be noassurance that such additional financing will be available on terms acceptableto us or at all. The failure to raise the funds necessary to finance our futurecash requirements or consummate future acquisitions could adversely affect ourability to pursue our business strategy and could negatively affect ouroperations in future periods.

We believe that our cash balance together with cashgenerated from operations and the potential to borrow funds and raise capitalshould be sufficient to fund our anticipated working capital needs and plannedcapital expenditures for the next 12 months. However, if we do not meetour operating plan we may also need additional borrowings to fund workingcapital needs.

We currently have nooutstanding debt on our books other than mortgage debt and the five-year termnote that is secured by our non-real estate assets. The balance of thisterm-note on December 31, 2005 was $600,000.

**RECENTLYISSUED ACCOUNTING STANDARDS**

In May 2005, the FASB issued FASB Statement No. 154,*Accounting Changes and Error Corrections.*This new standard replaces APB Opinion No. 20,*Accounting Changes,* and FASB Statement No. 3,*Reporting Accounting Changes in Interim FinancialStatements*, and represents another step in the FASB’s 

37

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goal to converge itsstandards with those issued by the IASB. Among other changes, Statement 154requires that a voluntary change in accounting principle be appliedretrospectively with all prior period financial statements presented on the newaccounting principle, unless it is impracticable to do so. Statement 154 alsoprovides that (1) a change in method of depreciating or amortizing along-lived nonfinancial asset be accounted for as a change in estimate(prospectively) that was effected by a change in accounting principle, and (2) correctionof errors in previously issued financial statements should be termed a “restatement.”The new standard is effective for accounting changes and correction of errorsmade in fiscal years beginning after December 15, 2005. Early adoption ofthis standard is permitted for accounting changes and correction of errors madein fiscal years beginning after June 1, 2005.

In March 2005, the SEC released Staff AccountingBulletin No. 107, “Share-Based Payment” (SAB 107), which providesinterpretive guidance related to the interaction between SFAS 123(R) andcertain SEC rules and regulations. It also provides the SEC staff’s viewsregarding valuation of share-based payment arrangements. In April 2005,the SEC amended the compliance dates for SFAS 123(R), to allow companies toimplement the standard at the beginning of their next fiscal year, instead ofthe next reporting period beginning after June 15, 2005.

In February 2006, theFASB issued FASB Statement No. 155, Accounting for Certain HybridFinancial Instruments. This Statement amends FASB Statements No. 133,Accounting for Derivative Instruments and Hedging Activities, and No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities. As we do not issue or expect to issue hybrid financialinstruments, we do not believe this pronouncement will have any material effecton our financial reporting.

**CONTRACTUALOBLIGATIONS AND COMMITMENTS**

The following table discloses our obligations andcommitments to make future payments under contractual obligations at December 31,2005.

| ** **                 | ** ** | **Payment Due by Period** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **Total**                                | ** ** | **Less  than  1 Year** | ** ** | **2-3  Years** | ** ** | **4-5  Years** | ** ** | **Thereafter** | ** ** |
| ** **                 | ** ** | **(in thousands)**                  | ** ** |
| Note Payable               |       | $                                        | 7,699      |   | $ | 532 |   | $ | 1,162 |   | $ | 1,164 |   |   | $ | 4,841 |   |   |
| Interest on Notes  Payable |       | 4,425                                    |       | 610 |   | 1,082 |   | 893 |   |   | 1,840 |   |   |
| Leases                     |       | 210                                      |       | 110 |   | 85 |   | 15 |   |   | 0 |   |   |
| Total                      |       | $                                        | 12,334     |   | $ | 1,252 |   | $ | 2,329 |   | $ | 2,072 |   |   | $ | 6,681 |   |   |

 

We lease part of our shipping facility and futureminimum lease payments due to us according to the lease are (in thousands):

| 2006  |   | 404 |   |
|-------|--------|-----|--------|
| 2007  |   | 417 |   |
| 2008  |   | 429 |   |
| 2009  |   | 367 |   |
| Total |   | $   | 1,617  |   |
|       |        |     |        |  |

 

However, as of year-end,our tenant was in arrears. In February, 2006, this tenant formally notified usof its intent to vacate the facility and we have commissioned a broker to finda new tenant. Although the tenant is responsible for all rent through the termof the lease, and although we are attempting to collect rent due us, there isno guarantee that the tenant will be able to pay us for rent owed even if aformal legal settlement is reached.

38

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**IMPACT OF INFLATION**

Generally, inflation hasnot had a material impact on our historical operations or profitability. We donot believe that the increase in the pricing of CoQ10 and whey are a reflectionof the general inflation in the economy. Inflation affects the cost of rawmaterials, goods and services used by us. In recent years, inflation has beenmodest. The competitive environment somewhat limits our ability to recoverhigher costs resulting from inflation by raising prices. We seek to mitigate theadverse effects of inflation primarily through improved productivity and costcontainment programs. We do not believe that inflation has had a materialimpact on our results of operations for the periods presented, except withrespect to payroll-related costs, and other costs arising from or related togovernment-imposed regulations.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Our exposure to market risks is limited to interestrate risks. The risks related to foreign currency exchange rates are immaterialand we do not use derivative financial instruments.

We are subject to interest rate market risk associatedwith our bank debt. Even so, we do not believe the risk associated with suchborrowing is significant. Additionally, we do not believe that the risk issignificant for our long-term debt due to the low fixed rates and relativeinsignificance of the fixed long-term debt to our balance sheet. Our long-termdebt is comprised of two fixed rate notes with a total principal balance ofapproximately $7,098,000 collateralized by our headquarters building and ourshipping facility and one variable rate note with a principal balance ofapproximately $600,000 collateralized by our general assets. The table belowpresents principal cash flows and related interest rates by fiscal year ofmaturity.

| ** **       | ** ** | **Expected Year of Maturity** | ** ** |
|------------------|------------|----------------------------------------------|------------|
| ** **       | ** ** | **2006**                                     | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** | **Fair Value  December 31,  2005(1)** | ** ** |
| ** **       | ** ** | **(in thousands)**                      | ** ** |
| Notes payable(2) |       | $                                            | 532        |   | $ | 564 |   | $ | 598 |   | $ | 637 |   | $ | 527 |   |   | $ | 4,841 |   |   | $ | 7,699 |   |   | $ | 8,016 |   |   |
|                  |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Our estimate of the fairvalue of our notes payable was based on an analysis of current market interestrates.

(2)          The weighted averageinterest rate for all years presented is 8.0% for the fixed rate notes and 9.0%for the variable rate note.

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**ITEM8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

| Index to Consolidated  Financial Statements:                                                                    |   |   |
|-----------------------------------------------------------------------------------------------------------------|--------|--------|
| Report of Independent Registered Public Accounting  Firm—Stonefield Josephson, Inc.                   |   | 41     |
| Report of Independent Registered Public Accounting  Firm—Deloitte & Touche LLP                    |   | 42     |
| Consolidated Balance Sheets as of December 31,  2005 and 2004                                              |   | 43     |
| Consolidated Statements of Operations for the years  ended December 31, 2005, 2004 and 2003                |   | 44     |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2005, 2004 and 2003 |   | 45     |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2005, 2004 and 2003                |   | 46     |
| Notes to Consolidated Financial Statements                                                                      |   | 47     |

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors and Stockholders of Natrol, Inc.and its subsidiaries:

We have audited the accompanying consolidated balancesheets of Natrol, Inc. and its subsidiaries (the “Company”) as of December 31,2005 and 2004, and the related consolidated statement of operations,stockholders’ equity, and cash flows for the years then ended. Our audits alsoincluded the financial statement schedule listed at the index in Item 15(a) asof and for the years ended December 31, 2005 and 2004. These consolidatedfinancial statements and schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Natrol, Inc. and its subsidiaries as of December 31, 2005and 2004, and the results of their operations and their cash flows for each ofthe two years in the period ended December 31, 2005, in conformity withaccounting principles generally accepted in the United States of America. Also,in our opinion, the financial statement schedule when considered inrelation to the basic consolidated financial statements, taken as a whole,presents fairly, in all material respects, the information set forth therein asof and for the years ended December 31, 2005 and 2004.
| /s/ STONEFIELD JOSEPHSON, INC. |   |
|------------------------------------------|--------|

 

CERTIFIED PUBLIC ACCOUNTANTSLos Angeles, CaliforniaFebruary 17, 2006 

41

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**Report of Independent Auditors**

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To: the Board ofDirectors and Stockholders of Natrol, Inc.Chatsworth, California

We have audited theaccompanying consolidated statement of operations, stockholders’ equity, andcash flows of Natrol, Inc. and subsidiaries (the “Company”) for the yearended December 31, 2003. Our audit also included the financial statementschedule for the year ended December 31, 2003 listed in the Index at Item15. These financial statements and the financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on the financial statements and financial statement schedule based onour audit.

We conducted ouraudit in accordance with standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. Anaudit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

In ouropinion, such consolidated financial statements present fairly, in all materialrespects, the results of the Company’s operations and its cash flows for theyear ended December 31, 2003, in conformity with accounting principlesgenerally accepted in the United States of America. Also, in our opinion, suchfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.
| /s/ DELOITTE & TOUCHE LLP |   |
|------------------------------------|--------|

 

Los Angeles, California

April 14, 2004

 

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**Natrol, Inc.and SubsidiariesConsolidated Balance Sheets(in thousands, except share and per share data)**

| ** **                                                                                                     | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                     |       |                  |       |   |   |
| Current assets:                                                                                                |       |                  |       |   |   |
| Cash                                                                                                           |       | $                     | 3,097      |   | $ | 6,022 |   |
| Accounts receivable, net  of allowances of $247 and $421 at December 31, 2005 and 2004,  respectively     |       | 6,723                 |       | 7,431 |   |
| Inventory                                                                                                      |       | 11,797                |       | 9,723 |   |
| Income taxes receivable                                                                                        |       | 439                   |       | 956 |   |
| Deferred income taxes                                                                                          |       | 2,021                 |       | 814 |   |
| Prepaid expenses and  other current assets                                                                     |       | 726                   |       | 793 |   |
| Total current assets                                                                                           |       | 24,803                |       | 25,739 |   |
| Property and equipment:                                                                                        |       |                  |       |   |   |
| Building and  improvements                                                                                     |       | 14,930                |       | 15,891 |   |
| Machinery and equipment                                                                                        |       | 5,754                 |       | 5,332 |   |
| Furniture and office  equipment                                                                                |       | 2,900                 |       | 3,112 |   |
|                                                                                                           |       | 23,584                |       | 24,335 |   |
| Accumulated depreciation  and amortization                                                                     |       | (8,684                | )          | (8,022 | ) |
| Property and equipment,  net                                                                                   |       | 14,900                |       | 16,313 |   |
| Property held for sale,  net                                                                                   |       | 761                   |       | — |   |
| Restricted cash                                                                                                |       | 5,000                 |       | 5,000 |   |
| Deferred income taxes                                                                                          |       | 3,905                 |       | 3,628 |   |
| Goodwill, net of  accumulated amortization and impairment charge of $37,381                                    |       | 2,026                 |       | 2,026 |   |
| Other assets                                                                                                   |       | 67                    |       | 218 |   |
| Total assets                                                                                                   |       | $                     | 51,462     |   | $ | 52,924 |   |
| **Liabilities and stockholders’ equity**                                                                  |       |                  |       |   |   |
| Current liabilities:                                                                                           |       |                  |       |   |   |
| Accounts payable                                                                                               |       | $                     | 4,647      |   | $ | 2,904 |   |
| Accrued expenses                                                                                               |       | 2,888                 |       | 2,483 |   |
| Accrued payroll and  related liabilities                                                                       |       | 826                   |       | 1,589 |   |
| Current portion of  long-term debt                                                                             |       | 532                   |       | 503 |   |
| Total current  liabilities                                                                                     |       | 8,893                 |       | 7,479 |   |
| Long-term debt, less  current portion                                                                          |       | 7,165                 |       | 7,685 |   |
| Commitments and contingencies                                                                                  |       |                  |       |   |   |
| Stockholders’ equity:                                                                                     |       |                  |       |   |   |
| Preferred stock, par value of $0.01 per share:                                                                 |       |                  |       |   |   |
| Authorized shares—2,000,000; Issued and outstanding  shares—none                                     |       |                  |       |   |   |
| Common stock, par value of $0.01 per share:                                                                    |       |                  |       |   |   |
| Authorized shares—50,000,000                                                                              |       |                  |       |   |   |
| Issued and outstanding  shares—14,457,737and 14,281,928 at December 31, 2005 and 2004,  respectively |       | 145                   |       | 143 |   |
| Additional paid-in  capital                                                                                    |       | 62,984                |       | 62,709 |   |
| Accumulated deficit                                                                                            |       | (24,844               | )          | (22,211 | ) |
|                                                                                                           |       | 38,285                |       | 40,641 |   |
| Shares held in treasury,  at cost—921,900 shares at December 31, 2005   and 2004                     |       | (2,881                | )          | (2,881 | ) |
| Total stockholders’  equity                                                                               |       | 35,404                |       | 37,760 |   |
| Total liabilities and stockholders’ equity                                                                |       | $                     | 51,462     |   | $ | 52,924 |   |

 

*See notes to consolidated financial statements.*

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**Natrol, Inc.and SubsidiariesConsolidated Statements of Operations(in thousands, except share and per share data)**

| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                                           |       | $                                           | 67,530     |   | $ | 79,269 |   | $ | 72,658 |   |
| Cost of goods  sold                                                 |       | 44,107                                      |       | 46,820 |   | 44,246 |   |
| Gross profit                                                        |       | 23,423                                      |       | 32,449 |   | 28,412 |   |
| Selling and  marketing expenses                                     |       | 18,000                                      |       | 19,560 |   | 17,701 |   |
| General and  administrative expenses                                |       | 9,525                                       |       | 9,348 |   | 10,063 |   |
| Total operating  expenses                                           |       | 27,525                                      |       | 28,908 |   | 27,764 |   |
| Operating income  (loss) from continuing operations                 |       | (4,102                                      | )          | 3,541 |   | 648 |   |
| Interest income                                                     |       | 189                                         |       | 101 |   | 54 |   |
| Interest expense                                                    |       | (638                                        | )          | (630 | ) | (649 | ) |
| Income (loss)  from continuing operations before income taxes  |       | (4,551                                      | )          | 3,012 |   | 53 |   |
| Income tax  provision (benefit)                                     |       | (1,918                                      | )          | 1,144 |   | 34 |   |
| Income from continuing  operations                                  |       | (2,633                                      | )          | 1,868 |   | 19 |   |
| Discontinued operations:                                            |       |                                        |       |   |   |   |   |
| (Loss) from  operations of discontinued Annasa component            |       | —                                      |       | — |   | (1,766 | ) |
| (Loss) from  operations of discontinued Tamsol component            |       | —                                      |       | — |   | (542 | ) |
| Income tax  benefit                                                 |       | —                                      |       | — |   | 821 |   |
| Loss on  discontinued operations                                    |       | —                                      |       | — |   | (1,487 | ) |
| Net income (loss)                                                   |       | $                                           | (2,633     | ) | $ | 1,868 |   | $ | (1,468 | ) |
| Basic income (loss) per  share:                                     |       |                                        |       |   |   |   |   |
| Income per share from continuing operations                         |       | $                                           | (0.20      | ) | $ | 0.14 |   | $ | 0.00 |   |
| Loss per share from discontinued operations                         |       | —                                      |       | — |   | (0.11 | ) |
| Income (loss) per share                                             |       | $                                           | (0.20      | ) | $ | 0.14 |   | $ | (0.11 | ) |
| Diluted income  (loss) per share:                                   |       |                                        |       |   |   |   |   |
| Income per share from continuing operations                         |       | $                                           | (0.20      | ) | $ | 0.13 |   | $ | 0.00 |   |
| Loss per share from discontinued operations                         |       | —                                      |       | — |   | (0.11 | ) |
| Income (loss) per share                                             |       | $                                           | (0.20      | ) | $ | 0.13 |   | $ | (0.11 | ) |
| Weighted-average  shares outstanding:                               |       |                                        |       |   |   |   |   |
| Basic                                                               |       | 13,473,647                                  |       | 13,276,618 |   | 12,945,938 |   |
| Diluted                                                             |       | 13,473,647                                  |       | 14,112,965 |   | 13,451,764 |   |

 

*See notes to consolidated financial statements.*

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**Natrol, Inc.and SubsidiariesConsolidated Statements of Stockholders’ Equity(in thousands, except share data)**

| ** **                                                   | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Shares Held** | ** ** | ** **           | ** ** |
|--------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                   | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**                          | ** ** | **Deficit)**         | ** ** | **in Treasury** | ** ** | **Totals** | ** ** |
| Balance,  January 1, 2003                               |       | 13,788,720            |       |                    | $          | 138                                  |       |                 |       | $                    | 62,005     |   |   |   | $ | (22,611 | ) |   |   | $ | (2,881 | ) |   | $ | 36,651 |   |
| Exercise of stock options                                    |       | 216,885               |       |                    | 2          |                                 |       |                 | 319        |                 |       |   |   |   |   |   |   |   |   | 321 |   |
| Shares issued in exchange for services                       |       | 10,437                |       |                    |       |                                 |       |                 | 16         |                 |       |   |   |   |   |   |   |   |   | 16 |   |
| Issuance of common stock under employee stock  purchase plan |       | 38,267                |       |                    | 1          |                                 |       |                 | 37         |                 |       |   |   |   |   |   |   |   |   | 38 |   |
| Net loss                                                     |       |                  |       |                    |       |                                 |       |                 |       |                 |       |   | (1,468 | ) |   |   |   |   |   | (1,468 | ) |
| Balance, December 31, 2003                              |       | 14,054,309            |       |                    | 141        |                                 |       |                 | 62,377     |                 |       |   | (24,079 | ) |   |   | (2,881 | ) |   | 35,558 |   |
| Exercise of stock options                                    |       | 192,638               |       |                    | 2          |                                 |       |                 | 249        |                 |       |   |   |   |   |   |   |   |   | 251 |   |
| Shares issued in exchange for services                       |       | 562                   |       |                    |       |                                 |       |                 | 2          |                 |       |   |   |   |   |   |   |   |   | 2 |   |
| Issuance of common stock under employee stock  purchase plan |       | 34,419                |       |                    |       |                                 |       |                 | 81         |                 |       |   |   |   |   |   |   |   |   | 81 |   |
| Net income                                                   |       |                  |       |                    |       |                                 |       |                 |       |                 |       |   | 1,868 |   |   |   |   |   |   | 1,868 |   |
| Balance, December 31, 2004                              |       | 14,281,928            |       |                    | 143        |                                 |       |                 | 62,709     |                 |       |   | (22,211 | ) |   |   | (2,881 | ) |   | 37,760 |   |
| Exercise of stock options                                    |       | 147,276               |       |                    | 2          |                                 |       |                 | 201        |                 |       |   |   |   |   |   |   |   |   | 203 |   |
| Issuance of common stock under employee stock  purchase plan |       | 28,533                |       |                    |       |                                 |       |                 | 74         |                 |       |   |   |   |   |   |   |   |   | 74 |   |
| Net loss                                                     |       |                  |       |                    |       |                                 |       |                 |       |                 |       |   | (2,633 | ) |   |   |   |   |   | (2,633 | ) |
| Balance,  December 31, 2005                             |       | 14,457,737            |       |                    | $          | 145                                  |       |                 |       | $                    | 62,984     |   |   |   | $ | (24,844 | ) |   |   | $ | (2,881 | ) |   | $ | 35,404 |   |

 

*See notes to consolidated financial statements.*

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**Natrol, Inc.and SubsidiariesConsolidated Statements of Cash Flows(in thousands)**

| ** **                                                                                                           | ** ** | **Years ended December 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating activities**                                                                                             |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                                                    |       | $                                          | (2,633     | ) | $ | 1,868 |   | $ | (1,468 | ) |
| Income (loss)  from continuing operations                                                                            |       | (2,633                                     | )          | 1,868 |   | 19 |   |
| Adjustments to reconcile  income from continuing operations to net cash provided by (used in) operating  activities: |       |                                       |       |   |   |   |   |
| Loss from discontinued operations                                                                                    |       | —                                     |       | — |   | (1,487 | ) |
| Change in net assets of discontinued operations                                                                      |       |                                       |       | 35 |   | 33 |   |
| Depreciation and amortization                                                                                        |       | 1,341                                      |       | 1,277 |   | 1,498 |   |
| Gain on disposal of property and equipment                                                                           |       | —                                     |       | — |   | (3 | ) |
| Provision for bad debts                                                                                              |       | (174                                       | )          | (223 | ) | 397 |   |
| Deferred income taxes                                                                                                |       | (1,483                                     | )          | 570 |   | (494 | ) |
| Shares issued for services                                                                                           |       | —                                     |       | 2 |   | 16 |   |
| Changes in operating  assets and liabilities:                                                                        |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                                                  |       | 881                                        |       | 490 |   | (1,315 | ) |
| Inventory                                                                                                            |       | (2,075                                     | )          | (670 | ) | (445 | ) |
| Income taxes receivable/payable                                                                                      |       | 517                                        |       | (607 | ) | (554 | ) |
| Prepaid expenses and other current assets                                                                            |       | 69                                         |       | 121 |   | 538 |   |
| Accounts payable                                                                                                     |       | 1,743                                      |       | (2,697 | ) | 1,206 |   |
| Accrued expenses                                                                                                     |       | 405                                        |       | 751 |   | (1,615 | ) |
| Accrued payroll and related liabilities                                                                              |       | (763                                       | )          | 817 |   | 92 |   |
| Net cash provided  by (used in) operating activities                                                                 |       | (2,172                                     | )          | 1,734 |   | (2,114 | ) |
| **Investing activities**                                                                                             |       |                                       |       |   |   |   |   |
| Purchases of  property and equipment                                                                                 |       | (691                                       | )          | (920 | ) | (384 | ) |
| Proceeds for sale  of property and equipment                                                                         |       | —                                     |       | — |   | 8 |   |
| Restricted cash                                                                                                      |       | —                                     |       | — |   | (5,000 | ) |
| Reduction of  goodwill arising from Prolab settlement                                                                |       | —                                     |       | 2,000 |   | — |   |
| Other assets                                                                                                         |       | 151                                        |       | (135 | ) | (44 | ) |
| Net cash provided  by (used in) investing activities                                                                 |       | (540                                       | )          | 945 |   | (5,420 | ) |
| **Financing activities**                                                                                             |       |                                       |       |   |   |   |   |
| Proceeds from  issuance of long-term debt                                                                            |       | —                                     |       | 750 |   | — |   |
| Repayments on  long-term debt                                                                                        |       | (490                                       | )          | (338 | ) | (303 | ) |
| Proceeds from  issuance of common stock                                                                              |       | 277                                        |       | 332 |   | 359 |   |
| Net cash provided  by (used in) provided by financing activities                                                     |       | (213                                       | )          | 744 |   | 56 |   |
| Net increase  (decrease) in cash and cash equivalents                                                                |       | (2,925                                     | )          | 3,423 |   | (7,478 | ) |
| Cash and cash  equivalents, beginning of year                                                                        |       | 6,022                                      |       | 2,599 |   | 10,077 |   |
| Cash and cash  equivalents, end of year                                                                              |       | $                                          | 3,097      |   | $ | 6,022 |   | $ | 2,599 |   |
| **Supplemental disclosures of  cash flow information**                                                               |       |                                       |       |   |   |   |   |
| Cash paid during the  year for:                                                                                      |       |                                       |       |   |   |   |   |
| Interest                                                                                                             |       | $                                          | 637        |   | $ | 630 |   | $ | 650 |   |
| Income taxes                                                                                                         |       | $                                          | 173        |   | $ | 1,174 |   | $ | 337 |   |

 

*See notes to consolidated financial statements.*

46

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**Natrol, Inc.Notes to Consolidated Financial Statements**

**1. Businessand Summary of Significant Accounting Policies**

***Description ofBusiness***

Natrol, Inc. and subsidiaries (collectively, the “Company”)manufactures and markets branded, high-quality dietary supplement productsunder three branded labels, Natrol, Laci Le Beau and Prolab. Our core Natrolbrand markets vitamins, minerals, hormonal supplements, herbal products, andspecialty combination formulations. The Laci Le Beau brand sells specialty teasand the Prolab brand markets sports nutrition products to athletes and otherhealth minded individuals. We sell our products through multiple channels ofdistribution that reach consumers through mass-market retailers, health foodstores, fitness centers, the Internet, catalogues and other points ofdistribution.

We also sell raw materialsand market limited contract manufacturing through our EPI division, whichoperates within our core operating unit.

***Principles of Consolidation***

The consolidated financialstatements include the accounts and operations of Natrol, Inc. and itswholly owned subsidiaries. All significant intercompany accounts have beeneliminated in consolidation.

***Estimates andAssumptions***

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions affecting the reported amounts in the consolidatedfinancial statements and accompanying notes. Actual results could differ fromthose estimates, although management does not believe any differences wouldmaterially affect our consolidated financial position or results of operations.

***Significant Risks and Uncertainties***

Product returns are a recurring part of our business.Estimating product returns requires significant management judgment. Productsmay be returned for various reasons including expiration dates or lack ofsufficient sales. During 2005, returns and reimbursements for damages andoutdated products were 6.2% of gross shipments, an increase from the 3.5% andthe 4.7%  of gross shipments experiencedin 2004 and 2003, respectively. In past years, the rate of returns has beenconsiderably higher reaching more than 14%. There is no guarantee that futurereturns will not increase to, or exceed, the levels experienced in the past.Furthermore, the possibility exists that should we lose a major account, we mayagree to accept a substantial amount of returns.

We monitor our inventoryand analyze it on a regular basis. Cycle counts are taken daily to verifyinventory levels. In addition, we analyze the movement of items within ourinventory in an effort to determine the likelihood that inventory will be soldor used before expiration dates are reached. We provide an allowance againstthat portion of inventory that we believe is unlikely to be sold or used beforeexpiration dates are reached. At December 31, 2005, inventory allowanceswere approximately $2.5 million.

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***Cash***

Substantially all of theCompany’s cash was held by one bank at December 31, 2005. The Company doesnot believe that, as a result of this concentration, it is subject to anyunusual financial risk beyond the normal risk associated with commercialbanking relationships.

***Restricted Cash***

Restrictedcash represents cash that has been deposited with an insurance company as partof our self-insurance program. The cash earns interest at a current rate of1.65% per annum, and will be returned should we terminate the policy. Thepolicy, which is cancelable by us, is effective through 2008.

***Inventory***

Inventory is stated at thelower of cost (determined by the first-in, first-out method) or market.

***Property andEquipment***

Property and equipment arestated at cost. Depreciation is computed using the straight-line method overthe estimated useful lives of the assets ranging from three-to-ten years forfurniture, machinery and equipment. Buildings are depreciated overforty years, and improvements are depreciated over periods ranging fromfive-to-forty years, using the straight-line method. Amortization of leaseholdimprovements is computed using the straight-line method over the shorter of theestimated useful lives of the assets or the lease terms. Depreciation expensein the years ended December 31, 2005, 2004 and 2003 amounted to $1,338,$1,277 and $1,496, respectively.

***Property held forsale***

At December 31, 2005, the Company’s facility inBloomfield, Connecticut. was for sale. This building became unoccupied when wemoved all of our Prolab subsidiary’s shipping and receiving functions fromConnecticut to our shipping and warehousing facility in Chatsworth, California.

The book value of theland, building and associated building improvements, net of accumulateddepreciation, amounted to approximately $0.8 million on December 31, 2005.The facility was sold in January 2006 for approximately $1.0 million.

***Long-Lived Assets***

We evaluate long-livedassets and certain identifiable intangibles for impairment whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of assets is measured by a comparison of thecarrying amount of an asset to future undiscounted net cash flows expected tobe generated by the asset. If such assets are considered to be impaired, theimpairment to be recognized is measured by the amount by which the carryingamount of the asset exceeds its fair value.

***Goodwill***

In June 2001, the Financial Accounting StandardsBoard (“FASB”) approved two new statements: Statement of Financial AccountingStandards (“SFAS”) No. 141, *BusinessCombinations*, and SFAS No. 142, *Goodwill and Other Intangible Assets*. SFAS No. 141requires business combinations entered into after June 30, 2001 to beaccounted for using the purchase method of accounting. SFAS No. 142requires that goodwill not be amortized, but be tested for impairment at leastannually. We adopted SFAS No. 142 on January 1, 2002. In accordancewith such adoption, we began testing goodwill for impairment annually at December 31in 2002.

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We performed our annual impairment test as of December 31for each of the years presented and concluded that goodwill was not impaired.

As part of our impairment test, we considered a numberof variables including, but not limited to, the market capitalization of theCompany, estimates of future earnings and discounted cash flows, third partyassessments of the value of the Company and transactions involving the purchaseand sale of businesses similar to ours.

As part of a legal settlement with the former ownersof Prolab, in 2004, we received $2.0 million, which was recorded asreduction of goodwill. The balance of goodwill as of December 31, 2004,therefore, was reduced to approximately $2 million.

Thechanges in the carrying value of goodwill for the years ended December 31,2003, 2004 and 2005 were as follows (in thousands):

| Balance,  December 31, 2002 and 2003            |   | $      | 4,026 |   |
|------------------------------------------------------|--------|--------|-------|--------|
| Reduction of  goodwill from legal settlement in 2004 |   | (2,000 | )     |
| Balance,  December 31, 2005 and 2004            |   | $      | 2,026 |   |

 

***Income Taxes***

Deferred income taxes areprovided for temporary differences between the financial statement and incometax bases of assets and liabilities, based on enacted tax rates. Managementprovides a valuation allowance when it believes it is more likely than not thatsome portion or all of the deferred income tax assets will not be realized.

***Revenue Recognition***

We sell our products toretail outlets through a direct sales force and a national broker network. Werecognize revenue from sales when product is shipped and risk of loss istransferred. We currently have no consignment accounts. If we had consignmentaccounts we would not recognize revenue until product was sold by theconsignment account to the consumer. Net sales represent product shipped lessactual and estimated returns, spoilage allowances, allowances for productdeemed to be unsaleable by customers, and slotting fees, rebates and otherexpenditures which, using Generally Accepted Accounting Principles (GAAP) inthe United States should be accounted for as reductions of revenue. Estimatesand allowances are based upon known claims and an estimate of additionalreturns when the amount of future returns can be reasonably estimated.

***Advertising Costs***

Advertising andpromotional costs are expensed as incurred. Advertising and promotional costswere (in thousands) $7,056, $6,122, and $5,427 for the years ended December 31,2005, 2004 and 2003, respectively. These amounts are exclusive of brochure andpublic relations expenses, as well as promotional and other costs that arenetted against sales revenue.

***Research and Development Costs***

Our research anddevelopment costs are expensed as incurred and were (in thousands) $964, $752and $608 for the years ended December 31, 2005, 2004 and 2003,respectively.

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***Shipping and Handling Costs***

We record all amountcharged to customers for shipping and handling as revenue. All shipping andfulfillment costs are classified as selling and marketing expenses and were (inthousands) $3,340, $3,432 and $3,172 for the years ended December 31,2005, 2004 and 2003, respectively.

***Stock-Based Compensation***

Weaccount for our employee stock option plan under the intrinsic value methodprescribed by Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations. We have a stock-based compensation plan. Our operatingresults do not include a compensation charge related to this plan, as alloptions granted had an exercise price equal to the market value of theunderlying common stock on the date of grant. The following table illustratesthe effect on the operating results and per share amounts if the fair valuerecognition provisions of Statement of Financial Accounting Standards No. 123,*Accounting for Stock-Based compensation,*hadbeen applied to stock-based employee compensation. SFAS 123 was adopted on January 1,2006 and option expenses will be included in our operating results beginning onthat date.

| ** **                                                                                                                                                                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                  | ** ** | **(in thousands)**                     | ** ** |
| Income (loss)  from continuing operations                                                                                                                                   |       | $                                           | (2,633     | ) | $ | 1,868 |   | $ | 19 |   |
| Total stock-based  employee compensation expense determined under the fair value-based method  for all awards, net of related tax benefits (“Stock Compensation”) |       | (38                                         | )          | (53 | ) | (222 | ) |
| Income (loss)  from continuing operations—pro forma                                                                                                                    |       | $                                           | (2,671     | ) | 1,815 |   | (203 | ) |
| Loss from  discontinued operations                                                                                                                                          |       | —                                      |       | — |   | (1,487 | ) |
| Net profit  (loss)—pro forma                                                                                                                                           |       | $                                           | (2,671     | ) | $ | 1,815 |   | $ | (1,690 | ) |
| Income (loss) per share  from continuing operations:                                                                                                                        |       |                                        |       |   |   |   |   |
| Basic—as reported                                                                                                                                                      |       | $                                           | (0.20      | ) | $ | 0.14 |   | $ | 0.00 |   |
| Basic—pro forma                                                                                                                                                        |       | $                                           | (0.20      | ) | $ | 0.14 |   | $ | (0.02 | ) |
| Diluted—as reported                                                                                                                                                    |       | $                                           | (0.20      | ) | $ | 0.14 |   | $ | 0.00 |   |
| Diluted—pro forma                                                                                                                                                      |       | $                                           | (0.20      | ) | $ | 0.14 |   | $ | (0.02 | ) |
| Net loss per share:                                                                                                                                                         |       |                                        |       |   |   |   |   |
| Basic—as reported                                                                                                                                                      |       | $                                           | (0.20      | ) | $ | 0.13 |   | $ | (0.11 | ) |
| Basic—pro forma                                                                                                                                                        |       | $                                           | (0.20      | ) | $ | 0.13 |   | $ | (0.13 | ) |
| Diluted—as reported                                                                                                                                                    |       | $                                           | (0.20      | ) | $ | 0.13 |   | $ | (0.11 | ) |
| Diluted—pro forma                                                                                                                                                      |       | $                                           | (0.20      | ) | $ | 0.13 |   | $ | (0.13 | ) |

 

Thefair value of the options is estimated using a Black-Scholes option-pricingmodel with the following weighted-average assumptions for grants:

| ** **                       | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|
| ** **                       | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Expected dividend  yield         |       | 0.0                                         | %          | 0.0 | % | 0.0 | % |
| Expected stock  price volatility |       | 63.0                                        |       | 64.6 |   | 68.7 |   |
| Risk free  interest rate         |       | 3.9                                         | %          | 3.6 | % | 3.0 | % |
| Expected life of options         |       | 5 years                                     |       | 5 years |   | 5 years |   |

 

These assumptions resulted in weighted-average fairvalues of $1.54, $1.66 and $0.87 for each stock option granted in 2005, 2004and 2003, respectively.

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In connection with hisappointment as President and CEO, Mr. Bos was awarded fully vested optionsto purchase 6,029,500 shares of the Company’s common stock with a strike priceof $2.282 per share. The strike price was equal to the price of the lastreported trade immediately prior to the time the Board determined to grant thisoption and therefore reflects the fair market value of our common stock at thetime of the grant. For a period of three years, Mr. Bos’s ability to sellthe majority of the shares he receives upon exercise of these options isrestricted, with the restrictions lapsing based upon the stock price reachingdefined hurdles. The grant is subject to shareholder approval. The grant willresult in a charge to operating earnings during the first quarter of 2006. Theamount of the charge has not yet been determined.

***Income (Loss) Per Share***

We calculate income (loss) per share in accordancewith SFAS No. 128, *Earnings per Share*.Basic income (loss) per share has been computed by dividing net income (loss)by the weighted-average number of common shares outstanding during the period.Diluted income (loss) per share has been computed by dividing net income (loss)by the weighted average number of common shares and dilutive common stockequivalents (stock options).

Stock options to purchase2,310,820, 2,442,000 and 2,950,000 shares of common stock at December 31,2005, 2004 and 2003, respectively, were outstanding and of these shares,2,310,820, 520,000 and 2,950,000 were respectively considered anti-dilutive.

***Fair Value of Financial Instruments***

The carrying value ofcertain financial instruments, including cash, accounts receivable, accountspayable and accrued expenses approximates fair market value based on theirshort-term nature. The fair value of the our long-term notes payable isestimated using discounted cash flow analyses, based on our current incrementalborrowing rates for similar types of borrowing arrangements. The estimated fairvalue of long-term notes payable exceeded the carrying value by approximately$0.3 million at December 31, 2005.

***Concentration of Credit Risk***

Financial instruments, which potentially subject us toconcentration of credit risk, consist principally of cash and accountsreceivable. We believe our exposure as it relates to cash is limited due to thefact that the cash we have is placed with our bank, which has a strongfinancial position. Significant portions of our sales are made directly to massmerchandisers and national retailers. Due to the increased volume of sales tothese channels, we have experienced an increased concentration of credit risk,and as a result, may at anytime have individually significant receivablebalances with such mass merchandisers and national retailers. While we monitorand manages this risk, financial difficulties on the part of one or more majorcustomers may have a material adverse effect. We perform ongoing creditevaluations of customers and maintain an allowance for potential credit losses.

One customer representedmore than 10% of our net sales in 2005 and no customer represented 10% or moreof our net sales in 2004 and 2003, respectively. Two accounts represented morethan 10% of our net accounts receivable as of December 31, 2005.  At December 31, 2004 no customeraccounted for more than 10% our trade receivables and one customer representedapproximately 16% of net accounts receivable at December 31, 2003.

***Recently Issued Accounting Standards***

In May 2005, the FASB issued FASB Statement No. 154,*Accounting Changes and Error Corrections.*This new standard replaces APB Opinion No. 20,*Accounting Changes,* and FASB Statement No. 3,*Reporting Accounting Changes in Interim FinancialStatements*, and represents another step in the FASB’s 

51

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goal to converge itsstandards with those issued by the IASB. Among other changes, Statement 154requires that a voluntary change in accounting principle be appliedretrospectively with all prior period financial statements presented on the newaccounting principle, unless it is impracticable to do so. Statement 154 alsoprovides that (1) a change in method of depreciating or amortizing along-lived nonfinancial asset be accounted for as a change in estimate(prospectively) that was effected by a change in accounting principle, and (2) correctionof errors in previously issued financial statements should be termed a “restatement.”The new standard is effective for accounting changes and correction of errorsmade in fiscal years beginning after December 15, 2005. Early adoption ofthis standard is permitted for accounting changes and correction of errors madein fiscal years beginning after June 1, 2005.

In March 2005, the SEC released Staff AccountingBulletin No. 107, “Share-Based Payment” (“SAB 107”), which providesinterpretive guidance related to the interaction between SFAS 123 and certainSEC rules and regulations. It also provides the SEC staff’s views regardingvaluation of share-based payment arrangements. In April 2005, the SECamended the compliance dates for SFAS 123, to allow companies to implement thestandard at the beginning of their next fiscal year, instead of the nextreporting period beginning after June 15, 2005.

In February 2006, theFASB issued FASB Statement No. 155, Accounting for Certain HybridFinancial Instruments. This Statement amends FASB Statements No. 133,Accounting for Derivative Instruments and Hedging Activities, and No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishmentsof Liabilities. As we do not issue or expect to issue hybrid financialinstruments, we do not believe this pronouncement will have any material effecton our financial reporting.

**2. Inventory**

Inventoryconsists of the following:

| ** **                           | ** ** | **December 31,**   | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| Raw material and  packaging supplies |       | $                       | 7,547      |   | $ | 5,357 |   |
| Finished goods                       |       | 4,250                   |       | 4,366 |   |
|                                 |       | $                       | 11,797     |   | $ | 9,723 |   |

 

Two of our suppliers eachaccounted for more than 10% of our inventory purchases in 2005. The loss ofeither supplier could have a material adverse effect on our ability to produceand sell goods. We do not have a long-term supply agreement with thesesuppliers.

**3. Financing**

During 1999, we entered into two mortgage notespayable in the aggregate amount of approximately $8,900,000, collateralized byour facilities. These notes are payable in monthly installments ofapproximately $74,000 in the aggregate, including interest ranging from 7.75%to 8.32%, maturing in 2014 and 2019.

In November 4, 2004, we executed a Revolving Notein favor of CNB for the principal sum of $3,000,000. This revolving noteexpired in December 2005 and we are currently renegotiating the terms of apotential line of credit. We also executed a Promissory Note in favor of CNBfor the original principal sum of $750,000. The $750,000 note payable iscollateralized by our non-real estate assets. This note is payable in monthlyinstallments of approximately $12,500 over 5 years plus interest at a variable rate based upon prime plus apremium of .75%. The initial rate upon entering into the note was 5.5%. Theprime rate at December 31, 2005 was 7.25%.

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Futurematurities of long-term debt at December 31, 2005 are as follows (inthousands):

| 2006       |   | $     | 532    |   |
|------------|--------|-------|--------|--------|
| 2007       |   | 564   |   |
| 2008       |   | 598   |   |
| 2009       |   | 637   |   |
| 2010       |   | 527   |   |
| Thereafter |   | 4,841 |   |
| Total      |   | $     | 7,699  |   |

 

**4. Income Taxes**

Theincome tax (benefit) provision consists of the following (in thousands):

| ** **                                              | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current:                                                |       |                                        |       |   |   |   |   |
| Federal                                                 |       | $                                           | (402       | ) | $ | 540 |   | $ | 526 |   |
| State                                                   |       | (32                                         | )          | 34 |   | 2 |   |
| Total current                                           |       | (434                                        | )          | 574 |   | 528 |   |
| Deferred                                                |       | (1,484                                      | )          | 570 |   | (494 | ) |
| Total income  taxes (benefit) for continuing operations |       | $                                           | (1,918     | ) | $ | 1,144 |   | $ | 34 |   |
| Income tax benefit from  discontinuing operations       |       | —                                      |       | $ | — |   | $ | (821 | ) |

 

Thedifference between actual income tax provision (benefit) and the amountcomputed using the U.S. federal statutory income tax rate is as follows (inthousands):

| ** **                                                          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Statutory rate  applied to income (loss) from continuing operations |       | $                                           | (1,547     | ) | $ | 1,008 |   |   | $ | 19 |   |   |
| State tax  provision                                                |       | (172                                        | )          | 115 |   |   | 2 |   |   |
| Other                                                               |       | (199                                        | )          | 21 |   |   | 13 |   |   |
| Income tax provision  from continuing operations                    |       | $                                           | (1,918     | ) | $ | 1,144 |   |   | $ | 34 |   |   |

 

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Thesignificant components of our deferred income tax assets and liabilities are asfollows (in thousands):

| ** **                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Deferred income tax  assets:      |       |                                        |       |   |   |   |   |
| Accounts receivable allowances    |       | $                                           | 98         |   | $ | 167 |   | $ | 253 |   |
| Inventory                         |       | 883                                         |       | 573 |   | 565 |   |
| Accrued liabilities               |       | 1,235                                       |       | 838 |   | 780 |   |
| Goodwill impairment               |       | 2,808                                       |       | 3,191 |   | 3,572 |   |
| Net operating loss carryforward   |       | 1,317                                       |       | — |   | 107 |   |
| Other                             |       | 0                                           |       | 107 |   | 72 |   |
|                              |       | 6,341                                       |       | 4,876 |   | 5,349 |   |
| Deferred tax income  liabilities: |       |                                        |       |   |   |   |   |
| Federal effect of state taxes     |       | (282                                        | )          | (223 | ) | (271 | ) |
| Depreciation                      |       | (133                                        | )          | (211 | ) | (66 | ) |
| Net deferred tax assets           |       | $                                           | 5,926      |   | $ | 5,012 |   | $ | 5,012 |   |

 

As of December 31,2005 and 2004 the Company had net operating loss carryforwards for federal andstate income tax purposes of approximately $3,333 and $3,143 respectively whichbegin to expire in the years 2025 and 2015.

**5. Stockholders’ Equity**

***Stock RepurchaseProgram***

In 2000, the Board of Directors authorized a stockrepurchase program for our common stock. Under the stock repurchase program, wecan effect common stock repurchases from time to time up to an aggregate of$10,000,000. The stock repurchase program does not have an expiration date. Nosuch repurchases were made in 2005 or 2004.

***Stock Options***

Under our 1996 Stock Option and Grant Plan, as amended(the “Plan”), the Board of Directors is authorized to grant incentive stockoptions or non-qualified stock options. Incentive stock options may be grantedonly to employees. Non-qualified stock options may be granted to officers andemployees as well as to non-employees. The maximum number of shares to beissued under the Plan is 3,468,568 shares, as amended. All options grantedunder the Plan have been made at prices not less than the fair market value ofthe stock at the date of grant. Generally, the options granted under the Planvest over three-to-five years. Options granted under the Plan have a term ofnot more than 10 years.

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Asummary of our stock option activity and related information is as follows (inthousands, except per share data):

| ** **                             | ** ** | **Number of  Options  (000’s)** | ** ** | **Weighted-Average  Exercise Price  Per Share** | ** ** | **Exercise Price  Per Share** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------|------------|
| Outstanding at  December 31, 2002 |       |                                      | 2,916      |                                                      |       |                                    | $          | 3.10 |   |   | $ | 1.10—$13.00 |   |
| Granted                                |       |                                      | 361        |                                                      |       |                                    | 1.31       |   |   | 1.10—2.04 |   |
| Forfeited                              |       |                                      | (111       | )                                                         |       |                                    | 2.23       |   |   | 1.45—6.03 |   |
| Exercised                              |       |                                      | (217       | )                                                         |       |                                    | 1.48       |   |   | 1.15—1.50 |   |
| Outstanding at December 31, 2003  |       |                                      | 2,949      |                                                      |       |                                    | 2.89       |   |   | 1.10—13.00 |   |
| Granted                                |       |                                      | 90         |                                                      |       |                                    | 2.84       |   |   | 2.67—3.04 |   |
| Forfeited                              |       |                                      | (405       | )                                                         |       |                                    | 3.35       |   |   | 1.10—6.03 |   |
| Exercised                              |       |                                      | (192       | )                                                         |       |                                    | 1.30       |   |   | 1.15—1.50 |   |
| Outstanding at December 31, 2004  |       |                                      | 2,442      |                                                      |       |                                    | 3.07       |   |   | 1.10—13.00 |   |
| Granted                                |       |                                      | 65         |                                                      |       |                                    | 2.72       |   |   | 1.74—3.09 |   |
| Forfeited                              |       |                                      | (49        | )                                                         |       |                                    | 5.16       |   |   | 1.32—10.40 |   |
| Exercised                              |       |                                      | (147       | )                                                         |       |                                    | 1.38       |   |   | 1.10—1.94 |   |
| Outstanding at  December 31, 2005 |       |                                      | 2,311      |                                                      |       |                                    | 3.07       |   |   | 1.15—13.00 |   |
|                                        |            |                                           |            |                                                           |            |                                         |            |  |  |  |  |  |  |

 

At December 31,2005, 951,617 shares were available for future grant. The weighted-averageremaining contractual life for the outstanding options in years was 4.84, 5.57,and 6.91 at December 31, 2005, 2004 and 2003, respectively.

| ** **                                  | ** ** | **Options Outstanding** | ** ** | ** **                            | ** ** | ** **                                    | ** ** |
|---------------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                  | ** ** | ** **                   | ** ** | **Weighted Average**             | ** ** | ** **                                    | ** ** | **Weighted Average** | ** ** |
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number  Outstanding  (000’s)** | ** ** | **Remaining  Contractual Life  (Years)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares  Exercisable  (000’s)** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $1.15—$2.35                            |       |                         | 1,726      |                                  |       |                                          | 5.04       |   |   |   | $ | 1.71 |   |   |   | 1,698 |   |   |   | $ | 1.71 |   |   |
| $2.67—$6.03                            |       |                         | 310        |                                  |       |                                          | 5.73       |   |   |   | 4.12 |   |   |   | 238 |   |   |   | 4.48 |   |   |
| $7.75—$13.00                           |       |                         | 275        |                                  |       |                                          | 2.60       |   |   |   | 10.90 |   |   |   | 275 |   |   |   | 10.90 |   |   |
| Total                                       |       |                         | 2,311      |                                  |       |                                          | 4.84       |   |   |   | $ | 3.13 |   |   |   | 2,211 |   |   |   | $ | 3.14 |   |   |
|                                             |            |                              |            |                                       |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**6. Commitments and Contingencies**

We lease some equipment under noncancelable operatingleases that expire in various years through 2006. Rent expense under operatingleases totaled approximately $160,000, $162,000 and $155,000, for the yearsended December 31, 2005, 2004 and 2003, respectively.

Futureminimum lease payments under noncancelable operating leases with initial termsof one year or more consisted of the following at December 31, 2005 (inthousands):

| 2005                          |   | $  | 110    |   |
|-------------------------------|--------|----|--------|--------|
| 2006                          |   | 73 |   |
| 2007                          |   | 12 |   |
| 2008                          |   | 11 |   |
| 2009                          |   | 4  |   |
| Total minimum lease  payments |   | $  | 210    |   |

 

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Welease part of our shipping facility and future minimum lease payments due to usare (in thousands):

| 2005  |   | $   | 393    |   |
|-------|--------|-----|--------|--------|
| 2006  |   | 404 |   |
| 2007  |   | 417 |   |
| 2008  |   | 429 |   |
| 2009  |   | 367 |   |
| Total |   | $   | 2,010  |   |

 

However, as of year-end, our tenant was in arrears. InFebruary 2006, this tenant formally notified us of its intent to vacatethe facility and we have commissioned a broker to find a new tenant. Althoughthe tenant is responsible for all rent through the term of the lease, andalthough we are attempting to collect rent due us, there is no guarantee thatthe tenant will be able to pay us for rent owed even if a formal legalsettlement is reached.

We are party to certainlegal actions arising in the normal course of business. In the opinion ofmanagement, the ultimate outcome of such litigations will not have a materialadverse effect on our financial position or results of operations.

**7. Employee Benefits Plans**

We have a profit sharing 401(k) plan that coverssubstantially all of our employees. Eligible employees may contribute up to themaximum allowed under law. Contributions are discretionary. However, wegenerally match 10.0% of the employees’ contributions up to the maximum of 1.0%of eligible compensation. Amounts recognized as expense were approximately$22,000, $33,000 and $26,000, for the years ended December 31, 2005, 2004and 2003, respectively.

In 1998, the Board of Directors approved the Natrol, Inc.Employee Stock Purchase Plan (ESPP), which allows substantially all employeesto purchase shares of our common stock, through payroll deductions, at 85.0% ofthe fair market value of the shares at the beginning or end of the offeringperiod, whichever is lower. We expense two thirds of the 15.0% discount givento employees under the plan. The ESPP provides for employees to authorizepayroll deductions of up to 10.0% of their compensation for each pay period. Inconjunction with the ESPP, we registered with the SEC 225,000 shares of theCompany’s common stock reserved for purchase under the ESPP. As of December 31,2005 and 2004, 64,920 and 93,453, respectively were available for issuanceunder this plan. For the year ended December 31, 2005, 28,533 shares wereissued at prices ranging from $1.36 to $2.39. For the year ended December 31,2004, 34,419 shares were issued at $2.33 per share. For the year ended December 31,2003, 38,267 shares were issued at $0.98 per share.

In 2004 and 2005, weadopted a bonus program for certain employees. The bonuses granted aredependent upon a formula based on corporate profits before taxes and interest.No bonus payments were issued to employees under the plan in 2005. The amountof bonus expensed in 2004 relative to this plan was approximately $600,000.

**8. Impairment of Goodwill**

In 2002, we adopted SFAS No. 142, “Goodwilland Other Intangible Assets.” SFAS No. 142 requires that goodwill not beamortized. Beginning in 2002, we have evaluated goodwill for impairmentannually, or whenever events or changes in circumstances indicate that thecarrying amount of goodwill may not be recoverable. We have performed thisevaluation annually, ever since, as of December 31 of each year.

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The remaining goodwill balance at December 31,2003 was approximately $4 million. In the fourth quarter of 2003, wecompleted our annual goodwill impairment testing and determined that goodwillwas not impaired. Additionally, during March 2004, we settled litigationwith the former owners of Prolab Nutrition, Inc. We received$2.0 million in cash, which was reflected in the financial statements forthe quarter ending March 31, 2004 as a reduction of goodwill. Wedetermined that this was the proper accounting for the settlement because thesellers did not deliver a key asset in the condition warranted, which was aclear and direct link to the purchase price, and accordingly resulted in apurchase price adjustment reducing goodwill, as opposed to a charge to income.

We performed an annualimpairment test as of December 31 for each of the years presented anddetermined that no impairment existed. In all years in which impairment wastested, we considered a number of variables including, but not limited to, themarket capitalization of the Company, estimates of future earnings anddiscounted cash flows, third party assessments of the value of the Company andtransactions involving the purchase and sale of businesses similar to ours.

**9. Discontinued Operations**

In December 2003, we discontinued our Annasa andTamsol units. Annasa, a subsidiary of Natrol and a multi-level marketer ofproprietary nutritional products began operations in 2002. Tamsol was alsoformed in 2002, to generate direct-to-consumer sales via radio, television,direct mail and other non-retail venues. We have reclassified our financialstatements to segregate the revenues, direct costs and expenses (excludingallocated costs), assets and liabilities and cash flows of the discontinuedoperations. The net operating results, net assets and net cash flows of thesebusinesses have been reported as “Discontinued Operations” in the accompanyingconsolidated financial statements.

Summarizedfinancial information for the discontinued operations is as follows (inthousands):

| ** **                              | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|
| Annasa:                                 |       |                        |       |   |   |
| Revenue                                 |       |                        | $          | 667 |   |   |
| Gross Margin                            |       |                        | 452        |   |   |
| Selling and  Marketing expenses         |       |                        | 1,224      |   |   |
| General and  administrative             |       |                        | 994        |   |   |
| Loss from  operations                   |       |                        | (1,766     | ) |   |
| Income tax  benefit                     |       |                        | 616        |   |   |
| Net loss                                |       |                        | $          | (1,150 | ) |   |
| Tamsol:                                 |       |                        |       |   |   |
| Revenue                                 |       |                        | $          | 30 |   |   |
| Gross Margin                            |       |                        | 30         |   |   |
| Selling and Marketing  expenses         |       |                        | 152        |   |   |
| General and  administrative             |       |                        | 420        |   |   |
| Loss from  operations                   |       |                        | (542       | ) |   |
| Income tax  benefit                     |       |                        | 205        |   |   |
| Net loss                                |       |                        | $          | (337 | ) |   |
| Net assets of  discontinued operations: |       |                        |       |   |   |
| Current assets                          |       |                        | $          | 115 |   |   |
| Total assets                            |       |                        | 150        |   |   |
| Current liabilities                     |       |                        | 115        |   |   |
| Net assets of  discontinued operations  |       |                        | 35         |   |   |

 

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**10. Operating Segments**

Prior to the fourthquarter of 2003, we reported revenue and income through three operatingsegments: Natrol, Annasa and Prolab. As discussed in Note 9, Annasa wasdiscontinued in the fourth quarter of 2003. Additionally, we consolidated theProlab operating unit into the core Natrol operating unit as of October 1,2003 and as of that date Prolab began operating as a brand within the coreoperating unit similar to our other brands. As of October 1, 2003, we nolonger considered Prolab a separate operating segment. As a result, segmentoperating results are no longer being reported.

**11. SelectedQuarterly Financial Data (unaudited)**

| ** **                           | ** ** | **2005 Quarters Ended**                                     | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                           | ** ** | **March 31,**                                                    | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                           | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net sales                            |       |                                                                  | $          | 17,669 |   |   | $ | 19,604 |   |   | $ | 15,390 |   |   |   | $ | 14,867 |   |   |
| Gross profit                         |       |                                                                  | 6,265      |   |   | 7,528 |   |   | 5,506 |   |   |   | 4,125 |   |   |
| Net income                           |       |                                                                  | (592       | ) |   | 291 |   |   | (742 | ) |   |   | (1,590 | ) |   |
| Basic and diluted income  per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic income per share               |       |                                                                  | $          | (0.04 | ) |   | $ | 0.02 |   |   | $ | (0.05 | ) |   |   | $ | (0.12 | ) |   |
| Diluted income  per share            |       |                                                                  | $          | (0.04 | ) |   | $ | 0.02 |   |   | $ | (0.05 | ) |   |   | $ | (0.12 | ) |   |

 

| ** **                           | ** ** | **2004 Quarters Ended**                                     | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                           | ** ** | **March 31,**                                                    | ** ** | **June 30,** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                           | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Net sales                            |       |                                                                  | $          | 20,425 |   |   | $ | 20,682 |   |   | $ | 20,879 |   |   |   | $ | 17,283 |   |   |
| Gross profit                         |       |                                                                  | 7,830      |   |   | 9,344 |   |   | 8,665 |   |   |   | 6,610 |   |   |
| Net income                           |       |                                                                  | 450        |   |   | 769 |   |   | 384 |   |   |   | 265 |   |   |
| Basic and diluted  income per share: |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic income per share               |       |                                                                  | $          | 0.03 |   |   | $ | 0.06 |   |   | $ | 0.03 |   |   |   | $ | 0.02 |   |   |
| Diluted income  per share            |       |                                                                  | $          | 0.03 |   |   | $ | 0.05 |   |   | $ | 0.03 |   |   |   | $ | 0.02 |   |   |

 

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Natrol, Inc.and Subsidiaries Schedule II—Valuation and Qualifying Accounts Years EndedDecember 31, 2005, 2004 and 2003

| **Description**                    | ** ** | ** ** | ** ** | **Balance at  Beginning  of Year** | ** ** | **Charged to  Cost and  Expense** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|------------------------------------|------------|------------|------------|----------------------------------------------|------------|---------------------------------------------|------------|----------------|------------|--------------------------------------------|------------|
| Allowance for Doubtful Accounts:   |       |       |       |                                         |       |                                        |       |           |       |                                       |       |   |   |   |   |   |   |
| Year ended December 31, 2003  |       |       | $          | 409                                          |       |                                        |       | $              | 397        |                                       |       |   | $ | 171 |   |   |   | $ | 635 |   |   |
| Year ended December 31, 2004  |       |       | $          | 635                                          |       |                                        |       | $              | (223       | )                                          |       |   | $ | (9 | ) |   |   | $ | 421 |   |   |
| Year ended December 31, 2005  |       |       | $          | 421                                          |       |                                        |       | $              | 147        |                                       |       |   | $ | 321 |   |   |   | $ | 247 |   |   |
| Allowance for Sales Returns:       |       |       |       |                                         |       |                                        |       |           |       |                                       |       |   |   |   |   |   |   |
| Year ended December 31, 2003  |       |       | $          | 1,593                                        |       |                                        |       | $              | 4,014      |                                       |       |   | $ | 4,372 | (1) |   |   | $ | 1,235 |   |   |
| Year ended December 31, 2004  |       |       | $          | 1,235                                        |       |                                        |       | $              | 3,172      |                                       |       |   | $ | 3,340 | (1) |   |   | $ | 1,067 |   |   |
| Year ended  December 31, 2005 |       |       | $          | 1,067                                        |       |                                        |       | $              | 4,874      |                                       |       |   | $ | 3,664 | (1) |   |   | $ | 2,277 |   |   |

----

(1)          Representsactual returns of goods

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**ITEM 9.**                CHANGES ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

On December 22,2004, the Audit Committee of the Board of Directors of Natrol informed Deloitte &Touche, LLP (Deloitte), our  independentpublic accountants for the fiscal year ended December 31, 2003, of ourdecision to no longer engage Deloitte & Touche, LLP as the Company’sindependent public accountants. On December 22, 2004, the Audit Committeeof the Board of Directors of Natrol engaged Stonefield Josephson, Inc. toserve as our independent public accountants for the fiscal year ended December 31,2004. On December 28, 2004, Natrol filed a Form 8-K announcingthis change in independent public accountants.

Deloitte’s independentauditors’ reports on our consolidated financial statements for each of thefiscal years in the two-year period ended December 31, 2003 did notcontain an adverse opinion, or disclaimer of opinion, nor were they qualifiedor modified as to uncertainty, audit scope or accounting principles. During thetwo fiscal years ended December 31, 2003 and the subsequent interim periodthrough December 22, 2004, there were no disagreements with Deloitte onany matter of accounting principles or practice, financial statementdisclosure, or auditing scope or procedure which, if not resolved to Deloitte’ssatisfaction, would have caused them to make reference to the subject matter ofthe disagreement in connection with their reports on our consolidated financialstatements for such periods; and there were no reportable events as defined inItem 304(a)(1)(v) of Regulation S-K during the two fiscal years endedDecember 31, 2003 and the subsequent interim period through December 22,2004.

Duringthe fiscal years ended December 31, 2002 and 2003 and through December 22,2004, we did not consult Stonefield Josephson, Inc. with respect to theapplication of accounting principles to a specified transaction, eithercompleted or proposed, or the type of audit opinion that might be rendered onour consolidated financial statements, or any other matters or reportableevents as set forth in Items 304(a)(2)(i) and (ii) ofRegulation S-K.

**Item 9A.**                *Disclosure Controls and Procedures*

*Evaluation of DisclosureControls and Procedures.**  *We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our principal executive and principal financial officers,as appropriate, to allow for timely decisions regarding required disclosure.

In designing and evaluating the disclosure controlsand procedures, we recognize that any controls and procedures, no matter howwell designed and operated, can provide only reasonable assurance of achievingthe desired control objectives, and we are required to apply our judgment inevaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), wecarried out an evaluation, under the supervision and with the participation ofour management, including our principal executive and principal financialofficers, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the year covered by this report. Basedon the foregoing, our principal executive and principal financial officers haveconcluded that our disclosure controls and procedures were effective at areasonable assurance level.

*Changesin Internal Control Over Financial Reporting.**  *There were no changes in ourinternal control over financial reporting that occurred during the last fiscalquarter that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

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**Item 9B.****               *Other Information***

None.

**PART III**

Information required underPart III (Items 10, 11, 12, 13, and 14 other than the information requiredby Item 201(d) of Regulation S-K for Item 12) is incorporatedherein by reference to the Company’s definitive proxy statement to be filedwith the SEC within 120 days after the year covered by this Form 10-Kwith respect to its Annual Meeting of Stockholders to be held in June 2006.

**ITEM 12.**         SECURITESAUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

The following tableprovides information as of December 31, 2005 regarding shares of ourcommon stock that may be used under our existing equity compensation plans,including the 1996 Stock Option and Grant Plan (the “1996 Plan”) and the 1998Employee Stock Purchase Plan.

**EquityCompensation Plan Information Table—Overview**

| ** **                                                  | ** ** | **Equity Compensation Plan Information** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Plan category**                                      | ** ** | ** **                                              | ** ** | **Number of  Securities to be  Issued Upon  Exercise of  Outstanding  Options, Warrants  and Rights(1)  (a)** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights  (b)** | ** ** | **Number of Securities  Remaining Available  for Future Issuance  Under Equity  Compensation Plans  (Excluding Securities  Reflected in Column  (a))(c)** | ** ** |
| Equity  compensation plans approved by security holders     |       |                                                    | 2,310,820  |   |   |   | $ | 3.13 |   |   |   | 1,157,766 | (1) |   |
| Equity  compensation Plans not approved by security holders |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total                                                       |       |                                                    | 2,310,820  |   |   |   | $ | 3.13 |   |   |   | 1,157,766 | (1) |   |
|                                                             |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Includes sharesavailable for future issuance under the ESPP.

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**PART IV**

**ITEM15.**         EXHIBITS AND FINANCIALSTATEMENT SCHEDULES

|        | ** ** | ** **                                                                                                                                                                                                   | ** ** | **Page** |
|--------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| (a)(1) |       | Consolidated Financial Statements                                                                                                                                                                            |       |     |
|   |       | The financial statements  included in this Annual Report on Form 10-K are provided under  Item 8.                                                                                                       |       |     |
| (a)(2) |       | Index to Consolidated  Financial Statement Schedules:                                                                                                                                                        |       |     |
|   |       | Schedule II—Valuation and Qualifying Accounts                                                                                                                                                      |       | 59       |
|   |       | All other schedules for  which provision is made in the applicable accounting regulations of the SEC  are not required under the related instructions or are not material, and  therefore have been omitted. |       |     |

 

(a)(3) Index to Exhibits:

| Articles of Incorporation and By-Laws:                                      |
|-----------------------------------------------------------------------------|
|  3.1                                                                   |   | The Third Amended and  Restated Certificate of Incorporation of the Company incorporated herein by  reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K,  as amended, filed on March 31, 1999. |
|  3.2                                                                   |   | The Amended and Restated  By-Laws of the Company (incorporated herein by reference to Exhibit 3.6  to the Company’s Amendment No. 2 to Registration Statement on  Form S-1, as amended, File No. 333-52109). |
| Instruments Defining the  Rights of Security Holders, Including Indentures: |
|  4.1                                                                   |   | Specimen Stock Certificate  for shares of Common Stock, $.01 par value, of the Company (incorporated  herein by reference to Exhibit 4.1 to the Company’s Registration  Statement on Form S-1, as amended, File No. 333-52109). |
| Material Contracts                                                          |
| 10.1                                                                        |   | Natrol, Inc.  Amended and Restated 1996 Stock Option Plan (incorporated herein by reference  to Appendix A filed on May 2, 2000 Proxy Statement); |
| 10.2                                                                        |   | Natrol, Inc.  Employee Stock Purchase Plan (incorporated herein by reference to  Exhibit 10.3 to the Company’s Registration Statement on Form S-1,  as amended, File No. 333-52109); |
| 10.3                                                                        |   | Form of  Indemnification Agreement between Natrol, Inc. and each of its directors  (incorporated herein by reference to Exhibit 10.4 to the Company’s  Registration Statement on Form S-1, as amended, File No. 333-52109); |
| 10.4                                                                        |   | Form of Incentive  Stock Option Agreement of the Natrol, Inc. Stock Option and Grant Plan  (incorporated herein by reference to Exhibit 10.9 to the Company’s  Registration Statement on Form S-1, as amended, File No. 333-52109); |
| 10.5                                                                        |   | Amended and Restated  Credit Agreement with Wells Fargo Bank, N. A (incorporated herein by  reference to Exhibit 10.9 to the Company’s Registration Statement on  Form S-1, as amended, File No. 333-52109); |
| 10.6                                                                        |   | Credit Agreement with  Wells Fargo Bank, N.A., dated as of March 1, 2001; (incorporated herein  by reference to Exhibit 10.6 to the Company’s Form 10-K)  filed on March 30, 2001. |

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| 10.7  |   | Revolving Line of Credit  Agreement with Wells Fargo Bank, N.A., dated as of March 1, 2001,  (incorporated herein by reference to Exhibit 10.7 to the Company’s  Form 10-K filed March 30, 2001;                                                                                                                                                                              |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8  |   | Supply Agreement, dated  as of February 8, 1998, by and between the Company and Basic Vegetable  Products, L.P. (incorporated herein by reference to Exhibit 10.10 to the  Company’s Registration Statement on Form S-1, as amended, File  No. 333-52109);                                                                                                                    |
| 10.9  |   | Assignment and Amendment  to Supply and Royalty Supply Agreement, dated as of November 7, 2000 by  and between the Company and ConAgra Foods, Inc., (incorporated by  reference to Exhibit 10.9 to the Company’s Form 10-K filed on  March 30, 2001;                                                                                                                     |
| 10.10 |   | Bonus Compensation Plan  (incorporated by reference to Exhibit 10.10 to the Company’s  Form 10-K filed on April 14, 2004). Code of Ethics  (incorporates herein by reference to Exhibit 99.1 to the Company’s  Form 8-K filed on June 9, 2004). Agreement withWayne Bos  filed as an exhibit to Company’s Form 8-K filed on  February 21, 2006. |
| 21.1  |   | Subsidiaries of  Natrol, Inc.                                                                                                                                                                                                                                                                                                                                                                     |
| 23.1  |   | Consent of Experts and  Counsel: Consent of Stonefield Josephson, Inc. is filed herewith as  Exhibit 23.1.                                                                                                                                                                                                                                                                                   |
| 23.2  |   | Consent of Experts and  Counsel: Consent of Deloitte & Touche, LLP is filed herewith as  Exhibit 23.2                                                                                                                                                                                                                                                                                    |
| 31.1  |   | Certification of Chief  Executive Officer pursuant to section 302 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                              |
| 31.2  |   | Certification of Chief  Financial Officer pursuant to section 302 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                              |
| 32.1  |   | Certification of Chief  Executive Officer pursuant to section 901 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                              |
| 32.2  |   | Certification of Chief  Financial Officer pursuant to section 901 of the Sarbanes Oxley Act of  2002                                                                                                                                                                                                                                                                                              |

 

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**SIGNATURE**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this Form 10-K to besigned on its behalf by the undersigned, thereunto duly authorized, this 30th day of March, 2006.

NATROL, INC.

|        | By:      | /s/ WAYNE BOS                           |
|--------|----------|-----------------------------------------|
|   |     | Wayne  Bos                              |
|   | * * | *President and Chief Executive Officer* |

Date:March 30, 2006

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons on behalf of the Registrant and in the capacities indicatedand on the dates indicated.

| Signatures Signed         | ** ** | ** **                                                                                                                     | ** ** | **Title**           | ** ** | **Date** |
|---------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|----------|
| Elliott Balbert           |       | Chairman of the Board and Executive Chairman                                                                                   |       | March 30, 2006 |
| Wayne Bos                 |       | President, Chief Executive Officer and Director  (Principal Executive Officer)                                                 |       | March 30, 2006 |
| Dennis Jolicoeur          |       | Chief Financial Officer, Executive Vice President and  Director (Principal Financial Officer and Principal Accounting Officer) |       | March 30, 2006 |
| Vernon Brunner            |       | Director                                                                                                                       |       | March 30, 2006 |
| Dennis De Concini         |       | Director                                                                                                                       |       | March 30, 2006 |
| Ronald Consiglio          |       | Director                                                                                                                       |       | March 30, 2006 |
| Thomas  Doorley, III |       | Director                                                                                                                       |       | March 30, 2006 |

 

 

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